UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Fiscal Year Ended September 30, 2006 OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File Number: 0-23333
TIMBERLAND BANCORP, INC.
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(Exact name of registrant as specified in its charter)
Washington 91-1863696
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(State or other jurisdiction of incorporation (I.R.S. Employer
or organization) Identification Number)
624 Simpson Avenue, Hoquiam, Washington 98550
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (360) 533-4747
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Securities registered pursuant to Section 12(b) of the Act:
Common Stock, par value $.01 per share The Nasdaq Stock Market LLC
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(Title of Each Class) (Name of Each Exchange
on Which Registered)
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the Registrant is a well-known seasoned issuer,
as defined in Rule 405 of the Securities Act. YES NO X
--- ---
Indicate by check mark if the Registrant is not required to file reports
pursuant to Section 13 of Section 15(d) of the Act. YES NO X
--- ---
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. YES X NO
--- ---
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. X
---
Indicate by check mark whether the Registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act (Check one):
Large accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ]
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 aggregate market value of the Common Stock outstanding held by
nonaffiliates of the Registrant based on the closing sales price of the
Registrant's Common Stock as quoted on The Nasdaq Stock Market LLC on March
31, 2006 was $106,436,303 (3,774,337 shares at $28.20 per share). For
purposes of this calculation, Common Stock held by officers and directors of
the Registrant and the Timberland Bank Employee Stock Ownership Plan and Trust
are considered nonaffiliates.
DOCUMENTS INCORPORATED BY REFERENCE
1. Portions of Definitive Proxy Statement for the 2007 Annual Meeting
of Stockholders (Part III).
TIMBERLAND BANCORP, INC.
2006 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PART I. Page
Item 1. Business
General.............................................. 1
Market Area.......................................... 1
Lending Activities................................... 3
Investment Activities................................ 20
Deposit Activities and Other Sources of Funds........ 21
Bank Owned Life Insurance............................ 26
Regulation of the Bank............................... 26
Regulation of the Company............................ 31
Taxation............................................. 34
Competition.......................................... 35
Subsidiary Activities................................ 35
Personnel............................................ 35
Executive Officers of the Registrant................. 35
Item 1A. Risk Factors........................................... 37
Item 1B. Unresolved Staff Comments.............................. 41
Item 2. Properties.............................................. 42
Item 3. Legal Proceedings....................................... 44
Item 4. Submission of Matters to a Vote of Security Holders..... 44
PART II.
Item 5. Market for Registrant's Common Equity, Related
Stockholder Matters and Issuer Purchases of Equity
Securities............................................. 44
Item 6. Selected Financial Data................................. 46
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations.................... 48
General. . 48
Special Note Regarding Forward-Looking Statements.... 48
Critical Accounting Policies......................... 48
New Accounting Pronouncements........................ 49
Operating Strategy................................... 49
Market Risk and Asset and Liability Management....... 50
Comparison of Financial Condition at September 30,
2006 and 2005....................................... 52
Comparison of Operating Results for Years Ended
September 30, 2006 and 2005......................... 53
Comparison of Operating Results for Years Ended
September 30, 2005 and 2004......................... 55
Average Balances, Interest and Average Yields/Cost... 57
Rate/Volume Analysis................................. 59
Liquidity and Capital Resources...................... 60
Effect of Inflation and Changing Prices.............. 61
Item 7A. Quantitative and Qualitative Disclosures About Market
Risk.................................................. 61
Item 8. Financial Statements and Supplementary Data............. 62
Item 9. Changes in and Disagreements With Accountants on
Accounting and Financial Disclosure.................... 107
Item 9A. Controls and Procedures................................ 107
Item 9B. Other Information...................................... 107
i
PART III.
Item 10. Directors and Executive Officers of the Registrant..... 107
Item 11. Executive Compensation................................. 108
Item 12. Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters............ 108
Item 13. Certain Relationships and Related Transactions......... 109
Item 14. Principal Accounting Fees and Services................. 109
PART IV.
Item 15. Exhibits and Financial Statement Schedules............. 109
ii
PART I
Item 1. Business
-----------------
General
Timberland Bancorp, Inc. ("Company"), a Washington corporation, was
organized on September 8, 1997 for the purpose of becoming the holding company
for Timberland Savings Bank, SSB ("Bank") upon the Bank's conversion from a
Washington-chartered mutual savings bank to a Washington-chartered stock
savings bank ("Conversion"). The Conversion was completed on January 12, 1998
through the sale and issuance of 6,612,500 shares of common stock by the
Company. At September 30, 2006, the Company had total assets of $577.1
million, total deposits of $431.1 million and total shareholders' equity of
$79.4 million. The Company's business activities generally are limited to
passive investment activities and oversight of its investment in the Bank.
Accordingly, the information set forth in this report, including consolidated
financial statements and related data, relates primarily to the Bank and its
subsidiary.
The Bank was established in 1915 as "Southwest Washington Savings and
Loan Association." In 1935, the Bank converted from a state-chartered mutual
savings and loan association to a federally chartered mutual savings and loan
association, and in 1972, changed its name to "Timberland Federal Savings and
Loan Association." In 1990, the Bank converted to a federally chartered
mutual savings bank under the name "Timberland Savings Bank, FSB." In 1991,
the Bank converted to a Washington-chartered mutual savings bank and changed
its name to "Timberland Savings Bank, SSB." On December 29, 2000, the Bank
changed its name to "Timberland Bank." The Bank's deposits are insured up to
applicable legal limits by the Federal Deposit Insurance Corporation ("FDIC").
The Bank has been a member of the Federal Home Loan Bank ("FHLB") System since
1937. The Bank is regulated by the Washington Department of Financial
Institutions, Division of Banks ("Division") and the FDIC.
The Bank is a community-oriented bank which has traditionally offered a
variety of savings products to its retail customers while concentrating its
lending activities on real estate mortgage loans. Lending activities have
been focused primarily on the origination of loans secured by one- to
four-family residential dwellings, including an emphasis on construction and
land development loans, as well as the origination of multi-family and
commercial real estate loans. The Bank originates adjustable-rate residential
mortgage loans that do not qualify for sale in the secondary market under
Federal Home Loan Mortgage Corporation ("FHLMC") guidelines. The Bank also
originates commercial business loans and in 1998 established a business
banking division to increase the origination of these loans.
Market Area
The Bank considered Grays Harbor, Thurston, Pierce, King, Kitsap and
Lewis Counties as its primary market areas as of September 30, 2006. The Bank
conducts operations from:
* its main office in Hoquiam (Grays Harbor County);
* five branch offices in Grays Harbor County (Ocean Shores,
Montesano, Elma, and two branches in Aberdeen);
* a branch office in King County (Auburn);
* five branch offices in Pierce County (Edgewood, Puyallup, Spanaway,
Tacoma, and Gig Harbor);
* five branch offices in Thurston County (Olympia, Yelm, Tumwater,
and two branches in Lacey);
* two branch offices in Kitsap County (Poulsbo and Silverdale); and
* two branch offices and a loan production office in Lewis County
(Winlock, Toledo and Centralia).
1
See "Item 2. Properties."
Hoquiam, with a population of approximately 9,000, is located in Grays
Harbor County which is situated along Washington State's central Pacific
coast. Hoquiam is located approximately 110 miles southwest of Seattle and
145 miles northwest of Portland, Oregon.
The Bank considers its primary market area to include six submarkets:
primarily rural Grays Harbor County with its historical dependence on the
timber and fishing industries; Pierce, Thurston and Kitsap Counties with their
dependence on state and federal government; King County with its broadly
diversified economic base; and Lewis County with its dependence on retail
trade, manufacturing, industrial services and local government. Each of these
markets presents operating risks to the Bank. The Bank's expansion into
Pierce, Thurston, King, Kitsap and Lewis Counties represents the Bank's
strategy to diversify its primary market area to become less reliant on the
economy of Grays Harbor County.
Grays Harbor County has a population of 71,000 according to the U.S.
Census Bureau 2005 estimates and a median family income of $48,900 according
to 2006 HUD estimates. The economic base in Grays Harbor has been
historically dependent on the timber and fishing industries. Other industries
that support the economic base are tourism, agriculture, shipping,
transportation and technology. According to the Washington State Employment
Security Department, the unemployment rate in Grays Harbor County increased to
6.8% at September 30, 2006 from 6.6% at September 30, 2005. The Bank has six
branches (including its home office) located throughout the county. A
slowdown in the Grays Harbor County economy could negatively impact the Bank's
profitability in this market area.
Pierce County is the second most populous county in the state and has a
population of 754,000 according to the U.S. Census Bureau 2005 estimates. The
county's median family income is $61,000 according to 2006 HUD estimates. The
economy in Pierce County is diversified with the presence of military related
government employment (Fort Lewis Army Base and McChord Air Force Base),
transportation and shipping employment (Port of Tacoma), and aerospace related
employment (Boeing). According to the Washington State Employment Security
Department, the unemployment rate for the Pierce County area decreased to 5.4%
at September 30, 2006 from 5.5% at September 30, 2005. The Bank has five
branches in Pierce County. These branches have been responsible for a
substantial portion of the Bank's construction lending activities. A slowdown
in the Pierce County economy could negatively impact the demand for
construction loans and could negatively impact the Bank's profitability.
Thurston County has a population of 229,000 according to the U.S. Census
Bureau 2005 estimates and a median family income of $64,300 according to 2006
HUD estimates. Thurston County is home of Washington State's capital
(Olympia) and its economic base is largely driven by state government related
employment. According to the Washington State Employment Security Department,
the unemployment rate for the Thurston County area had increased to 4.8% at
September 30, 2006 from 4.6% at September 30, 2005. The Bank currently has
five branches in Thurston County. This county has a stable economic base
primarily attributable to the state government presence. A slowdown in the
Thurston County economy could negatively impact the Bank's lending
opportunities in this market.
Kitsap County has a population of 241,000 according to the U.S. Census
Bureau 2005 estimates and a median family income of $63,200 according to 2006
HUD estimates. Timberland has two branches in Kitsap County. The economic
base of Kitsap County is largely supported by military related government
employment through the United States Navy. According to the Washington State
Employment Security Department, the unemployment rate for the Kitsap County
area increased to 5.2% at September 30, 2006 from 4.8% at September 30, 2005.
Reductions in the naval personnel stationed in Kitsap County could have a
negative impact on the county's economy and could negatively impact the Bank's
lending opportunities in this market.
King County is the most populous county in the state and has a population
of 1.8 million according to the U.S. Census Bureau 2005 estimates. The
county's median family income is $74,300 according to 2006 HUD estimates.
King County's economic base is diversified with many industries including
shipping, transportation, aerospace (Boeing), computer technology and biotech
industries. According to the Washington State Employment Security Department,
the
2
unemployment rate for the King County area decreased to 4.1% at September 30,
2006 from 4.8% at September 30, 2005. A slowdown in the King County economy
could negatively impact the Bank's lending opportunities in this market.
Lewis County has a population of 72,000 according to the U.S. Census
Bureau 2005 estimates and a median family income of $48,900 according to 2006
HUD estimates. The economic base in Lewis County is supported by
manufacturing, retail trade, local government and industrial services.
According to the Washington State Employment Security Department, the
unemployment rate in Lewis County was 6.5% at September 30, 2006 and 2005.
The Bank has two branches and a loan production office located in Lewis
County. A slowdown in the Lewis County economy could negatively impact the
Bank's lending opportunities in this market.
Lending Activities
General. Historically, the principal lending activity of the Bank has
consisted of the origination of loans secured by first mortgages on
owner-occupied, one- to four-family residences and loans for the construction
of one- to four-family residences. Since 1998, the Bank has emphasized its
origination of construction and land development loans and commercial real
estate loans. The Bank's net loans receivable, including loans held for sale,
totaled approximately $424.6 million at September 30, 2006, representing
approximately 73.6% of consolidated total assets, and at that date
construction and land development loans (including undisbursed loans in
process), and loans secured by commercial properties were $284.5 million, or
58.0%, of total loans. Construction and land development loans and commercial
real estate loans typically have higher rates of return than one- to
four-family loans; however, they also present a higher degree of risk. See "-
Lending Activities - Construction and Land Development Lending" and "- Lending
Activities - Commercial Real Estate Lending."
The Bank's internal loan policy limits the maximum amount of loans to one
borrower to 25% of its Tier 1capital. At September 30, 2006, the maximum
amount which the Bank could have lent to any one borrower and the borrower's
related entities was approximately $15.8 million under this policy. At
September 30, 2006, the Bank had no loans to one borrower and the borrower's
related entities with an aggregate outstanding balance in excess of this
amount. At that date, the Bank had 60 borrowers or related borrowers with
total loans outstanding in excess of $1.0 million. The largest amount
outstanding to any one borrower and the borrower's related entities was
approximately $9.0 million (including $4.9 million of undisbursed loans in
process balance), which represents a commercial real estate loan and several
commercial real estate construction loans in Thurston County. These loans
were performing according to the required loan terms at September 30, 2006.
3
Loan Portfolio Analysis. The following table sets forth the composition of the Bank's loan portfolio
by type of loan as of the dates indicated.
At September 30,
--------------------------------------------------------------------------------------------
2006 2005 2004 2003 2002
---------------- ---------------- ---------------- ---------------- ----------------
Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent
------ ------- ------ ------- ------ ------- ------ ------- ------ -------
(Dollars in thousands)
Mortgage Loans:
One- to four-
family(1)
(2)..........$ 98,709 20.11% $101,763 23.24% $ 99,835 25.25% $ 95,371 26.21% $113,144 31.28%
Multi-family.. 17,689 3.60 20,170 4.61 17,160 4.34 18,241 5.01 24,135 6.67
Commercial.... 137,609 28.04 124,849 28.51 108,276 27.39 102,972 28.30 97,644 27.00
Construction
and land
development.. 146,855 29.92 112,470 25.68 106,241 26.88 94,117 25.87 80,144 22.16
Land(2)....... 29,598 6.03 24,981 5.71 19,895 5.03 15,628 4.30 15,453 4.27
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total
mortgage
loans....... 430,460 87.70 384,233 87.75 351,407 88.89 326,329 89.69 330,520 91.38
Consumer Loans:
Home equity
and second
mortgage..... 37,435 7.63 32,298 7.38 23,549 5.96 19,233 5.29 13,718 3.79
Other......... 11,127 2.27 9,330 2.13 9,270 2.34 8,799 2.42 8,097 2.24
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
48,562 9.90 41,628 9.51 32,819 8.30 28,032 7.71 21,815 6.03
Commercial
business
loans........ 11,803 2.40 12,013 2.74 11,098 2.81 9,475 2.60 9,365 2.59
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total loans.. 490,825 100.00% 437,874 100.00% 395,324 100.00% 363,836 100.00% 361,700 100.00%
-------- ====== -------- ====== -------- ====== -------- ====== -------- ======
Less:
Undisbursed
portion of
construction
loans in
process...... (59,260) (42,771) (43,563) (34,785) (32,324)
Deferred loan
origination
fees......... (2,798) (2,895) (3,176) (2,924) (3,218)
Allowance for
loan losses.. (4,122) (4,099) (3,991) (3,891) (3,630)
-------- -------- -------- -------- --------
Total loans
receivable,
net.......... $424,645 $388,109 $344,594 $322,236 $322,528
======== ======== ======== ======== ========
----------------
(8) Includes loans held-for-sale.
(9) Includes real estate contracts. See " - Lending Activities - Real Estate Contracts."
Residential One- to Four-Family Lending. At September 30, 2006, $98.7
million, or 20.1%, of the Bank's loan portfolio consisted of loans secured by
one- to four-family residences. The Bank originates both fixed-rate loans and
adjustable-rate loans.
Generally, fixed-rate loans, including 15, 20, 30, and five and seven
year balloon reset loans are originated to meet the requirements for sale in
the secondary market to the FHLMC. From time to time, however, a portion of
these fixed-rate loans may be retained in the loan portfolio to meet the
Bank's asset/liability management objectives. The Bank periodically retains
fixed-rate five and seven year balloon reset loans in its loan portfolio and
classifies them as held to maturity. The Bank uses an automated underwriting
program, which preliminarily qualifies a loan as conforming to FHLMC
underwriting standards when the loan is originated. At September 30, 2006,
$56.1 million, or 57.5%, of the Bank's one- to four-family loan portfolio due
after one year consisted of fixed-rate mortgage loans.
The Bank also offers adjustable-rate mortgage ("ARM") loans at rates and
terms competitive with market conditions. All of the Bank's ARM loans are
retained in its loan portfolio rather than intended for sale. The Bank offers
several ARM products which adjust annually after an initial period ranging
from one to five years subject to a limitation on the annual increase of 2%
and an overall limitation of 6%. These ARM products are priced utilizing the
weekly average yield on one year U.S. Treasury securities adjusted to a
constant maturity of one year plus a margin of 3.00% to 4.00%. Loans tied to
the prime rate or to LIBOR indices typically do not have periodic, or lifetime
adjustment limits. Loans tied to these indices normally have margins ranging
from 0.0% to 3.0%. ARM loans held in the Bank's portfolio do not permit
negative amortization of principal. Borrower demand for ARM loans versus
fixed-rate mortgage loans is a function of the level of interest rates, the
expectations of changes in the level of interest rates and the difference
between the initial interest rates and fees charged for each type of loan.
The relative amount of fixed-rate mortgage loans and ARM loans that can be
originated at any time is largely determined by the demand for each in a
competitive
4
environment. At September 30, 2006, $41.8 million, or 42.4%, of the Bank's
one- to four- family loan portfolio consisted of ARM loans.
A portion of the Bank's ARM loans are "non-conforming" because they do
not satisfy acreage limits, or various other requirements imposed by the
FHLMC. Some of these loans are also originated to meet the needs of borrowers
who cannot otherwise satisfy the FHLMC credit requirements because of personal
and financial reasons (i.e., divorce, bankruptcy, length of time employed,
etc.), and other aspects, which do not conform to the FHLMC's guidelines.
Many of these borrowers have higher debt-to-income ratios, or the loans are
secured by unique properties in rural markets for which there are no
comparable sales of comparable properties to support value according to
secondary market requirements. These loans are known as non-conforming loans
and the Bank may require additional collateral or lower loan-to-value ratios
to reduce the risk of these loans. The Bank believes that these loans satisfy
a need in its local market area. As a result, subject to market conditions,
the Bank intends to continue to originate these types of loans.
The retention of ARM loans in the Bank's loan portfolio helps reduce the
Bank's exposure to changes in interest rates. There are, however,
unquantifiable credit risks resulting from the potential of increased interest
to be paid by the customer as a result of increases in interest rates. It is
possible that during periods of rising interest rates the risk of default on
ARM loans may increase as a result of repricing and the increased costs to the
borrower. Furthermore, because the ARM loans originated by the Bank generally
provide, as a marketing incentive, for initial rates of interest below the
rates which would apply were the adjustment index used for pricing initially,
these loans are subject to increased risks of default or delinquency. The
Bank attempts to reduce the potential for delinquencies and defaults on ARM
loans by qualifying the borrower based on the borrower's ability to repay the
ARM loan assuming that the maximum interest rate that could be charged at the
first adjustment period remains constant during the loan term. Another
consideration is that although ARM loans allow the Bank to increase the
sensitivity of its asset base due to changes in the interest rates, the extent
of this interest sensitivity is limited by the periodic and lifetime interest
rate adjustment limits. Because of these considerations, the Bank has no
assurance that yield increases on ARM loans will be sufficient to offset
increases in the Bank's cost of funds.
While fixed-rate, single-family residential mortgage loans are normally
originated with 15 to 30 year terms, these loans typically remain outstanding
for substantially shorter periods because borrowers often prepay their loans
in full upon sale of the property pledged as security or upon refinancing the
original loan. In addition, substantially all mortgage loans in the Bank's
loan portfolio contain due-on-sale clauses providing that the Bank may declare
the unpaid amount due and payable upon the sale of the property securing the
loan. Typically, the Bank enforces these due-on-sale clauses to the extent
permitted by law and as business judgment dictates. Thus, average loan
maturity is a function of, among other factors, the level of purchase and sale
activity in the real estate market, prevailing interest rates and the interest
rates received on outstanding loans.
The Bank requires that fire and extended coverage casualty insurance be
maintained on all of its real estate secured loans. Loans originated since
1994 also require flood insurance, if appropriate.
The Bank's lending policies generally limit the maximum loan-to-value
ratio on mortgage loans secured by owner-occupied properties to 95% of the
lesser of the appraised value or the purchase price. However, the Bank
usually obtains private mortgage insurance ("PMI") on the portion of the
principal amount that exceeds 80% of the appraised value of the security
property. The maximum loan-to-value ratio on mortgage loans secured by
non-owner-occupied properties is generally 80% (90% for loans originated for
sale in the secondary market to the FHLMC).
Construction and Land Development Lending. Prompted by unfavorable
economic conditions in its primary market area in the 1980s, the Bank sought
to establish a market niche and, as a result, began originating construction
loans outside of Grays Harbor County. In recent periods, construction lending
activities have been primarily in the Pierce, King, Thurston, and Kitsap
County markets. Competition from other financial institutions has increased
in recent periods and it is possible that margins on construction loans may
be reduced in the future.
The Bank currently originates three types of residential construction
loans: (i) speculative construction loans, (ii) custom construction loans and
(iii) owner/builder construction loans. The Bank initiated its construction
lending with
5
the origination of speculative construction loans. As a result, the Bank
began to establish contacts with the building community and increased the
origination of custom construction and land development loans in rural and
suburban market areas. The Bank believes that its computer tracking system
has enabled it to establish processing and disbursement procedures to meet the
needs of these borrowers. To a lesser extent, the Bank also originates
construction loans for the development of multi-family and commercial
properties. Subject to market conditions, the Bank intends to continue to
emphasize its construction lending activities.
At September 30, 2006, the composition of the Bank's construction and
land development loan portfolio was as follows:
Outstanding Percent of
Balance Total
----------- ----------
(In thousands)
Speculative construction............... $ 34,363 23.40%
Custom and owner/builder construction.. 46,346 31.56
Multi-family........................... 7,662 5.22
Land development....................... 16,086 10.95
Commercial real estate................. 42,398 28.87
-------- ------
Total................................ $146,855 100.00%
======== ======
Speculative construction loans are made to home builders and are termed
"speculative" because the home builder does not have, at the time of loan
origination, a signed contract with a home buyer who has a commitment for
permanent financing with either the Bank or another lender for the finished
home. The home buyer may be identified either during or after the
construction period, with the risk that the builder will have to debt service
the speculative construction loan and finance real estate taxes and other
carrying costs of the completed home for a significant time after the
completion of construction until the home buyer is identified and a sale is
consummated. The Bank lends to approximately 50 builders located in the
Bank's primary market area, each of which generally have two to eight
speculative loans outstanding from the Bank during a 12 month period. Rather
than originating lines of credit to home builders to construct several homes
at once, the Bank originates and underwrites a separate loan for each home.
Speculative construction loans are generally originated for a term of 12
months, with current rates ranging from prime rate plus 1.0% to 1.5%, and with
a loan-to-value ratio of no more than 80% of the appraised estimated value of
the completed property. During this 12 month period, the borrower is required
to make monthly payments of accrued interest on the outstanding loan balance.
At September 30, 2006, speculative construction loans totaled $34.4 million,
or 23.4%, of the total construction loan portfolio. At September 30, 2006,
the Bank had 16 borrowers each with aggregate outstanding speculative loan
balances of more than $500,000. The largest aggregate outstanding balance to
one borrower amounted to $5.1 million (including $2.1 million of undisbursed
loans in process balance), and the largest outstanding balance for a single
speculative loan was $1.1 million (including $409,000 of undisbursed loans in
process balance). At September 30, 2006, all speculative construction loans
were performing according to their terms.
Unlike speculative construction loans, custom construction loans are made
to home builders who, at the time of construction, have a signed contract with
a home buyer who has a commitment for permanent financing for the finished
home with the Bank or another lender. Custom construction loans are generally
originated for a term of six to 12 months, with fixed interest rates currently
ranging from 7.0% to 7.5% and with loan-to-value ratios of 80% of the
appraised estimated value of the completed property or sales price, whichever
is less. During the construction period, the borrower is required to make
monthly payments of accrued interest on the outstanding loan balance.
Owner/builder construction loans are originated to the home owner rather
than the home builder as a single loan that automatically converts to a
permanent loan at the completion of construction. The construction phase of a
owner/builder construction loan generally lasts up to 12 months with fixed
interest rates currently ranging from 7.0% to 7.5%, and with loan-to-value
ratios of 80% (or up to 95% with PMI) of the appraised estimated value of the
completed property or cost, whichever is less. During the construction
period, the borrower is required to make monthly payments
6
of accrued interest on the outstanding loan balance. At the completion of
construction, the loan converts automatically to either a fixed-rate mortgage
loan, which conforms to secondary market standards, or an ARM loan for
retention in the Bank's portfolio. At September 30, 2006, custom and
owner/builder construction loans totaled $46.3 million, or 31.6%, of the total
construction loan portfolio. At September 30, 2006, the largest outstanding
custom and owner/builder construction loan had an outstanding balance of
$998,000 (including $108,000 of undisbursed loans in process balance) and was
performing according to its terms.
The Bank originates loans to local real estate developers with whom it
has established relationships for the purpose of developing residential
subdivisions (i.e., installing roads, sewers, water and other utilities)
(generally with ten to 50 lots). At September 30, 2006, subdivision
development loans totaled $16.1 million, or 11.0% of construction and land
development loans receivable. Land development loans are secured by a lien on
the property and made for a period of two to five years with fixed or variable
interest rates, and are made with loan-to-value ratios generally not exceeding
75%. Monthly interest payments are required during the term of the loan.
Land development loans are structured so that the Bank is repaid in full upon
the sale by the borrower of approximately 80% of the subdivision lots.
Substantially all of the Bank's land development loans are secured by property
located in its primary market area. In addition, in the case of a corporate
borrower, the Bank also generally obtains personal guarantees from corporate
principals and reviews their personal financial statements. At September 30,
2006, the largest land development loan had an outstanding loan balance of
$3.9 million (including $1.8 million of undisbursed loans in process balance),
and was performing according to its terms.
Land development loans secured by land under development involve greater
risks than one- to four-family residential mortgage loans because these loans
are advanced upon the predicted future value of the developed property. If
the estimate of the future value proves to be inaccurate, in the event of
default and foreclosure the Bank may be confronted with a property the value
of which is insufficient to assure full repayment. The Bank attempts to
minimize this risk by generally limiting the maximum loan-to-value ratio on
land loans to 75% of the estimated developed value of the secured property.
The Bank also provides construction financing for multi-family and
commercial properties. At September 30, 2006, these loans amounted to $50.1
million, or 34.1% of construction loans. These loans are secured by motels,
apartment buildings, condominiums, office buildings and retail rental space
located in the Bank's primary market area and currently range in amount from
$25,000 to $8.0 million. At September 30, 2006, the largest outstanding
multi- family construction loan had a balance of $3.2 million (including
$727,000 of undisbursed loans in process balance). At September 30, 2006, the
largest outstanding commercial real estate construction loan had a balance of
$8.0 million (including $7.7 million of undisbursed loans in process balance).
This loan was secured by a condominium project in Grays Harbor County and was
performing according to its terms.
All construction loans must be approved by one of the Bank's Loan
Committees or the Bank's Board of Directors. See "- Lending Activities - Loan
Solicitation and Processing." Prior to preliminary approval of any
construction loan application, an independent fee appraiser inspects the site
and the Bank reviews the existing or proposed improvements, identifies the
market for the proposed project and analyzes the pro forma data and
assumptions on the project. In the case of a speculative or custom
construction loan, the Bank reviews the experience and expertise of the
builder. After preliminary approval has been given, the application is
processed, which includes obtaining credit reports, financial statements and
tax returns on the borrowers and guarantors, an independent appraisal of the
project, and any other expert reports necessary to evaluate the proposed
project. In the event of cost overruns, the Bank generally requires that the
borrower increase the funds available for construction by depositing its own
funds into a secured savings account, the proceeds of which are used to pay
construction costs.
Loan disbursements during the construction period are made to the
builder, materials' supplier or subcontractor, based on a line item budget.
Periodic on-site inspections are made by qualified inspectors to document the
reasonableness of the draw request. For most builders, the Bank disburses
loan funds by providing vouchers to suppliers, which when used by the builder
to purchase supplies are submitted by the supplier to the Bank for payment.
7
The Bank regularly monitors the construction loan disbursements using an
internal computer program. The Bank believes that its internal monitoring
system helps reduce many of the risks inherent with construction lending.
The Bank originates construction loan applications primarily through
customer referrals, contacts in the business community and occasionally real
estate brokers seeking financing for their clients.
Construction lending affords the Bank the opportunity to achieve higher
interest rates and fees with shorter terms to maturity than does its
single-family permanent mortgage lending. Construction lending, however, is
generally considered to involve a higher degree of risk than single-family
permanent mortgage lending because of the inherent difficulty in estimating
both a property's value at completion of the project and the estimated cost of
the project. The nature of these loans is such that they are generally more
difficult to evaluate and monitor. If the estimate of construction cost
proves to be inaccurate, the Bank may be required to advance funds beyond the
amount originally committed to permit completion of the project. If the
estimate of value upon completion proves to be inaccurate, the Bank may be
confronted with a project whose value is insufficient to assure full
repayment. Projects may also be jeopardized by disagreements between
borrowers and builders and by the failure of builders to pay subcontractors.
Loans to builders to construct homes for which no purchaser has been
identified carry more risk because the payoff for the loan depends on the
builder's ability to sell the property prior to the time that the construction
loan is due. The Bank has sought to address these risks by adhering to strict
underwriting policies, disbursement procedures, and monitoring practices. In
addition, because the Bank's construction lending is primarily secured by
properties in its primary market area, changes in the local and state
economies and real estate markets could adversely affect the Bank's
construction loan portfolio.
Real Estate Contracts. The Bank purchases real estate contracts and
deeds of trust from individuals who have privately sold their homes or
property. These contracts are generally secured by one- to four-family
properties, building lots and undeveloped land and range in principal amount
from $10,000 to $200,000, but typically are in amounts between $20,000 and
$40,000. Properties securing real estate contracts purchased by the Bank are
generally located within its primary market area. Prior to purchasing the
real estate contract, the Bank reviews the contract and analyzes and assesses
the collateral for the loan, the down payment made by the borrower and the
credit history on the loan. As of September 30, 2006, the Bank had
outstanding real estate contracts of $729,000.
Multi-Family Lending. At September 30, 2006, the Bank had $17.7 million,
or 3.6% of the Bank's total loan portfolio, secured by multi-family dwelling
units (more than four units) located primarily in the Bank's primary market
area. Multi-family loans are generally originated with variable rates of
interest ranging from 2.00% to 3.50% over the one-year constant maturity U.S.
Treasury Bill Index or a matched term FHLB advance, with principal and
interest payments fully amortizing over terms of up to 30 years. Multi-family
loans currently range in principal balance from $40,000 to $5.8 million. At
September 30, 2006, the largest multi-family loan had an outstanding principal
balance of $5.8 million and was secured by an apartment building located in
the Bank's primary market area. At September 30, 2006, this loan was
performing according to its terms.
The maximum loan-to-value ratio for multi-family loans is generally 75%.
The Bank generally requests its multi-family loan borrowers to submit
financial statements and rent rolls on the subject property annually. The
Bank also inspects the subject property annually. The Bank generally imposes
a minimum debt coverage ratio of approximately 1.10 times for loans secured by
multi-family properties.
Multi-family mortgage lending affords the Bank an opportunity to receive
interest at rates higher than those generally available from one- to four-
family residential lending. However, loans secured by multi-family properties
usually are greater in amount, more difficult to evaluate and monitor and,
therefore, involve a greater degree of risk than one- to four-family
residential mortgage loans. Because payments on loans secured by multi-family
properties are often dependent on the successful operation and management of
the properties, repayment of such loans may be affected by adverse conditions
in the real estate market or the economy. The Bank seeks to minimize these
risks by strictly scrutinizing the financial condition of the borrower, the
quality of the collateral and the management of the property securing the
loan. If the borrower is other than an individual, the Bank also generally
obtains personal guarantees from the principals based on a review of personal
financial statements.
8
Commercial Real Estate Lending. Commercial real estate loans totaled
$137.6 million, or 28.0% of the total loan portfolio at September 30, 2006,
and consisted of 312 loans. The Bank originated $32.2 million of commercial
mortgage loans during the year ended September 30, 2006 compared to $32.3
million originated during the year ended September 30, 2005. The Bank
originates commercial real estate loans generally at variable interest rates
and these loans are secured by properties, such as restaurants, motels, office
buildings and retail/wholesale facilities, located in the Bank's primary
market area. The principal balances of commercial real estate loans currently
ranges between $10,000 and $4.7 million. At September 30, 2006, the largest
commercial real estate loan was secured by a commercial property located in
Olympia, Washington, had a balance of $4.7 million and was performing
according to its terms. At September 30, 2006, all commercial real estate
loans were performing according to their terms. See "- Lending Activities -
Nonperforming Assets and Delinquencies."
The Bank requires appraisals of all properties securing commercial real
estate loans. Appraisals are performed by independent appraisers designated
by the Bank, all of which are reviewed by management. The Bank considers the
quality and location of the real estate, the credit history of the borrower,
the cash flow of the project and the quality of management involved with the
property. The Bank generally imposes a minimum debt coverage ratio of
approximately 1.10 for originated loans secured by income producing commercial
properties. Loan-to-value ratios on commercial real estate loans are
generally limited to not more than 80%. The Bank generally obtains loan
guarantees from financially capable parties and reviews their personal
financial statements.
Commercial real estate lending affords the Bank an opportunity to receive
interest at rates higher than those generally available from one- to
four-family residential lending. However, loans secured by such properties
usually are greater in amount, more difficult to evaluate and monitor and,
therefore, involve a greater degree of risk than one- to four-family
residential mortgage loans. Because payments on loans secured by commercial
properties often depend upon the successful operation and management of the
properties, repayment of these loans may be affected by adverse conditions in
the real estate market or the economy. The Bank seeks to minimize these risks
by generally limiting the maximum loan-to-value ratio to 80% and strictly
scrutinizing the financial condition of the borrower, the quality of the
collateral and the management of the property securing the loan. The Bank
also requests annual financial information and rent rolls on the subject
property from the borrowers.
Land Lending. The Bank originates loans for the acquisition of land upon
which the purchaser can then build or make improvements necessary to build or
to sell as improved lots. At September 30, 2006, land loans totaled $29.6
million, or 6.0% of the Bank's total loan portfolio. Land loans originated by
the Bank are generally fixed-rate loans and have maturities of five to ten
years. Land loans generally range in principal amount from $5,000 to
$800,000. The largest land loan had an outstanding balance of $779,000 at
September 30, 2006 and was performing according to its terms. At September
30, 2006, all land loans were performing according to their terms. See "-
Lending Activities - Nonperforming Assets and Delinquencies."
Loans secured by undeveloped land or improved lots involve greater risks
than one- to four-family residential mortgage loans because these loans are
more difficult to evaluate. If the estimate of value proves to be inaccurate,
in the event of default and foreclosure the Bank may be confronted with a
property the value of which is insufficient to assure full repayment. The
Bank attempts to minimize this risk by generally limiting the maximum
loan-to-value ratio on land loans to 75%.
Consumer Lending. Consumer lending has traditionally been a small part
of the Bank's business. Consumer loans generally have shorter terms to
maturity and higher interest rates than mortgage loans. Consumer loans
include home equity lines of credit, second mortgage loans, savings account
loans, automobile loans, boat loans, motorcycle loans, recreational vehicle
loans and unsecured loans. Consumer loans are made with both fixed and
variable interest rates and with varying terms. At September 30, 2006,
consumer loans amounted to $48.6 million, or 9.9%, of the total loan
portfolio.
At September 30, 2006, the largest component of the consumer loan
portfolio consisted of second mortgage loans and home equity lines of credit,
which totaled $37.4 million, or 7.6%, of the total loan portfolio. Home
equity lines of credit and second mortgage loans are made for purposes such as
the improvement of residential properties, debt
9
consolidation and education expenses, among others. The majority of these
loans are made to existing customers and are secured by a first or second
mortgage on residential property. The Bank occasionally solicits these loans.
The loan-to-value ratio is typically 80% or less, when taking into account
both the first and second mortgage loans. Second mortgage loans typically
carry fixed interest rates with a fixed payment over a term between five and
15 years. Home equity lines of credit are generally made at interest rates
tied to the 26 week Treasury Bill or the prime rate. Second mortgage loans
and home equity lines of credit have greater credit risk than one- to
four-family residential mortgage loans because they are secured by mortgages
subordinated to the existing first mortgage on the property, which may or may
not be held by the Bank.
Consumer loans entail greater risk than do residential mortgage loans,
particularly in the case of consumer loans that are unsecured or secured by
rapidly depreciating assets such as automobiles. In such cases, any
repossessed collateral for a defaulted consumer loan may not provide an
adequate source of repayment of the outstanding loan balance as a result of
the greater likelihood of damage, loss or depreciation. The remaining
deficiency often does not warrant further substantial collection efforts
against the borrower beyond obtaining a deficiency judgment. In addition,
consumer loan collections are dependent on the borrower's continuing financial
stability, and are more likely to be adversely affected by job loss, divorce,
illness or personal bankruptcy. Furthermore, the application of various
federal and state laws, including federal and state bankruptcy and insolvency
laws, may limit the amount that can be recovered on such loans. The Bank
believes that these risks are not as prevalent in the case of the Bank's
consumer loan portfolio because a large percentage of the portfolio consists
of second mortgage loans and home equity lines of credit that are underwritten
in a manner such that they result in credit risk that is substantially similar
to one- to four-family residential mortgage loans. At September 30, 2006, the
Bank did not have any consumer loans delinquent in excess of 90 days. See
"Lending Activities - Non-performing Assets and Delinquencies."
Commercial Business Lending. Commercial business loans totaled $11.8
million, or 2.4% of the loan portfolio at September 30, 2006, and consisted of
45 loans. In July 1998, the Bank established a business banking division
staffed by three experienced commercial lenders to increase the Bank's
origination of commercial business loans and commercial real estate loans.
Currently, the division is staffed by a Division Manager and seven commercial
lenders. Commercial business loans are generally secured by business
equipment, accounts receivable, inventory or other property and are made at
variable rates of interest equal to a negotiated margin above the prime rate.
The Bank also generally obtains personal guarantees from financially capable
applicants based on a review of personal financial statements. At September
30, 2006, all commercial business loans were performing according to terms.
See "Lending Activities-Nonperforming Assets and Delinquencies."
Commercial business lending generally involves greater risk than
residential mortgage lending and involves risks that are different from those
associated with residential and commercial real estate lending. Real estate
lending is generally considered to be collateral based lending with loan
amounts based on predetermined loan to collateral values and liquidation of
the underlying real estate collateral is viewed as the primary source of
repayment in the event of borrower default. Although commercial business
loans are often collateralized by equipment, inventory, accounts receivable or
other business assets, the liquidation of collateral in the event of a
borrower default is often an insufficient source of repayment because accounts
receivable may be uncollectible and inventories and equipment may be obsolete
or of limited use, among other things. Accordingly, the repayment of a
commercial business loan depends primarily on the creditworthiness of the
borrower (and any guarantors), while liquidation of collateral is a secondary
and often insufficient source of repayment.
10
Loan Maturity. The following table sets forth certain information at
September 30, 2006 regarding the dollar amount of loans maturing in the Bank's
portfolio based on their contractual terms to maturity, but does not include
scheduled payments or potential prepayments. Demand loans, loans having no
stated schedule of repayments and no stated maturity, and overdrafts are
reported as due in one year or less.
After After After
One Year 3 Years 5 Years
Within Through Through Through After
One Year 3 Years 5 Years 10 Years 10 Years Total
-------- -------- ------- -------- -------- -------
(In thousands)
Mortgage loans:
One- to four-
family (1)...... $ 992 $ 1,580 $ 5,705 $ 6,147 $ 84,285 $ 98,709
Multi-family..... 1,281 532 3 12,964 2,909 17,689
Commercial....... 6,395 12,035 6,167 87,539 25,473 137,609
Construction and
land
development(2).. 106,073 2,557 458 9,446 28,321 146,855
Land............. 6,429 6,834 14,296 379 1,660 29,598
Consumer loans:
Home equity and
second
mortgage........ 9,052 1,427 1,009 2,191 23,756 37,435
Other............ 2,294 707 1,993 1,155 4,978 11,127
Commercial business
loans............ 3,533 3,031 1,142 2,267 1,830 11,803
-------- ------- ------- -------- -------- --------
Total............ $136,049 $28,703 $30,773 $122,088 $173,212 $490,825
-------- ------- ------- -------- -------- --------
Less:
Undisbursed
portion of
construction
loans in
process......... 59,260
Deferred loan
origination
fees............ 2,798
Allowance for
loan losses..... 4,122
--------
Loans receivable,
net............. $424,645
========
-----------------
(1) Includes loans held-for-sale.
(2) Includes construction/permanent loans that convert to permanent mortgage
loans once construction is completed.
The following table sets forth the dollar amount of all loans due after
one year from September 30, 2006, which have fixed interest rates and have
floating or adjustable interest rates.
Fixed Floating or
Rates Adjustable Rates Total
----- ---------------- ------
(In thousands)
Mortgage loans:
One- to four-family(1).................... $ 56,139 $ 41,579 $ 97,718
Multi-family.............................. 6,051 10,357 16,408
Commercial................................ 13,246 117,968 131,214
Construction and land development......... 25,377 15,405 40,782
Land...................................... 19,856 3,313 23,169
Consumer loans:
Home equity and second mortgage........... 23,243 5,140 28,383
Other..................................... 8,720 113 8,833
Commercial business loans................. 3,471 4,798 8,269
-------- -------- --------
Total................................... $156,103 $198,673 $354,776
======== ======== ========
--------------
(1) Includes loans held-for-sale.
11
Scheduled contractual principal repayments of loans do not reflect the
actual life of these assets. The average life of loans is substantially less
than their contractual terms because of prepayments. In addition, due-on-sale
clauses on loans generally give the Bank the right to declare loans
immediately due and payable in the event, among other things, that the
borrower sells the real property subject to the mortgage and the loan is not
repaid. The average life of mortgage loans tends to increase, however, when
current mortgage loan interest rates are substantially higher than interest
rates on existing mortgage loans and, conversely, decrease when interest rates
on existing mortgage loans are substantially higher than current mortgage loan
interest rates.
Loan Solicitation and Processing. Loan originations are obtained from a
variety of sources, including walk-in customers, and referrals from builders
and realtors. Upon receipt of a loan application from a prospective borrower,
a credit report and other data are obtained to verify specific information
relating to the loan applicant's employment, income and credit standing. An
appraisal of the real estate offered as collateral generally is undertaken by
an appraiser retained by the Bank and certified by the State of Washington.
Loan applications are initiated by loan officers and are required to be
approved by one of the Bank's Loan Committees or the Bank's Board of
Directors. The Bank's Consumer Loan Committee, which consists of two
underwriters, can approve one-to four-family mortgage loans and other consumer
loans up to and including $417,000. Certain consumer loans up to and
including $25,000 may be approved by individual loan officers and the Bank's
Consumer Lending Department Manager may approve consumer loans up to and
including $75,000. The Bank's Commercial Loan Committee, which consists of
the Bank's President, Chief Lending Officer, Executive Vice President of
Commercial Lending, Executive Vice President of Community Lending and Senior
Vice President of Administration, may approve commercial real estate loans and
commercial business loans up to and including $1.5 million. The Bank's
President, Chief Lending Officer, Executive Vice President of Commercial
Lending, Executive Vice President of Community Lending and Senior Vice
President of Administration also have individual lending authority for loans
up to and including $500,000. The Bank's Board Loan Committee, which consists
of two rotating non-employee Directors and the Bank's President, may approve
loans up to and including $3.0 million. Loans in excess of $3.0 million, as
well as loans of any amount granted to a single borrower whose aggregate loans
exceed $3.0 million, must be approved by the Bank's Board of Directors.
Loan Originations, Purchases and Sales. During the years ended September
30, 2006 and 2005, the Bank's total gross loan originations were $256.3
million and $230.0 million, respectively. Periodically, the Bank purchases
participation interests in construction and land development loans and
multi-family loans, secured by properties generally located in the Bank's
primary market area, from other lenders. These purchases are underwritten to
the Bank's underwriting guidelines and are without recourse to the seller
other than for fraud. See "- Lending Activities - Construction and Land
Development Lending" and "- Lending Activities - Multi-Family Lending."
Consistent with its asset/liability management strategy, the Bank's policy
generally is to retain in its portfolio all ARM loans originated and to sell
fixed rate one-to four-family mortgage loans in the secondary market to the
FHLMC; however, from time to time, a portion of fixed-rate loans may be
retained in the Bank's portfolio to meet its asset-liability objectives.
Loans sold in the secondary market are generally sold on a servicing retained
basis. At September 30, 2006, the Bank's loan servicing portfolio totaled
$156.2 million.
12
The following table shows total loans originated, purchased, sold and
repaid during the periods indicated.
Year Ended September 30,
-------------------------------
2006 2005 2004
--------- --------- ---------
Loans originated: (In thousands)
Mortgage loans:
One- to four-family..................... $ 33,483 $ 33,290 $ 36,824
Multi-family............................ 3,037 4,685 1,150
Commercial.............................. 32,174 32,266 29,056
Construction and land development....... 129,623 104,714 94,373
Land.................................... 17,518 15,330 11,033
Consumer................................. 29,858 29,287 18,952
Commercial business loans................ 10,559 10,233 9,754
--------- --------- ---------
Total loans originated.................. 256,252 229,805 201,142
Loans purchased:
Mortgage loans:
One- to four-family..................... 48 209 30
Commercial.............................. 79 -- --
--------- --------- ---------
Land.................................... 28 -- --
Total loans purchased.................. 155 209 30
--------- --------- ---------
Total loans originated and purchased.. 256,407 230,014 201,172
Loans sold:
Whole loans sold......................... (26,445) (25,358) (35,741)
Credit card loans sold................... -- (1,523) --
--------- --------- ---------
Total loans sold......................... (26,445) (26,881) (35,741)
Loan principal repayments................. (177,011) (160,583) (133,943)
Decrease (increase) in other items, net... (16,415) 965 (9,130)
--------- --------- ---------
Net increase in loans receivable.......... $ 36,536 $ 43,515 $ 22,358
========= ========= =========
Loan Origination Fees. The Bank generally receives loan origination
fees. Loan fees are a percentage of the principal amount of the loan which
are charged to the borrower for funding the loan. The amount of fees charged
by the Bank is generally 0.5% to 2.0% of the loan amount. Current accounting
principles generally accepted in the United States of American require fees
received and certain loan origination costs for originating loans to be
deferred and amortized into interest income over the contractual life of the
loan. Net deferred fees or costs associated with loans that are prepaid are
recognized as income at the time of prepayment. Deferred loan origination
fees totaled $2.8 million at September 30, 2006.
Non-performing Assets and Delinquencies. The Bank assesses late fees or
penalty charges on delinquent loans of approximately 5% of the monthly loan
payment amount. Substantially all fixed-rate and ARM loan payments are due on
the first day of the month; however, the borrower is given a 15 day grace
period to make the loan payment. When a mortgage loan borrower fails to make
a required payment when due, the Bank institutes collection procedures. A
notice is mailed to the borrower 16 days after the date the payment is due.
Attempts to contact the borrower by telephone generally begin on or before the
30th day of delinquency. If a satisfactory response is not obtained,
continuous follow-up contacts are attempted until the loan has been brought
current. Before the 90th day of delinquency, attempts to interview the
borrower, preferably in person, are made to establish (i) the cause of the
delinquency, (ii) whether the cause is temporary, (iii) the attitude of the
borrower toward the debt, and (iv) a mutually satisfactory arrangement for
curing the default.
13
If the borrower is chronically delinquent and all reasonable means of
obtaining payment on time have been exhausted, foreclosure is initiated
according to the terms of the security instrument and applicable law.
Interest income on loans in foreclosure is reduced by the full amount of
accrued and uncollected interest.
When a consumer loan borrower or commercial business borrower fails to
make a required payment on a loan by the payment due date, the Bank institutes
similar collection procedures as for its mortgage loan borrowers. Loans
becoming 90 days or more past due are placed on non-accrual status, with any
accrued interest reversed against interest income, unless they are well
secured and in the process of collection.
The Bank's Board of Directors is informed monthly as to the status of
loans that are delinquent by more than 30 days, the status of all loans
currently in foreclosure, and the status of all foreclosed and repossessed
property owned by the Bank.
The following table sets forth information with respect to the Company's
nonperforming assets at the dates indicated.
At September 30,
------------------------------------------------
2006 2005 2004 2003 2002
-------- -------- -------- -------- --------
Loans accounted for on a (Dollars in thousands)
non-accrual basis:
Mortgage loans:
One- to four-family........ $ 80 $ 2,208 $ 430 $ 1,409 $ 1,138
Commercial................. -- 261 640 538 688
Construction and land
development............... -- -- -- 1,185 1,571
Land....................... -- 23 322 521 251
Consumer loans.............. -- 133 23 212 49
Commercial business loans... -- 301 27 30 44
-------- -------- -------- -------- --------
Total................... 80 2,926 1,442 3,895 3,741
Accruing loans which are
contractually past due 90
days or more............... -- -- -- -- --
Total of non-accrual and 90
days past due loans........ 80 2,926 1,442 3,895 3,741
Other real estate owned and
other repossessed assets... 15 509 421 1,258 680
-------- -------- -------- -------- --------
Total nonperforming
assets................. $ 95 $ 3,435 $ 1,863 $ 5,153 $ 4,421
======== ======== ======== ======== ========
Restructured loans.......... $ -- $ -- $ -- $ -- $ --
Non-accrual and 90 days or
more past due loans as a
percentage of loans
receivable, net............ 0.02% 0.75% 0.41% 1.19% 1.15%
Non-accrual and 90 days or
more past due loans as a
percentage of total
assets..................... 0.01% 0.53% 0.31% 0.87% 0.87%
Nonperforming assets as a
percentage of total
assets..................... 0.02% 0.62% 0.40% 1.15% 1.03%
Loans receivable, net(1).... $428,767 $392,208 $348,585 $326,127 $326,158
======== ======== ======== ======== ========
Total assets................ $577,087 $552,765 $460,419 $449,633 $431,054
======== ======== ======== ======== ========
-------------
(1) Includes loans held-for-sale and is before the allowance for loan losses.
The Bank's non-accrual loans decreased by $2.8 million to $80,000 at
September 30, 2006 from $2.9 million at September 30, 2005, primarily as a
result of a $2.1 million decrease in one- to four-family mortgage loans on
non-accrual status, a $301,000 decrease in commercial business loans on
non-accrual status, and a $261,000 decrease in commercial real estate loans on
non-accrual status.
14
Additional interest income which would have been recorded for the year
ended September 30, 2006 had non-accruing loans been current in accordance
with their original terms totaled approximately $2,000.
Other Real Estate Owned and Other Repossessed Items. Real estate
acquired by the Bank as a result of foreclosure or by deed-in-lieu of
foreclosure is classified as other real estate owned until sold. When
property is acquired, it is recorded at the lower of its cost, which is the
unpaid principal balance of the related loan plus foreclosure costs, or fair
market value. Subsequent to foreclosure, the property is recorded at the
lower of the foreclosed amount or fair value, less estimated selling costs.
At September 30, 2006, the Bank had $15,000 in other real estate owned, which
consisted of one land parcel.
Restructured Loans. Under accounting principles generally accepted in
the United States of America, the Bank is required to account for certain loan
modifications or restructuring as a "troubled debt restructuring." In
general, the modification or restructuring of a debt constitutes a troubled
debt restructuring if the Bank for economic or legal reasons related to the
borrower's financial difficulties grants a concession to the borrowers that
the Bank would not otherwise consider. Debt restructuring or loan
modifications for a borrower does not necessarily always constitute troubled
debt restructuring, however, and troubled debt restructurings do not
necessarily result in non-accrual loans. The Bank had no restructured loans
at September 30, 2006.
Other Loans of Concern. Loans not reflected in the table above, but
where known information about possible credit problems of borrowers causes
management to have doubts as to the ability of the borrower to comply with
present repayment terms and that may result in disclosure of such loans and
leases as underperforming assets in the future are commonly referred to as
"potential problem loans." The amount included in potential problem loans
results from an evaluation, on a loan-by-loan basis, of loans classified as
"substandard" and "special mention," as those terms are defined under "Asset
Classification" below. The amount of potential problem loans was $12.9
million at September 30, 2006 and $11.3 million at September 30, 2005. The
vast majority of these loans, as well as our nonperforming assets, are
collateralized.
Asset Classification. Applicable regulations require that each insured
institution review and classify its assets on a regular basis. In addition,
in connection with examinations of insured institutions, regulatory examiners
have authority to identify problem assets and, if appropriate, require them to
be classified. There are three classifications for problem assets:
substandard, doubtful and loss. Substandard assets have one or more defined
weaknesses and are characterized by the distinct possibility that the insured
institution will sustain some loss if the deficiencies are not corrected.
Doubtful assets have the weaknesses of substandard assets with the additional
characteristic that the weaknesses make collection or liquidation in full on
the basis of currently existing facts, conditions and values questionable, and
there is a high possibility of loss. An asset classified as loss is
considered uncollectible and of such little value that continuance as an asset
of the institution is not warranted. When an insured institution classifies
problem assets as either substandard or doubtful, it is required to establish
general allowances for loan losses in an amount deemed prudent by management.
These allowances represent loss allowances which have been established to
recognize the inherent risk associated with lending activities and the risks
associated with particular problem assets. When an insured institution
classifies problem assets as loss, it charges off the balance of the asset
against the allowance for loan losses. Assets which do not currently expose
the insured institution to sufficient risk to warrant classification in one of
the aforementioned categories but possess weaknesses are required to be
designated as special mention. The Bank's determination of the classification
of its assets and the amount of its valuation allowances is subject to review
by the FDIC and the Division which can order the establishment of additional
loss allowances.
15
The aggregate amounts of the Bank's classified and special mention loans
(as determined by the Bank), and of the Bank's allowances for loan losses at
the dates indicated, were as follows:
At September 30,
----------------------------
2006 2005 2004
------- ------- -------
(In thousands)
Loss......................... $ -- $ -- $ --
Doubtful..................... -- -- --
Substandard(1)............... 3,985 9,876 11,847
Special mention(1)........... 9,015 4,320 3,676
------- ------- -------
Total classified and special
mention loans............... $13,000 $14,196 $15,523
======= ======= =======
Allowance for loan losses.... $ 4,122 $ 4,099 $ 3,991
---------------
(1) For further information concerning the change in classified assets, see "-
Lending Activities - Nonperforming Assets and Delinquencies."
The Bank's classified and special mention loans decreased by $1.2 million
from September 30, 2005 to September 30, 2006, primarily as a result of a $5.9
million decrease in loans classified as substandard. This decrease was
partially offset by a $4.7 million increase in loans classified as special
mention.
Special mention loan are defined as those credits deemed by management to
have some potential weakness that deserve management's close attention. If
left uncorrected these potential weaknesses may result in the deterioration of
the payment prospects of the loan. Assets in this category are not adversely
classified and currently do not expose the Bank to sufficient risk to warrant
a substandard classification. Three loans comprise a majority of the amount
classified as special mention. They include a $3.4 million loan secured by a
commercial office building in Thurston County, a $3.2 million loan secured by
a motel in Pierce County, and a $729,000 land development loan in Grays Harbor
County. At September 30, 2006 these loans were current and paying in
accordance with the required loan terms.
Substandard loans are classified as those loans that are inadequately
protected by the current net worth, and paying capacity of the obligor, or of
the collateral pledged. Assets classified as substandard have a well-defined
weakness, or weaknesses that jeopardize the repayment of the debt. If the
weakness, or weaknesses are not corrected there is the distinct possibility
that some loss will be sustained. The aggregate amount of loans classified as
substandard at September 30, 2006 decreased by $5.9 million to $4.0 million
from $9.9 million at September 30, 2005. At September 30, 2006, 23 loans were
classified as substandard compared to 37 at September 30, 2005. The largest
loan currently classified as substandard is a $1.4 million commercial business
loan on two mini-storage facility operations in Pierce County. At September
30, 2006, this loan was current. The next largest loans classified as
substandard include a $666,000 loan secured by a single-family home in King
County and a $365,000 loan secured by a single-family home in Thurston County.
At September 30, 2006, the $666,000 single-family home loan was 60 days
delinquent and the $365,000 single-family home loan was 30 days delinquent.
Allowance for Loan Losses. The allowance for loan losses is maintained
to cover estimated losses in the loan portfolio. The Bank has established a
comprehensive methodology for the determination of provisions for loan losses
that takes into consideration the need for an overall general valuation
allowance. The Bank's methodology for assessing the adequacy of its allowance
for loan losses is based on its historic loss experience for various loan
segments; adjusted for changes in economic conditions, delinquency rates, and
other factors. Using these loss estimate factors, management develops a range
of probable loss for each loan category. Certain individual loans for which
full collectibility may not be assured are evaluated individually with loss
exposure based on estimated discounted cash flows or collateral values. The
total estimated range of loss based on these two components of the analysis is
compared to the loan loss allowance
16
balance. Based on this review, management will adjust the allowance as
necessary to maintain directional consistency with trends in the loan
portfolio.
In originating loans, the Bank recognizes that losses will be experienced
and that the risk of loss will vary with, among other things, the type of loan
being made, the creditworthiness of the borrower over the term of the loan,
general economic conditions and, in the case of a secured loan, the quality of
the security for the loan. The Bank increases its allowance for loan losses
by charging provisions for loan losses against the Bank's income.
The Board of Directors reviews the adequacy of the allowance for loan
losses at least quarterly based on management's assessment of current economic
conditions, past loss and collection experience, and risk characteristics of
the loan portfolio.
At September 30, 2006, the Bank's allowance for loan losses totaled $4.1
million. This represents 0.96% of the total loans receivable and 5,152.50% of
non-performing loans. The Bank's allowance for loan losses as a percentage of
total loans receivable has decreased to 0.96% at September 30, 2006 from 1.11%
at September 2002 primarily due to improved historical loss performance (which
have translated into lower loss factors assigned to certain loan categories),
decreased levels of non-performing loans, and decreased levels of classified
loans. Partially offsetting the improved credit quality ratios in recent
years, has been a shift in the loan portfolio into a higher percentage of
construction and land development loans, which typically involve more risk
than one- to four-family loans.
Management believes that the amount maintained in the allowance is
adequate to absorb probable losses in the portfolio. Although management
believes that it uses the best information available to make its
determinations, future adjustments to the allowance for loan losses may be
necessary and results of operations could be significantly and adversely
affected if circumstances differ substantially from the assumptions used in
making the determinations.
While the Bank believes it has established its existing allowance for
loan losses in accordance with accounting principles generally accepted in the
United States of America, there can be no assurance that regulators, in
reviewing the Bank's loan portfolio, will not request the Bank to increase
significantly its allowance for loan losses. In addition, because future
events affecting borrowers and collateral cannot be predicted with certainty,
there can be no assurance that the existing allowance for loan losses is
adequate or that substantial increases will not be necessary should the
quality of any loans deteriorate as a result of the factors discussed above.
Any material increase in the allowance for loan losses may adversely affect
the Bank's financial condition and results of operations.
The following table sets forth an analysis of the Bank's allowance for
loan losses for the periods indicated.
Year Ended September 30,
-----------------------------------------------
2006 2005 2004 2003 2002
------ ------ ------- ------- -------
(Dollars in thousands)
Allowance at beginning of
year....................... $4,099 $3,991 $ 3,891 $ 3,630 $ 3,050
Provision for loan losses... -- 141 167 347 992
Recoveries:
Mortgage loans:
One- to four-family....... -- -- 6 -- --
Consumer loans:
Home equity and second
mortgage................. -- 5 -- -- --
Other..................... 5 3 16 12 13
Commercial business loans... 20 9 3 70 96
------ ------ ------- ------- -------
Total recoveries........ 25 17 25 82 109
(table continued on following page)
17
Year Ended September 30,
--------------------------------------------
2006 2005 2004 2003 2002
------ ------ ------- ------- -------
(Dollars in thousands)
Charge-offs:
Mortgage loans:
One- to four-family....... -- -- 6 30 16
Multi-family.............. -- 1 -- -- --
Consumer.................... -- -- -- -- 32
Commercial business loans... -- -- 3 -- --
Land........................ -- 1 -- 10 --
Consumer loans:
Home equity and second
mortgage................. -- -- 9 40 --
Other..................... 2 12 68 88 143
Commercial business loans... -- 36 6 -- 330
------ ------ ------ ------ ------
Total charge-offs......... 2 50 92 168 521
------ ------ ------ ------ ------
Net charge-offs
(recoveries)............. (23) 33 67 86 412
------ ------ ------ ------ ------
Balance at end of year.. $4,122 $4,099 $3,991 $3,891 $3,630
====== ====== ====== ====== ======
Allowance for loan losses
as a percentage of
total loans receivable
(net)(1) outstanding
at the end of the year..... 0.96% 1.05% 1.14% 1.19% 1.11%
Net charge-offs (recoveries)
as a percentage of average
loans outstanding during
the year................... (0.01%) 0.01% 0.02% 0.03% 0.13%
Allowance for loan losses
as a percentage of
non-performing loans at
end of year................ 5,152.50% 140.09% 276.77% 99.90% 97.03%
--------------
(1) Total loans receivable (net) includes loans held for sale and is before
the allowance for loan losses.
18
The following table sets forth the allocation of the allowance for loan losses by loan category at the
dates indicated.
At September 30,
----------------------------------------------------------------------------------------------
2006 2005 2004 2003 2002
----------------- ------------------ ---------------- ----------------- ------------------
Percent Percent Percent Percent Percent
of Loans of Loans of Loans of Loans of Loans
in in in in in
Category Category Category Category Category
to Total to Total to Total to Total to Total
Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans
------- -------- -------- -------- ------ -------- ------- -------- ------- ---------
(Dollars in thousands)
Mortgage loans:
One- to four-
family....... $ 502 20.11% $ 494 23.24% $ 386 25.25% $ 317 26.21% $ 322 31.28%
Multi-family.. 112 3.60 194 4.61 242 4.34 374 5.01 214 6.67
Commercial.... 1,222 28.04 1,544 28.51 1,443 27.39 1,041 28.30 1,072 27.00
Construction.. 761 29.92 652 25.68 538 26.88 583 25.87 536 22.16
Land.......... 275 6.03 255 5.71 226 5.03 169 4.30 152 4.27
Non-mortgage
loans:
Consumer
loans........ 497 9.90 255 9.51 427 8.30 458 7.71 512 6.03
Commercial
business
loans........ 753 2.40 705 2.74 729 2.81 949 2.60 822 2.59
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total
allowance
for loan
losses...... $4,122 100.00% $4,099 100.00% $3,991 100.00% $3,891 100.00% $3,630 100.00%
====== ====== ====== ====== ====== ====== ====== ====== ====== ======
19
Investment Activities
The investment policies of the Company are established and monitored by
the Board of Directors. The policies are designed primarily to provide and
maintain liquidity, to generate a favorable return on investments without
incurring undue interest rate and credit risk, and to compliment the Bank's
lending activities. These policies dictate the criteria for classifying
securities as either available-for-sale or held-to-maturity. The policies
permit investment in various types of liquid assets permissible under
applicable regulations, which includes U.S. Treasury obligations, securities
of various federal agencies, certain certificates of deposit of insured banks,
banker's acceptances, federal funds, mortgage-backed securities, and mutual
funds. The Company's investment policy also permits investment in equity
securities in certain financial service companies.
At September 30, 2006, the Company's investment portfolio totaled $81.5
million, primarily consisting of $32.1 million of mutual funds available for
sale, $17.6 million of mortgage-backed securities available-for-sale, $31.7
million of U.S. agency securities available-for-sale, and $75,000 of
securities held-to-maturity. This compares with a total portfolio of $89.7
million at September 30, 2005, comprised of $32.2 million of mutual funds
available-for-sale, $23.7 million of mortgage-backed securities available-for-
sale, $33.7 million of U.S. agency securities available-for-sale and $104,000
of securities held-to-maturity. The mutual funds invest primarily in
mortgage-backed products and U.S. agency securities. The composition of the
portfolios by type of security, at each respective date is presented in the
table, which follows.
At September 30,
--------------------------------------------------------
2006 2005 2004
----------------- ----------------- ------------------
Percent Percent Percent
Recorded of Recorded of Recorded of
Value Total Value Total Value Total
-------- ------- -------- ------- -------- --------
(Dollars in thousands)
Held-to-Maturity:
Mortgage-backed
securities......... $ 75 0.09% $ 104 0.12% $ 174 0.29%
Available-for-Sale
(at fair value):
U.S. agency
securities........ 31,718 38.93 33,695 37.56 8,983 14.96
Mortgage-backed
securities........ 17,603 21.60 23,735 26.46 18,329 30.52
Municipal bonds.... -- -- -- -- -- --
Mutual funds....... 32,087 39.38 32,165 35.86 32,577 54.23
------- ------ ------- ------ ------- ------
Total portfolio..... $81,483 100.00% $89,699 100.00% $60,063 100.00%
======= ====== ======= ====== ======= ======
20
The following table sets forth the maturities and weighted average yields
of the investment and mortgage-backed securities in the Company's investment
securities portfolio at September 30, 2006. Mutual funds, which by their
nature do not have maturities, are classified in the less than one year
category.
After One to After Five to After Ten
One Year or Less Five Years Ten Years Years
---------------- ---------------- ---------------- ----------------
Amount Yield Amount Yield Amount Yield Amount Yield
------ ----- ------ ----- ------ ----- ------ -----
(Dollars in thousands)
Held-to-Maturity:
Mortgage-backed
securities............. $ -- --% $ -- --% $ -- --% $ 75 3.79%
Available-for-Sale:
U.S. agency securities.. 5,964 3.43 23,787 4.12 1,968 4.04 -- --
Mortgage-backed
securities............. -- -- 520 5.67 128 5.89 16,954 4.84
Mutual funds............ 32,087 5.16 -- -- -- -- -- --
------- ---- ------- ---- ------ ---- ------- ----
Total portfolio......... $38,051 4.89% $24,307 4.15% $2,096 4.15% $17,029 4.83%
======= ==== ======= ==== ====== ==== ======= ====
The following table sets forth certain information with respect to each
security which had an aggregate book value in excess of 10% of the Company's
total equity at the date indicated.
At September 30, 2006
----------------------
Amortized Fair
Cost Value
--------- -------
(In thousands)
Asset Management Fund-Ultra Short
Mortgage Fund (ASARX).................. $16,600 $16,195
Asset Management Fund-Ultra Short Fund
(AULTX)................................ 10,000 9,779
------- -------
Total................................... $26,600 $25,974
======= =======
Deposit Activities and Other Sources of Funds
General. Deposits and loan repayments are the major sources of the
Bank's funds for lending and other investment purposes. Scheduled loan
repayments are a relatively stable source of funds, while deposit inflows and
outflows and loan prepayments are influenced significantly by general interest
rates and money market conditions. Borrowings through the FHLB-Seattle may be
used to compensate for reductions in the availability of funds from other
sources.
Deposit Accounts. Substantially all of the Bank's depositors are
residents of Washington. Deposits are attracted from within the Bank's market
area through the offering of a broad selection of deposit instruments,
including money market deposit accounts, checking accounts, regular savings
accounts and certificates of deposit. Deposit account terms vary, according
to the minimum balance required, the time periods the funds must remain on
deposit and the interest rate, among other factors. In determining the terms
of its deposit accounts, the Bank considers current market interest rates,
profitability to the Bank, matching deposit and loan products and its customer
preferences and concerns. In recent periods, the Bank has used deposit
interest rate promotions in connection with the opening of new branch offices.
The Bank actively seeks consumer and commercial checking accounts through a
checking account acquisition marketing program that was implemented in 2000.
At September 30, 2006, the Bank had 34.2% of total deposits in non-interest
bearing accounts and NOW checking accounts.
21
At September 30, 2006 the Bank had $52.9 million of jumbo certificates of
deposit of $100,000 or more. The Bank does not have any brokered deposits and
believes that its jumbo certificates of deposit, which represented 12.3% of
total deposits at September 30, 2006, present similar interest rate risk
compared to its other deposit products.
The following table sets forth information concerning the Bank's deposits
at September 30, 2006.
Weighted Percentage
Average of Total
Category Interest Rate Amount Deposits
---------------------------------------- ------------- --------- ----------
(In thousands)
Non-Interest Bearing.................... --% $ 57,905 13.43%
Negotiable order of withdrawal ("NOW")
Checking............................... 0.69 89,509 20.77
Savings................................. 0.71 60,235 13.97
Money Market Accounts................... 2.11 42,378 9.83
-------- ------
Subtotal............................... 0.79 250,027 58.00
-------- ------
Certificates of Deposit(1)
----------------------------------------
Maturing within 1 year.................. 4.23 153,939 35.71
Maturing after 1 year but within 2
years.................................. 3.91 20,037 4.65
Maturing after 2 years but within 5
years.................................. 3.92 7,010 1.63
Maturing after 5 years.................. 3.85 48 0.01
-------- ------
Total certificates of deposit......... 4.19 181,034 42.00
-------- ------
Total deposits...................... 2.24 $431,061 100.00%
======== ======
--------------
(1) Based on remaining maturity of certificates.
The following table indicates the amount of the Bank's jumbo certificates
of deposit by time remaining until maturity as of September 30, 2006. Jumbo
certificates of deposit have principal balances of $100,000 or more and the
rates paid on these accounts are generally negotiable.
Maturity Period Amount
------------------------------------ --------
(In thousands)
Three months or less................ $17,871
Over three through six months....... 15,436
Over six through twelve months...... 14,142
Over twelve months.................. 5,402
-------
Total............................. $52,851
=======
22
Deposit Flow. The following table sets forth the balances of deposits in the various types of accounts
offered by the Bank at the dates indicated.
At September 30,
------------------------------------------------------------------------------------
2006 2005 2004
------------------------------ ----------------------------- -------------------
Percent Percent Percent
of Increase of Increase of
Amount Total (Decrease) Amount Total (Decrease) Amount Total
-------- ------- ---------- -------- -------- ---------- ------- --------
(Dollars in thousands)
Non-interest-bearing... $ 57,905 13.43% $ 6,114 $ 51,791 12.58% $14,641 $ 37,150 11.63%
NOW checking........... 89,509 20.77 (3,969) 93,478 22.71 16,236 77,242 24.17
Savings accounts....... 60,235 13.97 (4,039) 64,274 15.61 16,074 48,200 15.08
Money market deposit... 42,378 9.83 (6,917) 49,295 11.98 7,643 41,652 13.03
Certificates of deposit
which mature:
Within 1 year........ 153,939 35.71 49,776 104,163 25.30 17,736 86,427 27.05
After 1 year, but
within 2 years...... 20,037 4.65 (10,732) 30,769 7.47 12,711 18,058 5.65
After 2 years, but
within 5 years...... 7,010 1.63 (10,735) 17,745 4.31 7,582 10,163 3.18
Certificates maturing
thereafter.......... 48 0.01 (102) 150 0.04 (528) 678 0.21
-------- ------ ------- -------- ------ ------- -------- ------
Total.................. $431,061 100.00% $19,396 $411,665 100.00% $92,095 $319,570 100.00%
======== ====== ======= ======== ====== ======= ======== ======
23
Certificates of Deposit by Rates. The following table sets forth the
certificates of deposit in the Bank classified by rates as of the dates
indicated.
At September 30,
------------------------------
2006 2005 2004
-------- -------- --------
(In thousands)
0.00 - 1.99%......... $ 2,176 $ 24,765 $ 60,258
2.00 - 3.99%......... 69,736 125,541 46,482
4.00 - 5.99%......... 108,636 2,034 7,890
6.00% - and over..... 486 487 696
-------- -------- --------
Total................ $181,034 $152,827 $115,326
======== ======== ========
Certificates of Deposit by Maturities. The following table sets forth
the amount and maturities of certificates of deposit at September 30, 2006.
Amount Due
-------------------------------------------------
After
One to Two to
Less Than Two Five After
One Year Years Years Five Years Total
--------- ------- ------- ---------- -------
(In thousands)
0.00 - 1.99%........... $ 2,023 $ 85 $ 68 $-- $ 2,176
2.00 - 3.99%........... 53,555 11,373 4,760 48 69,736
4.00 - 5.99%........... 98,302 8,520 1,814 -- 108,636
6.00% and over......... 59 59 368 -- 486
-------- ------- ------ --- --------
Total.................. $153,939 $20,037 $7,010 $48 $181,034
======== ======= ====== === ========
Deposit Activities. The following table sets forth the savings
activities of the Bank for the periods indicated.
Year Ended September 30,
------------------------------
2006 2005 2004
-------- -------- --------
(In thousands)
Beginning balance....................... $411,665 $319,570 $307,672
Net deposits before interest credited... 11,491 86,673 7,730
Interest credited....................... 7,905 5,422 4,168
-------- -------- --------
Net increase in deposits................ 19,396 92,095 11,898
-------- -------- --------
Ending balance.......................... $431,061 $411,665 $319,570
======== ======== ========
Borrowings. Deposits are the primary source of funds for the Bank's
lending and investment activities and for general business purposes. The Bank
has the ability to use advances from the FHLB-Seattle to supplement its supply
of lendable funds and to meet deposit withdrawal requirements. The
FHLB-Seattle functions as a central reserve bank providing credit for member
financial institutions. As a member of the FHLB-Seattle, the Bank is required
to own capital stock in the FHLB-Seattle and is authorized to apply for
advances on the security of such stock and certain mortgage loans and other
assets (principally securities which are obligations of, or guaranteed by, the
United States government) provided certain creditworthiness standards have
been met. Advances are made pursuant to several different credit programs.
Each credit program has its own interest rate and range of maturities.
Depending on the program, limitations on the amount of advances are based on
the financial condition of the member institution and the adequacy of
collateral pledged to secure the credit. At September 30, 2006, the Bank
maintained an uncommitted credit facility with the FHLB-adequacy of collateral
pledged to secure the credit. At September 30, 2006, the Bank maintained an
uncommitted credit facility with the FHLB-Seattle that provided for
immediately available advances up to an aggregate amount of 30% of the Bank's
total assets, limited by available collateral, under which $62.8 million was
outstanding. The Bank also utilizes overnight repurchase
24
agreements with customers. These overnight repurchase agreements are
classified as other borrowings and totaled $947,000 at September 30, 2006 and
$781,000 at September 30, 2005. There were no repurchase agreements in effect
at September 30, 2004. At September 30, 2006, the Bank also maintained a
$10.0 million overnight borrowing line with Pacific Coast Banker's Bank
("PCBB") under which there was no outstanding balance.
The following table sets forth certain information regarding borrowings
by the Bank at the end of and during the periods indicated:
At or For the
Year Ended September 30,
--------------------------
2006 2005 2004
------ ------ ------
(Dollars in thousands)
Average total borrowings........................ $55,773 $60,537 $57,778
Weighted average rate paid on total borrowings.. 5.22% 5.26% 5.46%
Total borrowings outstanding at end of period... $63,708 $63,134 $65,421
The following table sets forth certain information regarding short-term
borrowings by the Bank at the end of and during the periods indicated.
Borrowings are considered short-term when the original maturity is less than
one year.
At or For the
Year Ended September 30,
--------------------------
2006 2005 2004
------ ------ ------
(Dollars in thousands)
Maximum amount outstanding at any month end:
FHLB advances................................. $29,000 $ 9,000 $10,485
Repurchase agreements......................... 1,895 2,102 --
PCBB advances................................. -- -- --
Average outstanding during period:
FHLB advances................................. $ 3,516 $ 4,529 $ 631
Repurchase agreements......................... 1,148 1,345 --
PCBB advances................................. -- 1 2
------- ------- --------
Total average outstanding during period......... $ 4,664 $ 5,875 $ 633
======= ======= ========
Weighted average rate paid during period:
FHLB advances................................. 4.81% 4.53% 1.89%
Repurchase agreements......................... 4.27 2.30 --
PCBB advances................................. -- 4.80 3.35
Total weighted average rate paid during period.. 4.67% 4.02% 1.90%
Outstanding at end of period:
FHLB advances................................. $29,000 $ 8,000 $10,485
Repurchase agreements......................... 947 781 --
------- ------- --------
Total outstanding at end of period.............. $29,947 $ 8,781 $10,485
======= ======= ========
Weighted average rate at end of period:
FHLB advances................................. 5.49% 3.79% 1.86%
Repurchase agreements......................... 5.01 3.14 --
Total weighted average rate at end of period.... 5.47% 3.73% 1.86%
25
Bank Owned Life Insurance
The Bank has purchased life insurance policies covering certain officers.
These policies are recorded at their cash surrender value, net of any policy
premium charged. Increases in cash surrender value, net of policy premiums,
and proceeds from death benefits are recorded in non-interest income. At
September 30, 2006, the Bank had $12.0 million in bank owned life insurance.
REGULATION OF THE BANK
General
The Bank, as a state-chartered savings bank, is subject to regulation and
oversight by the Division and the applicable provisions of Washington law and
regulations of the Division adopted thereunder. The Bank also is subject to
regulation and examination by the FDIC, which insures the deposits of the Bank
to the maximum extent permitted by law, and requirements established by the
Federal Reserve. State law and regulations govern the Bank's ability to take
deposits and pay interest thereon, to make loans on or invest in residential
and other real estate, to make consumer loans, to invest in securities, to
offer various banking services to its customers, and to establish branch
offices. Under state law, savings banks in Washington also generally have all
of the powers that federal savings banks have under federal laws and
regulations. The Bank is subject to periodic examination and reporting
requirements by and of the Division.
Federal Deposit Insurance Reform Act of 2005
The Federal Deposit Insurance Reform Act of 2005 ("Reform Act") was
signed into law on February 8, 2006 and amended current laws regarding the
federal deposit insurance system. The legislation merged the Bank Insurance
Fund and the Savings Association Insurance Fund to form the Deposit Insurance
Fund, eliminated any disparities in bank and thrift risk-based premium
assessments, reduced the administrative burden of maintaining and operating
two separate funds and established certain new insurance coverage limits and a
mechanism for possible periodic increases. The legislation also gave the FDIC
greater discretion to identify the relative risks all institutions present to
the Deposit Insurance Fund and set risk-based premiums.
Major provisions in the legislation include:
* merging the Savings Association Insurance Fund and Bank Insurance
Fund, which became effective March 31, 2006;
* maintaining basic deposit and municipal account insurance coverage
at $100,000 but providing for a new basic insurance coverage for
retirement accounts of $250,000. Insurance coverage for basic
deposit and retirement accounts could be increased for inflation
every five years in $10,000 increments beginning in 2011;
* providing the FDIC with the ability to set the designated reserve
ratio within a range of between 1.15% and 1.50%, rather than
maintaining 1.25% at all times regardless of prevailing economic
conditions;
* providing a one-time assessment credit of $4.7 billion to banks and
savings associations in existence on December 31, 1996, which may
be used to offset future premiums with certain limitations;
* requiring the payment of dividends of 100% of the amount that the
insurance fund exceeds 1.5% of the estimated insured deposits and
the payment of 50% of the amount that the insurance fund exceeds
1.35% of the estimated insured deposits (when the reserve is
greater than 1.35% but no more than 1.5%); and
* providing for a new risk-based assessment system and allows the
FDIC to establish separate risk-based assessment systems for large
and small members of the Deposit Insurance Fund.
26
On November 2, 2006, the FDIC set the designated reserve ratio for the
deposit insurance fund at 1.25% of estimated insured deposits, and adopted
final regulations to implement the risk-based deposit insurance assessment
system mandated by the Reform Act , which is intended to more closely tie each
bank's deposit insurance assessments to the risk it poses to the deposit
insurance fund. Under the new risk-based assessment system, the FDIC will
evaluate each institution's risk based on three primary factors -- supervisory
ratings for all insured institution, financial ratios for most institutions,
and long-term debt issuer ratings for large institutions that have them. An
institution's assessment rate will depend upon the level of risk it poses to
the deposit insurance system as measured by these factors. The new rates for
most institutions will vary between 5 and 7 cents for every $100 of domestic
insurable deposits.
The new assessment rates will take effect at the beginning of 2007.
However, the Reform Act provides credits to institutions that paid high
premiums in the past to bolster the FDIC's insurance reserves, as a result of
which the FDIC has announced that a majority of banks will have assessment
credits to initially offset all of their premiums in 2007. Management does not
believe it is possible at this time to reliably estimate the net assessment
cost, if any that may be imposed on Timberland Bank. There are a number of
uncertain factors that could affect the assessment rate that the FDIC will
decide to apply to Timberland Bank and the actual assessment credit that will
be available to Timberland Bank in 2007.
Insurance of Accounts and Regulation by the FDIC
The Bank is a member of the DIF, which is administered by the FDIC. The
FDIC insures deposits up to the applicable limits and this insurance is backed
by the full faith and credit of the United States government. As insurer, the
FDIC imposes deposit insurance premiums and is authorized to conduct
examinations of and to require reporting by FDIC-insured institutions. It
also may prohibit any FDIC-insured institution from engaging in any activity
the FDIC determines by regulation or order to pose a serious risk to the FDIC.
The FDIC also has the authority to initiate enforcement actions against
savings institutions, after giving the FDIC an opportunity to take such
action, and may terminate the deposit insurance if it determines that the
institution has engaged in unsafe or unsound practices or is in an unsafe or
unsound condition.
The FDIC's deposit insurance premiums are assessed through a risk-based
system under which all insured depository institutions are placed into one of
nine categories and assessed insurance premiums based upon their level of
capital and supervisory evaluation. Under the system, institutions classified
as well capitalized (i.e., a core capital ratio of at least 5%, a ratio of
Tier 1 or core capital to risk-weighted assets ("Tier 1 risk-based capital")
of at least 6% and a risk-based capital ratio of at least 10%) and considered
healthy pay the lowest premiums while institutions that are less than
adequately capitalized (i.e., core or Tier 1 risk-based capital ratios of less
than 4% or a risk-based capital ratio of less than 8%) and considered of
substantial supervisory concern pay the highest premiums. Risk classification
of all insured institutions is made by the FDIC for each semi-annual
assessment period. The Reform Act authorizes the FDIC to revise its current
risk-based system, subject to public notice and comment, although no deadline
was given by Congress for the creation or implementation of such regulations.
DIF-insured institutions are required to pay a Financing Corporation
("FICO") assessment, in order to fund the interest on bonds issued to resolve
thrift failures in the 1980s. The assessment rate for the third quarter of
2006 was 0.0126% of insured deposits and is adjusted quarterly. These
assessments, which may be revised based upon the level of DIF deposits, will
continue until the FICO bonds mature in the years 2017 through 2019.
Prompt Corrective Action
The FDIC is required to take certain supervisory actions against
undercapitalized savings institutions, the severity of which depends upon the
institution's degree of undercapitalization. Generally, an institution that
has a ratio of total capital to risk-weighted assets of less than 8%, a ratio
of Tier I (core) capital to risk-weighted assets of less than 4%, or a ratio
of core capital to total assets of less than 4% (3% or less for institutions
with the highest examination rating) is considered to be undercapitalized. An
institution that has a total risk-based capital ratio less than 6%, a Tier I
capital ratio of less than 3% or a leverage ratio that is less than 3% is
considered to be significantly undercapitalized and an institution that has a
tangible capital to assets ratio equal to or less than 2% is deemed to be
critically
27
undercapitalized. Subject to a narrow exception, the FDIC is required to
appoint a receiver or conservator for a savings institution that is critically
undercapitalized. FDIC regulations also require that a capital restoration
plan be filed with the FDIC within 45 days of the date a savings institution
receives notice that it is undercapitalized, significantly undercapitalized or
critically undercapitalized. Compliance with the plan must be guaranteed by
any parent holding company in an amount of up to the lesser of 5% of the
institution's assets or the amount which would bring the institution into
compliance with all capital standards. In addition, numerous mandatory
supervisory actions become immediately applicable to an undercapitalized
institution, including, but not limited to, increased monitoring by regulators
and restrictions on growth, capital distributions and expansion. The FDIC
also could take any one of a number of discretionary supervisory actions,
including the issuance of a capital directive and the replacement of senior
executive officers and directors.
At September 30, 2006, the Bank was categorized as "well capitalized"
under the prompt corrective action regulations of the FDIC.
Standards for Safety and Soundness
The federal banking regulatory agencies have prescribed, by regulation,
guidelines for all insured depository institutions relating to: internal
controls, information systems and internal audit systems, loan documentation,
credit underwriting, interest rate risk exposure, asset growth, asset quality,
earnings, and compensation, fees and benefits. The guidelines set forth the
safety and soundness standards that the federal banking agencies use to
identify and address problems at insured depository institutions before
capital becomes impaired. If the FDIC determines that the Bank fails to meet
any standard prescribed by the guidelines, the agency may require the Bank to
submit to the agency an acceptable plan to achieve compliance with the
standard. FDIC regulations establish deadlines for the submission and review
of such safety and soundness compliance plans. Management of the Bank is not
aware of any conditions relating to these safety and soundness standards which
would require submission of a plan of compliance.
Capital Requirements
FDIC regulations recognize two types or tiers of capital: core ("Tier 1")
capital and supplementary ("Tier 2") capital. Tier 1 capital generally
includes common shareholders' equity and noncumulative perpetual preferred
stock, less most intangible assets. Tier 2 capital, which is limited to 100%
of Tier 1 capital, includes such items as qualifying general loan loss
reserves, cumulative perpetual preferred stock, mandatory convertible debt,
term subordinated debt and limited life preferred stock; however, the amount
of term subordinated debt and intermediate term preferred stock (original
maturity of at least five years but less than 20 years) that may be included
in Tier 2 capital is limited to 50% of Tier 1 capital.
The FDIC currently measures an institution's capital using a leverage
limit together with certain risk-based ratios. The FDIC's minimum leverage
capital requirement specifies a minimum ratio of Tier 1 capital to average
total assets. Most banks are required to maintain a minimum leverage ratio of
at least 4% to 5% of total assets. At September 30, 2006, the Bank had a Tier
1 leverage capital ratio of 11.5%. The FDIC retains the right to require an
institution to maintain a higher capital level based on the institution's
particular risk profile.
FDIC regulations also establish a measure of capital adequacy based on
ratios of qualifying capital to risk-weighted assets. Assets are placed in
one of four categories and given a percentage weight based on the relative
risk of that category. In addition, certain off-balance-sheet items are
converted to balance-sheet credit equivalent amounts, and each amount is then
assigned to one of the four categories. Under the guidelines, the ratio of
total capital (Tier 1 capital plus Tier 2 capital) to risk-weighted assets
must be at least 8%, and the ratio of Tier 1 capital to risk-weighted assets
must be at least 4%. In evaluating the adequacy of a bank's capital, the FDIC
may also consider other factors that may affect a bank's financial condition.
Such factors may include interest rate risk exposure, liquidity, funding and
market risks, the quality and level of earnings, concentration of credit risk,
risks arising from nontraditional activities, loan and investment quality, the
effectiveness of loan and investment policies, and management's ability to
monitor and control financial operating risks. At September 30, 2006, the
Bank's ratio of total capital to risk-weighted assets was 15.6% and the ratio
of Tier 1 capital to risk-weighted assets was 14.6%.
28
The Division requires that net worth equal at least 5% of total assets.
Intangible assets must be deducted from net worth and assets when computing
compliance with this requirement. At September 30, 2006, the Bank had a net
worth of 11.0% of total assets.
The table below sets forth the Bank's capital position relative to its
FDIC capital requirements at September 30, 2006. The definitions of the terms
used in the table are those provided in the capital regulations issued by the
FDIC, and the Bank has not been notified by the FDIC of any higher capital
requirements specifically applicable to it.
At September 30, 2006
----------------------------
Percent of Adjusted
Amount Total Assets (1)
------ -------------------
(Dollars in thousands)
Tier 1 (leverage) capital (2)............. $63,222 11.5%
Tier 1 (leverage) capital requirement..... 22,017 4.0
------- ----
Excess.................................... $41,205 7.5%
======= ====
Tier 1 risk adjusted capital.............. $63,222 14.6%
Tier 1 risk adjusted capital requirement.. 17,314 4.0
------- ----
Excess.................................... $45,908 10.6%
======= ====
Total risk-based capital.................. $67,344 15.6%
Total risk-based capital requirement...... 34,627 8.0
------- ----
Excess.................................... $32,717 7.6%
======= ====
------------------
(1) For the Tier 1 (leverage) capital and Washington regulatory capital
calculations, percent of total average assets of $550.4 million. For the
Tier 1 risk-based capital and total risk-based capital calculations,
percent of total risk-weighted assets of $432.8 million.
(2) As a Washington-chartered savings bank, the Bank is subject to the
capital requirements of the FDIC and the Division. The FDIC requires
state-chartered savings banks, including the Bank, to have a minimum
leverage ratio of Tier 1 capital to total assets of at least 3%,
provided, however, that all institutions, other than those (i) receiving
the highest rating during the examination process and (ii) not
anticipating any significant growth, are required to maintain a ratio of
1% to 2% above the stated minimum, with an absolute total capital to
risk-weighted assets of at least 8%. The Bank has not been notified by
the FDIC of any leverage capital requirement specifically applicable to
it.
The Bank's management believes that, under the current regulations, the
Bank will continue to meet its minimum capital requirements in the foreseeable
future. However, events beyond the control of the Bank, such as a downturn in
the economy in areas where the Bank has most of its loans, could adversely
affect future earnings and, consequently, the ability of the Bank to meet its
capital requirements.
Activities and Investments of Insured State-Financial Institutions
Federal law generally limits the activities and equity investments of
FDIC-insured, state-chartered banks to those that are permissible for national
banks. An insured state bank is not prohibited from, among other things, (i)
acquiring or retaining a majority interest in a subsidiary, (ii) investing as
a limited partner in a partnership the sole purpose of which is direct or
indirect investment in the acquisition, rehabilitation or new construction of
a qualified housing project, provided that such limited partnership
investments may not exceed 2% of the bank's total assets, (iii) acquiring up
to 10% of the voting stock of a company that solely provides or reinsures
directors', trustees' and officers' liability insurance coverage or bankers'
blanket bond group insurance coverage for insured depository institutions, and
(iv) acquiring or retaining the voting shares of a depository institution if
certain requirements are met.
29
Washington law provides financial institution parity between commercial
banks and savings banks. Primarily, the law affords Washington-chartered
commercial banks the same powers as Washington-chartered savings banks. In
order for a bank to exercise these powers, it must provide 30 days notice to
the Director of Washington Division of Financial Institutions and the Director
must authorize the requested activity. In addition, the law provides that
Washington-chartered commercial banks may exercise any of the powers that the
Federal Reserve has determined to be closely related to the business of
banking and the powers of national banks, subject to the approval of the
Director in certain situations. The law also provides that
Washington-chartered savings banks may exercise any of the powers of
Washington-chartered commercial banks, national banks and federally-chartered
savings banks, subject to the approval of the Director in certain situations.
Finally, the law provides additional flexibility for Washington-chartered
commercial and savings banks with respect to interest rates on loans and other
extensions of credit. Specifically, they may charge the maximum interest rate
allowable for loans and other extensions of credit by federally-chartered
financial institutions to Washington residents.
Environmental Issues Associated With Real Estate Lending
The Comprehensive Environmental Response, Compensation and Liability Act
("CERCLA"), a federal statute, generally imposes strict liability on all prior
and present "owners and operators" of hazardous waste sites. However, the
U.S. Congress created a safe harbor provision to protect secured creditors by
providing that the term "owner and operator" excludes a person whose ownership
is limited to protecting its security interest in the site. Since the
enactment of the CERCLA, this "secured creditor exemption" has been the
subject of judicial interpretations which have left open the possibility that
lenders could be liable for cleanup costs on contaminated property that they
hold as collateral for a loan.
To the extent that legal uncertainty exists in this area, all creditors,
including the Bank, that have made loans secured by properties with potential
hazardous waste contamination (such as petroleum contamination) could be
subject to liability for cleanup costs, which costs often substantially exceed
the value of the collateral property.
Federal Reserve System
The Federal Reserve Board requires under Regulation D that all depository
institutions, including savings banks, maintain reserves on transaction
accounts or non-personal time deposits. These reserves may be in the form of
cash or non-interest-bearing deposits with the regional Federal Reserve Bank.
Negotiable order of withdrawal accounts and other types of accounts that
permit payments or transfers to third parties fall within the definition of
transaction accounts and are subject to Regulation D reserve requirements, as
are any non-personal time deposits at a savings bank. As of September 30,
2006, the Bank's deposit with the Federal Reserve and vault cash exceeded its
Regulation D reserve requirements.
Affiliate Transactions
The Company and the Bank are separate and distinct legal entities.
Various legal limitations restrict the Bank from lending or otherwise
supplying funds to the Company (an "affiliate"), generally limiting such
transactions with the affiliate to 10% of the bank's capital and surplus and
limiting all such transactions to 20% of the bank's capital and surplus.
These transactions, including extensions of credit, sales of securities or
assets and provision of services, also must be on terms and conditions
consistent with safe and sound banking practices, including credit standards,
that are substantially the same or at least as favorable to the bank as those
prevailing at the time for transactions with unaffiliated companies.
Federally insured banks are subject, with certain exceptions, to certain
restrictions on extensions of credit to their parent holding companies or
other affiliates, on investments in the stock or other securities of
affiliates and on the taking of such stock or securities as collateral from
any borrower. In addition, such banks are prohibited from engaging in certain
tie-in arrangements in connection with any extension of credit or the
providing of any property or service.
30
Community Reinvestment Act
Banks are also subject to the provisions of the Community Reinvestment
Act of 1977 ("CRA"), which requires the appropriate federal bank regulatory
agency, in connection with its regular examination of a bank, to assess the
bank's record in meeting the credit needs of the community serviced by the
bank, including low and moderate income neighborhoods. The regulatory
agency's assessment of the bank's record is made available to the public.
Further, such assessment is required of any bank which has applied, among
other things, to establish a new branch office that will accept deposits,
relocate an existing office or merge or consolidate with, or acquire the
assets or assume the liabilities of, a federally regulated financial
institution. The Bank received a "satisfactory" rating during its most recent
CRA examination.
Dividends
Dividends from the Bank constitute the major source of funds for
dividends which may be paid by the Company. The amount of dividends payable
by the Bank to the Company depends upon the Bank's earnings and capital
position, and is limited by federal and state laws, regulations and policies.
According to Washington law, the Bank may not declare or pay a cash dividend
on its capital stock if it would cause its net worth to be reduced below (i)
the amount required for liquidation accounts or (ii) the net worth
requirements, if any, imposed by the Director of the Division. In addition,
dividends on the Bank's capital stock may not be paid in an aggregate amount
greater than the aggregate retained earnings of the Bank, without the approval
of the Director of the Division.
The amount of dividends actually paid during any one period will be
strongly affected by the Bank's management policy of maintaining a strong
capital position. Federal law further provides that no insured depository
institution may make any capital distribution (which would include a cash
dividend) if, after making the distribution, the institution would be
"undercapitalized," as defined in the prompt corrective action regulations.
Moreover, the federal bank regulatory agencies also have the general authority
to limit the dividends paid by insured banks if such payments should be deemed
to constitute an unsafe and unsound practice.
Privacy Standards
The Gramm-Leach-Bliley Financial Services Modernization Act of 1999
("GLBA"), which was enacted in 1999, modernized the financial services
industry by establishing a comprehensive framework to permit affiliations
among commercial banks, insurance companies, securities firms and other
financial service providers. The Bank is subject to FDIC regulations
implementing the privacy protection provisions of the GLBA. These regulations
require the Bank to disclose its privacy policy, including identifying with
whom it shares "non-public personal information," to customers at the time of
establishing the customer relationship and annually thereafter.
Anti-Money Laundering and Customer Identification
Congress enacted the Uniting and Strengthening America by Providing
Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001
(the "USA Patriot Act") on October 26, 2001 in response to the terrorist
events of September 11, 2001. The USA Patriot Act gives the federal government
new powers to address terrorist threats through enhanced domestic security
measures, expanded surveillance powers, increased information sharing, and
broadened anti-money laundering requirements. In March 2006, Congress
re-enacted certain expiring provisions of the USA Patriot Act.
REGULATION OF THE COMPANY
General
The Company, as the sole shareholder of the Bank is a bank holding
company and is registered as such with the Federal Reserve. Bank holding
companies are subject to comprehensive regulation by the Federal Reserve under
the Bank Holding Company Act of 1956, as amended ("BHCA"), and the regulations
of the Federal Reserve. As a bank
31
holding company, the Company is required to file with the Federal Reserve
annual reports and such additional information as the Federal Reserve may
require and will be subject to regular examinations by the Federal Reserve.
The Federal Reserve also has extensive enforcement authority over bank holding
companies, including, among other things, the ability to assess civil money
penalties, to issue cease and desist or removal orders and to require that a
holding company divest subsidiaries (including its bank subsidiaries). In
general, enforcement actions may be initiated for violations of law and
regulations and unsafe or unsound practices.
The Bank Holding Company Act
Under the Bank Holding Company Act, the Company is supervised by the
Federal Reserve. The Federal Reserve has a policy that a bank holding company
is required to serve as a source of financial and managerial strength to its
subsidiary banks and may not conduct its operations in an unsafe or unsound
manner. In addition, the Federal Reserve provides that bank holding companies
should serve as a source of strength to its subsidiary banks by being prepared
to use available resources to provide adequate capital funds to its subsidiary
banks during periods of financial stress or adversity, and should maintain the
financial flexibility and capital raising capacity to obtain additional
resources for assisting its subsidiary banks. A bank holding company's
failure to meet its obligation to serve as a source of strength to its
subsidiary banks will generally be considered by the Federal Reserve to be an
unsafe and unsound banking practice or a violation of the Federal Reserve's
regulations or both.
The Company is required to file quarterly and periodic reports with the
Federal Reserve and provide additional information as the Federal Reserve may
require. The Federal Reserve may examine the Company, and any of its
subsidiaries, and charge the Company for the cost of the examination.
The Company and any subsidiaries that it may control are considered
"affiliates" within the meaning of the Federal Reserve Act, and transactions
between our bank subsidiary and affiliates are subject to numerous
restrictions. With some exceptions, the Company and its subsidiaries, are
prohibited from tying the provision of various services, such as extensions of
credit, to other services offered by the Company, or its affiliates.
Acquisitions
The BHCA prohibits a bank holding company, with certain exceptions, from
acquiring direct or indirect ownership or control of more than 5% of the
voting shares of any company that is not a bank or bank holding company and
from engaging directly or indirectly in activities other than those of
banking, managing or controlling banks, or providing services for its
subsidiaries. Under the BHCA, the Federal Reserve is authorized to approve
the ownership of shares by a bank holding company in any company, the
activities of which the Federal Reserve has determined to be so closely
related to the business of banking or managing or controlling banks as to be a
proper incident thereto. The list of activities determined by regulation to
be closely related to banking within the meaning of the BHCA includes, among
other things: operating a savings institution, mortgage company, finance
company, credit card company or factoring company; performing certain data
processing operations; providing certain investment and financial advice;
underwriting and acting as an insurance agent for certain types of
credit-related insurance; leasing property on a full-payout, non-operating
basis; selling money orders, travelers' checks and U.S. Savings Bonds; real
estate and personal property appraising; providing tax planning and
preparation services; and, subject to certain limitations, providing
securities brokerage services for customers.
Interstate Banking
The Federal Reserve must approve an application of an adequately
capitalized and adequately managed bank holding company to acquire control of,
or acquire all or substantially all of the assets of, a bank located in a
state other than such holding company's home state, without regard to whether
the transaction is prohibited by the laws of any state. The Federal Reserve
may not approve the acquisition of a bank that has not been in existence for
the minimum time period, not exceeding five years, specified by the statutory
law of the host state. Nor may the Federal Reserve approve an application if
the applicant, and its depository institution affiliates, controls or would
control more than 10% of the insured deposits in the United States or 30% or
more of the deposits in the target bank's home state or in any state in
32
which the target bank maintains a branch. Federal law does not affect the
authority of states to limit the percentage of total insured deposits in the
state which may be held or controlled by a bank holding company to the extent
such limitation does not discriminate against out-of-state banks or bank
holding companies. Individual states may also waive the 30% state-wide
concentration limit contained in the federal law.
The Federal banking agencies are authorized to approve interstate merger
transactions without regard to whether such transaction is prohibited by the
law of any state, unless the home state of one of the banks adopted a law
prior to June 1, 1997 which applies equally to all out-of-state banks and
expressly prohibits merger transactions involving out-of-state banks.
Interstate acquisitions of branches will be permitted only if the law of the
state in which the branch is located permits such acquisitions. Interstate
mergers and branch acquisitions will also be subject to the nationwide and
statewide insured deposit concentration amounts described above.
Dividends
The Federal Reserve has issued a policy statement on the payment of cash
dividends by bank holding companies, which expresses the Federal Reserve's
view that a bank holding company should pay cash dividends only to the extent
that the company's net income for the past year is sufficient to cover both
the cash dividends and a rate of earning retention that is consistent with the
company's capital needs, asset quality and overall financial condition. The
Federal Reserve also indicated that it would be inappropriate for a company
experiencing serious financial problems to borrow funds to pay dividends.
Stock Repurchases
Bank holding companies, except for certain "well-capitalized" and highly
rated bank holding companies, are required to give the Federal Reserve prior
written notice of any purchase or redemption of its outstanding equity
securities if the gross consideration for the purchase or redemption, when
combined with the net consideration paid for all such purchases or redemptions
during the preceding 12 months, is equal to 10% or more of their consolidated
net worth. The Federal Reserve may disapprove such a purchase or redemption
if it determines that the proposal would constitute an unsafe or unsound
practice or would violate any law, regulation, Federal Reserve order, or any
condition imposed by, or written agreement with, the Federal Reserve.
Capital Requirements
The Federal Reserve has established capital adequacy guidelines for bank
holding companies that generally parallel the capital requirements of the FDIC
for the Bank. The Federal Reserve regulations provide that capital standards
will be applied on a consolidated basis in the case of a bank holding company
with $150 million or more in total consolidated assets.
The Company's total risk based capital must equal 8% of risk-weighted
assets and one half of the 8%, or 4%, must consist of Tier 1 (core) capital.
As of September 30, 2006, the Company's total risk based capital was 17.5% of
risk-weighted assets and its risk based capital of Tier 1 (core) capital was
16.6% of risk-weighted assets.
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act") was signed into law
on July 30, 2002 in response to public concerns regarding corporate
accountability in connection with certain accounting scandals. The stated
goals of the Sarbanes-Oxley Act are to increase corporate responsibility, to
provide for enhanced penalties for accounting and auditing improprieties at
publicly traded companies and to protect investors by improving the accuracy
and reliability of corporate disclosures pursuant to the securities laws. The
Sarbanes-Oxley Act generally applies to all companies, both U.S. and non-U.S.,
that file or are required to file periodic reports with the Securities and
Exchange Commission ("SEC"), under the Securities Exchange Act of 1934
("Exchange Act"), including the Company.
33
The Sarbanes-Oxley Act includes very specific additional disclosure
requirements and new corporate governance rules, requires the SEC and
securities exchanges to adopt extensive additional disclosure, corporate
governance and other related rules and mandates. The Sarbanes-Oxley Act
represents significant federal involvement in matters traditionally left to
state regulatory systems, such as the regulation of the accounting profession,
and to state corporate law, such as the relationship between a board of
directors and management and between a board of directors and its committees.
TAXATION
Federal Taxation
General. The Company and the Bank report their income on a fiscal year
basis using the accrual method of accounting and are subject to federal income
taxation in the same manner as other corporations with some exceptions,
including particularly the Bank's reserve for bad debts discussed below. The
following discussion of tax matters is intended only as a summary and does not
purport to be a comprehensive description of the tax rules applicable to the
Bank or the Company.
Bad Debt Reserve. Historically, savings institutions such as the Bank
which met certain definitional tests primarily related to their assets and the
nature of their business ("qualifying thrift") were permitted to establish a
reserve for bad debts and to make annual additions thereto, which may have
been deducted in arriving at their taxable income.
The provisions repealing the current thrift bad debt rules were passed by
Congress as part of "The Small Business Job Protection Act of 1996." These
rules required that all institutions recapture all or a portion of their bad
debt reserves added since the base year (last taxable year beginning before
January 1, 1988). The Bank had previously recorded deferred taxes equal to
the bad debt recapture and as such the new rules had no effect on the net
income or federal income tax expense. For taxable years beginning after
December 31, 1995, the Bank's bad debt deduction is determined under the
experience method using a formula based on actual bad debt experience over a
period of years or, if the Bank is a "large" association (assets in excess of
$500 million) on the basis of net charge-offs during the taxable year. The
unrecaptured base year reserves will not be subject to recapture as long as
the institution continues to carry on the business of banking. In addition,
the balance of the pre-1988 bad debt reserves continue to be subject to
provisions of present law referred to below that require recapture in the case
of certain excess distributions to shareholders. As of September 30, 2005,
the Bank has recaptured all federal tax bad debt reserves that had been
accumulated since October 1, 1988.
Distributions. To the extent that the Bank makes "nondividend
distributions" to the Company, such distributions will be considered to result
in distributions from the balance of its bad debt reserve as of December 31,
1987 (or a lesser amount if the Bank's loan portfolio decreased since December
31, 1987) and then from the supplemental reserve for losses on loans ("Excess
Distributions"), and an amount based on the Excess Distributions will be
included in the Bank's taxable income. Nondividend distributions include
distributions in excess of the Bank's current and accumulated earnings and
profits, distributions in redemption of stock and distributions in partial or
complete liquidation. However, dividends paid out of the Bank's current or
accumulated earnings and profits, as calculated for federal income tax
purposes, will not be considered to result in a distribution from the Bank's
bad debt reserve. The amount of additional taxable income created from an
Excess Distribution is an amount that, when reduced by the tax attributable to
the income, is equal to the amount of the distribution. Thus, if the Bank
makes a "nondividend distribution," then approximately one and one-half times
the Excess Distribution would be includable in gross income for federal income
tax purposes, assuming a 35% corporate income tax rate (exclusive of state and
local taxes). See "Regulation of the Bank - Dividends" for limits on the
payment of dividends by the Bank. The Bank does not intend to pay dividends
that would result in a recapture of any portion of its tax bad debt reserve.
Corporate Alternative Minimum Tax. The Code imposes a tax on alternative
minimum taxable income ("AMTI") at a rate of 20%. In addition, only 90% of
AMTI can be offset by net operating loss carryovers. AMTI is increased by an
amount equal to 75% of the amount by which the Bank's adjusted current
earnings exceeds its AMTI (determined without regard to this preference and
prior to reduction for net operating losses).
34
Dividends-Received Deduction. The Company may exclude from its income
100% of dividends received from the Bank as a member of the same affiliated
group of corporations. The corporate dividends-received deduction is
generally 70% in the case of dividends received from unaffiliated corporations
with which the Company and the Bank will not file a consolidated tax return,
except that if the Company or the Bank owns more than 20% of the stock of a
corporation distributing a dividend, then 80% of any dividends received may be
deducted.
Audits. The Bank's federal income tax returns have been audited through
September 30, 1997.
Washington Taxation
The Bank is subject to a business and occupation tax imposed under
Washington law at the rate of 1.50% of gross receipts. Interest received on
loans secured by mortgages or deeds of trust on residential properties is
exempt from such tax.
Competition
The Bank operates in an intensely competitive market for the attraction
of deposits (its primary source of lendable funds) and in the origination of
loans. Historically, its most direct competition for deposits has come from
large commercial banks, thrift institutions and credit unions in its primary
market area. In times of high interest rates, the Bank experiences additional
significant competition for investors' funds from short-term money market
securities and other corporate and government securities. The Bank's
competition for loans comes principally from mortgage bankers, commercial
banks and other thrift institutions. Such competition for deposits and the
origination of loans may limit the Bank's future growth and earnings
prospects.
Subsidiary Activities
The Bank has one wholly-owned subsidiary, Timberland Service Corporation
("Timberland Service"), whose primary function is to act as the Bank's escrow
department and offer non-deposit investment services.
Personnel
As of September 30, 2006, the Bank had 236 full-time employees and 28
part-time employees. The employees are not represented by a collective
bargaining unit and the Bank believes its relationship with its employees is
good.
Executive Officers of the Registrant
The following table sets forth certain information with respect to the
executive officers of the Company and the Bank.
Executive Officers of the Company and Bank
Age at Position
September -------------------------------------------------
Name 30, 2006 Company Bank
----------------- --------- ---------------------- ----------------------
Clarence E. Hamre 72 Chairman of the Board Chairman of the Board
Michael R. Sand 52 President and Chief President and Chief
Executive Officer Executive Officer
(table continued on following page)
35
Age at Position
September -------------------------------------------------
Name 30, 2006 Company Bank
----------------- --------- ---------------------- ----------------------
Dean J. Brydon 39 Executive Vice President, Executive Vice
Chief Financial Officer President, Chief
and Secretary Financial Officer and
Secretary
Robert A. Drugge 55 Executive Vice President Executive Vice
President and
Business Banking
Division Manager
Roger A. Johansen 56 Executive Vice President Executive Vice
President and Chief
Lending Officer
John P. Norawong 41 Executive Vice President Executive Vice
President and
Community Banking
Division Manager
Marci A. Basich 37 Senior Vice President and Senior Vice President
Treasurer and Treasurer
Kathie M. Bailey 55 Senior Vice President Senior Vice President
and Chief Operations
Officer
Michael J. Rasmusson 60 Senior Vice President Senior Vice President
Biographical Information.
Clarence E. Hamre is Chairman of the Board of the Company and the Bank.
He has been affiliated with the Bank since 1969 and served as President and
Chief Executive Officer of the Bank since 1969 and as President and Chief
Executive Officer of the Company since 1997. On January 23, 2003, Mr. Hamre
retired as President of the Bank and the Company and on September 30, 2003, he
retired as Chief Executive Officer of the Bank and the Company.
Michael R. Sand has been affiliated with the Bank since 1977 and has
served as President of the Bank and the Company since January 23, 2003. On
September 30, 2003, he was appointed as Chief Executive Officer of the Bank
and Company. Prior to appointment as President and Chief Executive Officer,
Mr. Sand had served as Executive Vice President and Secretary of the Bank
since 1993 and as Executive Vice President and Secretary of the Company since
its formation in 1997.
Dean J. Brydon has been affiliated with the Bank since 1994 and has
served as the Chief Financial Officer of the Company and the Bank since
January 2000 and Secretary of the Company and Bank since January 2004. Mr.
Brydon is a Certified Public Accountant.
Robert A. Drugge has been affiliated with the Bank since April 2006 and
has served as Executive Vice President and Business Banking Manager since
September 2006. Prior to joining Timberland, Mr. Drugge was employed at Bank
of America as an executive officer and most recently served as Senior Vice
President. Mr. Drugge began his banking career at Seafirst in 1974, which was
acquired by Bank America Corp. and became known as Bank of America.
Roger A. Johansen has been affiliated with the Bank since 2000 and has
served as Executive Vice President and Chief Lending Officer since September
2006. Prior to being appointed Chief Lending Officer, Mr. Johansen had served
as the Bank's Business Banking Manager.
36
John P. Norawong has been affiliated with the Bank since July 2006 and
has served as Executive Vice President and Community Banking Division Manager
since September 2006. Prior to joining Timberland, Mr. Norawong served as
Senior Vice President and Commercial Bank Manager at United Commercial Bank
from February 2006 to July 2006, and as Vice President and Senior Vice
President at Key Bank from 1999 through 2006.
Marci A. Basich has been affiliated with the Bank since 1999 and has
served as Treasurer of the Company and the Bank since January 2002. Ms.
Basich is a Certified Public Accountant.
Kathie M. Bailey has been affiliated with the Bank since 1984 and has
served as Senior Vice President and Chief Operations Officer since 2003.
Michael J. Rasmusson has been affiliated with the Bank since 2001 and has
served as Senior Vice President since 2003. Prior to his current position as
the administrative supervisor of the Bank's data processing and loan servicing
departments, Mr. Rasmusson was the Bank's Chief Credit Administrator.
Item 1A. Risk Factors
----------------------
We assume and manage a certain degree of risk in order to conduct our
business strategy. In addition to the risk factors described below, other
risks and uncertainties not specifically mentioned, or that are currently
known to, or deemed by, management to be immaterial also may materially and
adversely affect our financial position, results of operation and/or cash
flows. Before making an investment decision, you should carefully consider
the risks described below together with all of the other information included
in this Form 10-K. If any of the circumstances described in the following
risk factors actually occur to a significant degree, the value of our common
stock could decline, and you could lose all or part of your investment.
Fluctuations in interest rates could reduce our profitability and affect the
value of our assets.
Like other financial institutions, we are subject to interest rate risk.
Our primary source of income is net interest income, which is the difference
between interest earned on loans and investment securities and the interest
paid on deposits and borrowings. We expect that we will periodically
experience imbalances in the interest rate sensitivities of our assets and
liabilities and the relationships of various interest rates to each other.
Over any period of time, our interest-earning assets may be more sensitive to
changes in market interest rates than our interest-bearing liabilities, or
vice versa. In addition, the individual market interest rates underlying our
loan and deposit products may not change to the same degree over a given time
period. In any event, if market interest rates should move contrary to our
position, our earnings may be negatively affected. In addition, loan volume
and quality and deposit volume and mix can be affected by market interest
rates. Changes in levels of market interest rates could materially adversely
affect our net interest spread, asset quality, origination volume and overall
profitability.
Interest rates have recently been at historically low levels. However,
since June 30, 2004, the U.S. Federal Reserve has increased its target for the
federal funds rate 17 times, from 1.00% to 5.25%, and the most recent interest
rate increase was on June 29, 2006. While these short-term market interest
rates have increased the pricing of our loans, it has been partially offset by
the rise in our funding costs. In a sustained rising interest rate
environment the asset yields may not match rising funding costs, which may
negatively impact interest margins. A sustained falling interest rate
environment would negatively impact margins.
We manage our assets and liabilities in order to achieve long-term
profitability while limiting our exposure to the fluctuation of interest
rates. We anticipate periodic imbalances in the interest rate sensitivity of
our assets and liabilities and the relationship of various interest rates to
each other. At any reporting period, we may have earning assets which are
more sensitive to changes in interest rates than interest-bearing liabilities,
or vice versa. The fluctuation of market interest rates can materially affect
our net interest spread, interest margin, loan originations, deposit volumes
and overall profitability. In addition, we may have valuation risk in
measuring our interest rate risk position. The valuation risk is attributable
to calculation methods (modeling risks) and assumptions used in the model,
including loan prepayments and forward interest rates.
37
For further information on our interest rate risks, see the discussion
included in "Item 7A. Quantitative and Qualitative Disclosure About Market
Risk" of this Form 10-K.
Our loan portfolio includes increased risk due to changes in category
composition of the portfolio. The percentage of loans secured by first
mortgages on one-to four-family residential properties has decreased as the
portfolio has shifted into higher-yielding loan categories that typically
involve a higher degree of risk.
From September 30, 2002, through September 30, 2006, our total loans have
grown by 31.7%. During this period the percentage of one- to four-family loans
in the loan portfolio has decreased to 20.1% from 31.3%. Our commercial real
estate loans, construction and land development loans, multi-family loans,
land loans, commercial business loans, and consumer loans accounted for
approximately 79.9% of our total loan portfolio as of September 30, 2006. We
consider these types of loans to involve a higher degree of risk compared to
first mortgage loans on one- to four-family, owner-occupied residential
properties, and therefore, may cause higher future loan losses. Accordingly,
as a result of the inherent risks associated with these types of loans, and
the unseasoned nature of a portion these loans, it may become necessary to
increase the level of our provision for loan losses. An increase in our
provision for loan losses would reduce our profits.
For further information concerning the risks associated with
multi-family, and commercial real estate loans, construction loans, and
consumer loans, see "Item 1. Business - Lending Activities."
We may be required to maintain a higher capital ratio because of our level of
commercial real estate loans.
The FDIC, along with the Federal Reserve and the Office of the
Comptroller of the Currency, has recently promulgated proposed regulations
governing financial institutions with concentrations in commercial real estate
lending. The proposed regulations provide that a bank has a concentration in
commercial real estate lending if (i) total reported loans for construction,
land development, and other land represent 100% or more of total capital or
(ii) total reported loans secured by multi-family and non-farm residential
properties and loans for construction, land development, and other land
represent 300% or more of total capital. If a concentration is present,
management must employ heightened risk management practices including board
and management oversight and strategic planning, development of underwriting
standards, risk assessment and monitoring through market analysis and stress
testing, and increasing capital requirements. Based on the Bank's projected
commercial real estate lending levels, we may be subject to these regulations
should they become effective.
We have increased our construction lending which presents greater risk than
one- to four-family and consumer lending.
Construction lending is generally considered to involve a higher level of
risk as compared to single-family residential or consumer lending, as a result
of the concentration of principal in a limited number of loans and borrowers,
and the effects of general economic conditions on developers and builders.
Moreover, a construction loan can involve additional risks because of the
inherent difficulty in estimating both a property's value at completion of the
project and the estimated cost (including interest) of the project. The nature
of these loans is such that they are generally more difficult to evaluate and
monitor. In addition, speculative construction loans to a builder are often
associated with homes that are not pre-sold, and thus pose a greater potential
risk to us than construction loans to individuals on their personal
residences. Construction loans on land under development or held for future
construction also poses additional risk because of the lack of income being
produced by the property and the potential illiquid nature of the security.
Our commercial business lending activities involves greater risk than other
types of lending.
Our commercial business lending has increased since 2003 and we intend to
continue to offer commercial business loans to small and medium sized
businesses. Our ability to originate commercial business loans is determined
by the demand for these loans and our ability to attract and retain qualified
commercial lending personnel. Because payments on commercial business loans
generally depend on the successful operation of the business involved,
repayment of commercial business loans may be subject to a greater extent to
adverse conditions in the economy than
38
other types of lending. Although commercial business loans often have
equipment, inventory, accounts receivable or other business assets as
collateral, the sale of the collateral in the event the borrower does not
repay the loan is often not sufficient to repay the loan because the
collateral may be uncollectible and inventories and equipment may be obsolete
or of limited use, among other things. Consequently, there can be no
assurance that we will continue to be successful in these efforts.
Our funding sources may prove insufficient to replace deposits and support our
future growth.
We rely on customer deposits and advances from the FHLB of Seattle and
other borrowings to fund our operations. Although we have historically been
able to replace maturing deposits and advances if desired, no assurance can be
given that we would be able to replace such funds in the future if our
financial condition or the financial condition of the FHLB of Seattle or
market conditions were to change. Our financial flexibility will be severely
constrained if we are unable to maintain our access to funding or if adequate
financing is not available to accommodate future growth at acceptable interest
rates. Finally, if we are required to rely more heavily on more expensive
funding sources to support future growth, our revenues may not increase
proportionately to cover our costs. In this case, our profitability would be
adversely affected.
Although we consider such sources of funds adequate for our liquidity
needs, we may seek additional debt in the future to achieve our long-term
business objectives. There can be no assurance additional borrowings, if
sought, would be available to us or, if available, would be on favorable
terms. If additional financing sources are unavailable or are not available
on reasonable terms, our growth and future prospects could be adversely
affected.
If our allowance for loan losses is not sufficient to cover future loan
losses, our earnings could decrease.
We make various assumptions and judgments about the collectibility of our
loan portfolio, including the creditworthiness of our borrowers and the value
of the real estate and other assets serving as collateral for the repayment of
many of our loans. In determining the amount of the allowance for loan losses,
we review several factors including our loan loss and delinquency experience,
underwriting practices, and economic conditions. If our assumptions are
incorrect, our allowance for loan losses may not be sufficient to cover future
losses in the loan portfolio, resulting in the need for greater additions to
our allowance. Material additions to the allowance could materially decrease
our net income. Our allowance for loan losses was 0.96% of total loans and
5,152.50% of non-performing loans at September 30, 2006.
In addition, bank regulators periodically review our allowance for loan
losses and may require us to increase our provision for loan losses or
recognize further loan charge-offs. Any increase in our allowance for loan
losses or loan charge-offs as required by these regulatory authorities may
have a material adverse effect on our financial condition and results of
operations.
Our profitability depends significantly on economic conditions in the State of
Washington.
Our success depends primarily on the general economic conditions of the
State of Washington and the specific local markets in which we operate.
Adverse economic conditions unique to the Washington markets could have a
material adverse effect on our financial condition and results of operations.
Further, a significant decline in general economic conditions, caused by
inflation, recession, unemployment, changes in securities markets or other
factors could impact our state and local markets and, in turn, also have a
material adverse effect on our financial condition and results of operations.
Of particular concern are the rising real estate values, which may prove
unsustainable in our current rising interest rate environment and may lead to
higher loan losses since the majority of our loans are secured by real estate
located within Washington. Similarly, if Washington were to experience
significant declines in real estate values, this decline may inhibit our
ability to recover on defaulted loans by selling the underlying real estate.
Competition with other financial institutions could adversely affect our
profitability.
The banking and financial services industry is very competitive. Legal and
regulatory developments have made it easier for new and sometimes unregulated
competitors to compete with us. Consolidation among financial service
39
providers has resulted in fewer very large national and regional banking and
financial institutions holding a large accumulation of assets. These
institutions generally have significantly greater resources, a wider
geographic presence or greater accessibility. Our competitors sometimes are
also able to offer more services, more favorable pricing or greater customer
convenience than we do. In addition, our competition has grown from new banks
and other financial services providers that target our existing or potential
customers. As consolidation continues among large banks, we expect additional
institutions to try to exploit our market.
Technological developments have allowed competitors including some
non-depository institutions, to compete more effectively in local markets and
have expanded the range of financial products, services and capital available
to our target customers. If we are unable to implement, maintain and use such
technologies effectively, we may not be able to offer products or achieve the
cost-efficiencies necessary to compete in our industry. In addition, some of
these competitors have fewer regulatory constraints and lower cost structures.
The loss of key members of our senior management team could adversely affect
our business.
We believe that our success depends largely on the efforts and abilities
of our senior management. Their experience and industry contacts
significantly benefit us. The competition for qualified personnel in the
financial services industry is intense, and the loss of any of our key
personnel or an inability to continue to attract, retain and motivate key
personnel could adversely affect our business.
We are subject to extensive government regulation and supervision.
We are subject to extensive federal and state regulation and supervision,
primarily through the Bank and certain non-bank subsidiaries. Banking
regulations are primarily intended to protect depositors' funds, federal
deposit insurance funds and the banking system as a whole, not shareholders.
These regulations affect our lending practices, capital structure, investment
practices, dividend policy and growth, among other things. Congress and
federal regulatory agencies continually review banking laws, regulations and
policies for possible changes. Changes to statutes, regulations or regulatory
policies, including changes in interpretation or implementation of statutes,
regulations or policies, could affect us in substantial and unpredictable
ways. Such changes could subject us to additional costs, limit the types of
financial services and products we may offer and/or increase the ability of
non-banks to offer competing financial services and products, among other
things. Failure to comply with laws, regulations or policies could result in
sanctions by regulatory agencies, civil money penalties and/or reputation
damage, which could have a material adverse effect on our business, financial
condition and results of operations. While we have policies and procedures
designed to prevent any such violations, there can be no assurance that such
violations will not occur. For further information, see "Item 1. Business -
REGULATION OF THE COMPANY."
We rely heavily on the proper functioning of our technology.
We rely heavily on communications and information systems to conduct our
business. Any failure, interruption or breach in security of these systems
could result in failures or disruptions in our customer relationship
management, general ledger, deposit, loan and other systems. While we have
policies and procedures designed to prevent or limit the effect of the
failure, interruption or security breach of our information systems, there can
be no assurance that any such failures, interruptions or security breaches
will not occur or, if they do occur, that they will be adequately addressed.
The occurrence of any failures, interruptions or security breaches of our
information systems could damage our reputation, result in a loss of customer
business, subject us to additional regulatory scrutiny, or expose us to civil
litigation and possible financial liability, any of which could have a
material adverse effect on our financial condition and results of operations.
We rely on third-party service providers for much of our communications,
information, operating and financial control systems technology. If any of our
third-party service providers experience financial, operational or
technological difficulties, or if there is any other disruption in our
relationships with them, we may be required to locate alternative sources of
such services, and we cannot assure that we could negotiate terms that are as
favorable to us, or could obtain
40
services with similar functionality, as found in our existing systems, without
the need to expend substantial resources, if at all. Any of these
circumstances could have an adverse effect on our business.
Terrorist activities could cause reductions in investor confidence and
substantial volatility in real estate and securities markets.
It is impossible to predict the extent to which terrorist activities may
occur in the United States or other regions, or their effect on a particular
security issue. It is also uncertain what effects any past or future terrorist
activities and/or any consequent actions on the part of the United States
government and others will have on the United States and world financial
markets, local, regional and national economics, and real estate markets
across the United States. Among other things, reduced investor confidence
could result in substantial volatility in securities markets, a decline in
general economic conditions and real estate related investments and an
increase in loan defaults. Such unexpected losses and events could materially
affect our results of operations.
We rely on dividends from subsidiaries for most of our revenue.
The Company is a separate and distinct legal entity from its
subsidiaries. We receive substantially all of our revenue from dividends from
our subsidiaries. These dividends are the principal source of funds to pay
dividends on our common stock and interest and principal on our debt. Various
federal and/or state laws and regulations limit the amount of dividends that
the Bank may pay to the Company. Also, our right to participate in a
distribution of assets upon a subsidiary's liquidation or reorganization is
subject to the prior claims of the subsidiary's creditors. In the event the
Bank is unable to pay dividends to the Company, we may not be able to service
our debt, pay obligations or pay dividends on our common stock. The inability
to receive dividends from the Bank could have a material adverse effect on our
business, financial condition and results of operations
If we fail to maintain an effective system of internal control over financial
reporting, we may not be able to accurately report our financial results or
prevent fraud, and, as a result, investors and depositors could lose
confidence in our financial reporting, which could adversely affect our
business, the trading price of our stock and our ability to attract additional
deposits.
In connection with the enactment of the Sarbanes-Oxley Act of 2002 and
the implementation of the rules and regulations promulgated by the SEC, we
document and evaluate our internal control over financial reporting in order
to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act. This
requires us to prepare an annual management report on our internal control
over financial reporting, including among other matters, management's
assessment of the effectiveness of internal control over financial reporting
and an attestation report by our independent auditors addressing these
assessments. If we fail to identify and correct any significant deficiencies
in the design or operating effectiveness of our internal control over
financial reporting or fail to prevent fraud, current and potential
shareholders and depositors could lose confidence in our internal controls and
financial reporting, which could adversely affect our business, financial
condition and results of operations, the trading price of our stock and our
ability to attract additional deposits.
Changes in accounting standards may affect our performance.
Our accounting policies and methods are fundamental to how we record and
report our financial condition and results of operations. From time to time
there are changes in the financial accounting and reporting standards that
govern the preparation of our financial statements. These changes can be
difficult to predict and can materially impact how we report and record our
financial condition and results of operations. In some cases, we could be
required to apply a new or revised standard retroactively, resulting in
restating prior period financial statements.
Item 1B. Unresolved Staff Comments
-----------------------------------
Not applicable.
39
Item 2. Properties
-------------------
At September 30, 2006 the Bank operated 21 full service facilities and
one loan production office. The following table sets forth certain
information regarding the Bank's offices, all of which are owned, except for
the Tacoma office, the Gig Harbor office, the Lacey office at 1751 Circle Lane
SE, the Centralia loan production office, and the Data Center office at 504
8th Street, which are leased.
Approximate Deposits at
Location Year Opened Square Footage September 30, 2006
--------------------------- ----------- -------------- ------------------
(In thousands)
Main Office:
624 Simpson Avenue 1966 7,700 $79,482
Hoquiam, Washington 98550
Branch Offices:
300 N. Boone Street 1974 3,400 30,678
Aberdeen, Washington 98520
201 Main Street South(1)(2) 2004 3,200 37,439
Montesano, Washington 98563
361 Damon Road 1977 2,100 22,331
Ocean Shores, Washington 98569
2418 Meridian East 1980 2,400 38,551
Edgewood, Washington 98371
202 Auburn Way South 1994 4,200 17,853
Auburn, Washington 98002
12814 Meridian East (South Hill) 1996 4,200 25,638
Puyallup, Washington 98373
1201 Marvin Road, N.E. 1997 4,400 12,454
Lacey, Washington 98516
101 Yelm Avenue W. 1999 1,800 12,637
Yelm, Washington 98597
20464 Viking Way NW 1999 3,400 7,236
Poulsbo, Washington 98370
2419 224th Street E. 1999 3,900 18,588
Spanaway, Washington 98387
801 Trosper Road SW 2001 3,300 16,523
Tumwater, Washington 98512
(table continued on following page)
42
Approximate Deposits at
Location Year Opened Square Footage September 30, 2006
--------------------------- ----------- -------------- ------------------
(In thousands)
7805 South Hosmer Street 2001 5,000 9,552
Tacoma, Washington 98408
2401Bucklin Hill Road 2003 4,000 9,735
Silverdale, Washington 98383
423 Washington Street SE 2003 3,000 13,993
Olympia, Washington 98501
3105 Judson St 2004 2,700 7,289
Gig Harbor, Washington 98335
117 N. Broadway(1) 2004 3,700 9,219
Aberdeen, Washington 98520
313 West Waldrip(1) 2004 5,900 21,415
Elma, Washington 98541
1751 Circle Lane SE(1) 2004 900 10,117
Lacey, Washington 98503
101 2nd Street 2004 1,800 17,404
Toledo, Washington 98591
209 NE 1st Street(1) 2004 3,400 12,927
Winlock, Washington 98586
Loan Production Office:
1641 Kresky Avenue, Suite 2 2006 800
Centralia, Washington 98531
Data Centers:
422 6th Street 1990 2,700
Hoquiam, Washington 98550
504 8th Street 2003 5,400
Hoquiam, Washington 98550
Loan Center:
120 Lincoln Street 2003 5,000
Hoquiam, Washington 98550
(table continued on following page)
43
Approximate Deposits at
Location Year Opened Square Footage September 30, 2006
--------------------------- ----------- -------------- ------------------
(In thousands)
Other Properties:
305 8th Street(1)(3)
Hoquiam, Washington 98550 2004 4,100
314 Main Street South(2)
Montesano, Washington 98563 1975 2,800
-------------------
(1) Acquired from Venture Bank on October 9, 2004.
(2) Office at 314 Main Street South, Montesano, Washington was consolidated
into the office at 201 Main Street South, Montesano, Washington on
November 15, 2004.
(3) Office at 305 8th Street, Hoquiam, Washington was consolidated into the
office at 624 Simpson Avenue, Hoquiam, Washington on November 15, 2004.
Management believes that all facilities, except for the Data Center
building located at 422 6th Street in Hoquiam are appropriately insured and
are adequately equipped for carrying on the business of the Bank. The Data
Center building at 422 6th Street in Hoquiam has sustained structural damage
and is not currently occupied. A pending claim has been filed with the Bank's
previous insurance company.
At September 30, 2006 the Bank operated 22 proprietary ATMs that are part
of a nationwide cash exchange network.
Item 3. Legal Proceedings
--------------------------
Periodically, there have been various claims and lawsuits involving the
Bank, such as claims to enforce liens, condemnation proceedings on properties
in which the Bank holds security interests, claims involving the making and
servicing of real property loans and other issues incident to the Bank's
business. The Bank is not a party to any pending legal proceedings that it
believes would have a material adverse effect on the financial condition or
operations of the Bank.
Item 4. Submission of Matters to a Vote of Security Holders
------------------------------------------------------------
No matters were submitted to a vote of security holders during the fourth
quarter of the fiscal year ended September 30, 2006.
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters
---------------------------------------------------------------------------
and Issuer Purchases of Equity Securities
-----------------------------------------
The Company's common stock is traded on the Nasdaq National Market under
the symbol "TSBK". As of November 30, 2006, there were 3,725,311 shares of
common stock issued and approximately 639 shareholders of record, excluding
persons or entities who hold stock in nominee or "street name" accounts with
brokers. The following table sets forth the market price range of the
Company's common stock for the years ended September 30, 2006 and 2005. This
information was provided by the Nasdaq Stock Market.
44
High Low Dividends
------ ------ ---------
Fiscal 2006
-----------
First Quarter............... $23.96 $23.04 $0.16
Second Quarter.............. 28.20 23.25 0.16
Third Quarter............... 31.60 28.00 0.16
Fourth Quarter.............. 39.03 31.22 0.18
Fiscal 2005
-----------
First Quarter............... $25.00 $22.85 $0.15
Second Quarter.............. 24.00 21.85 0.15
Third Quarter............... 23.47 22.02 0.15
Fourth Quarter.............. 23.80 22.30 0.16
Dividends
Dividend payments by the Company are dependent primarily on dividends
received by the Company from the Bank. Under federal regulations, the dollar
amount of dividends the Bank may pay is dependent upon its capital position
and recent net income. Generally, if the Bank satisfies its regulatory
capital requirements, it may make dividend payments up to the limits
prescribed in the FDIC regulations. However, institutions that have converted
to a stock form of ownership may not declare or pay a dividend on, or
repurchase any of, its common stock if the effect thereof would cause the
regulatory capital of the institution to be reduced below the amount required
for the liquidation account which was established in connection with the
mutual to stock conversion.
Equity Compensation Plan Information
The equity compensation plan information presented under subparagraph (d)
in Part III, Item 12. of this Form 10-K is incorporated herein by reference.
Stock Repurchases
The Company has had various buy-back programs since January 1998. On
April 7, 2005, the Company announced a plan to repurchase 187,955 shares of
the Company's common stock. This marked the Company's 13th stock repurchase
plan. As of September 30, 2006, the Company has repurchased 136,450 of these
shares at an average price of $31.85 per share. Cumulatively, the Company has
repurchased 3,475,721 shares at an average price of $15.97 per share. This
represents 52.6% of the 6,612,500 shares that were issued when the Company
went public in January 1998.
The following table sets forth the Company's repurchases of its
outstanding Common Stock during the fourth quarter of the year ended September
30, 2006.
Maximum
Total Number Number (or
of Shares Approximate
Purchased as Dollar Value)
Total Part of of Shares that
Number of Average Publicly May Yet Be
Shares Price Paid Announced Purchased
Period Purchased per Share Plans Under the Plans
----------------------- --------- ---------- ----------- ---------------
July 1, 2006 - July 31,
2006.................. -- $ -- -- 101,905
August 1, 2006 - August
31, 2006.............. 31,000 38.87 31,000 70,905
September 1, 2006 -
September 30, 2006.... 19,400 38.66 19,400 51,505
------ ------ ------
Total.................. 50,400 $38.79 50,400
====== ====== ======
45
Item 6. Selected Financial Data
--------------------------------
The following table sets forth certain information concerning the
consolidated financial position and results of operations of the Company and
subsidiaries at and for the dates indicated. The consolidated data is
derived in part from, and should be read in conjunction with, the Consolidated
Financial Statements of the Company and its subsidiary presented herein.
At September 30,
----------------------------------------------
2006 2005 2004 2003 2002
------ ------ ------ ------ ------
(In thousands)
SELECTED FINANCIAL CONDITION
DATA:
Total assets................ $577,087 $552,765 $460,419 $449,633 $431,054
Loans receivable and loans
held for sale, net......... 424,645 388,109 344,594 322,236 322,528
Investment securities
available-for-sale......... 63,805 65,860 41,560 36,933 23,694
Mortgage-backed securities
held to maturity........... 75 104 174 279 --
Mortgage-backed securities
available-for-sale......... 17,603 23,735 18,329 17,098 17,888
FHLB Stock.................. 5,705 5,705 5,682 5,454 5,139
Cash and due from financial
institutions, interest-
bearing deposits in banks
and fed funds sold......... 22,889 28,718 19,833 38,098 36,073
Deposits.................... 431,061 411,665 319,570 307,672 292,316
FHLB advances............... 62,761 62,353 65,421 61,605 61,759
Shareholders' equity........ 79,365 74,642 72,817 77,611 74,396
Year Ended September 30,
----------------------------------------------
2006 2005 2004 2003 2002
------ ------ ------ ------ ------
(In thousands, except per share data)
SELECTED OPERATING DATA:
Interest and dividend
income..................... $35,452 $30,936 $26,571 $27,345 $29,975
Interest expense............ 10,814 8,609 7,325 8,946 10,890
------- ------- ------- ------- -------
Net interest income......... 24,638 22,327 19,246 18,399 19,085
Provision for loan losses... -- 141 167 347 992
------- ------- ------- ------- -------
Net interest income after
provision for loan losses.. 24,638 22,186 19,079 18,052 18,093
Noninterest income.......... 6,244 6,073 4,576 6,385 4,946
Noninterest expense......... 18,896 18,536 15,575 14,832 12,716
Income before income taxes.. 11,986 9,723 8,080 9,605 10,323
Federal income taxes........ 3,829 3,105 2,492 2,966 3,432
------- ------- ------- ------- -------
Net income.................. $ 8,157 $ 6,618 $ 5,588 $ 6,639 $ 6,891
======= ======= ======= ======= =======
Earnings per common share:
Basic..................... $ 2.32 $ 1.90 $ 1.54 $ 1.74 $ 1.76
Diluted................... $ 2.24 $ 1.82 $ 1.46 $ 1.66 $ 1.71
Dividends per share......... $ 0.66 $ 0.61 $ 0.57 $ 0.50 $ 0.45
Dividend payout ratio....... 28.45% 32.11% 37.01% 28.74% 25.57%
46
At September 30,
-------------------------------------------
2006 2005 2004 2003 2002
------ ------ ------ ------ ------
OTHER DATA:
Number of real estate loans
outstanding.................. 3,005 3,022 2,857 2,824 2,911
Deposit accounts.............. 51,392 51,496 40,348 39,313 36,896
Full-service offices.......... 21 21 16 15 13
At or For the Year Ended September 30,
-------------------------------------------
2006 2005 2004 2003 2002
------ ------ ------ ------ ------
KEY FINANCIAL RATIOS:
Performance Ratios:
Return on average assets (1). 1.47% 1.23% 1.24% 1.52% 1.73%
Return on average equity (2). 10.59 9.08 7.52 8.67 9.42
Interest rate spread (3)..... 4.49 4.30 4.30 4.02 4.27
Net interest margin (4)...... 4.91 4.60 4.67 4.52 4.96
Average interest-earning
assets to average interest-
bearing liabilities......... 119.20 116.56 120.68 122.74 125.73
Noninterest expense as a
percent of average total
assets...................... 3.41 3.44 3.46 3.39 3.19
Efficiency ratio (5)......... 61.19 65.27 65.38 59.85 52.91
Book value per share (6)..... $21.12 $19.85 $18.76 $18.25 $17.14
Book value per share (7)..... 22.44 21.30 20.28 19.77 18.69
Tangible book value per
share (6)(8)................ 19.22 17.86 18.76 18.25 17.14
Tangible book value per
share (7)(8)................ 20.41 19.16 20.28 19.77 18.69
Asset Quality Ratios:
Nonaccrual and 90 days or more
past due loans as a percent
of total loans receivable,
net......................... 0.02% 0.75% 0.41% 1.19% 1.15%
Nonperforming assets as a
percent of total assets..... 0.02 0.62 0.40 1.15 1.03
Allowance for loan losses as
a percent of total loans
receivable, net (9)......... 0.96 1.05 1.14 1.19 1.11
Allowance for losses as a
percent of nonperforming
loans....................... 5,152.50 140.09 276.77 99.90 97.03
Net charge-offs (recoveries)
to average outstanding
loans....................... (0.01) 0.01 0.02 0.03 0.13
Capital Ratios:
Total equity-to-assets
ratio....................... 13.75 13.50 15.82 17.26 17.26
Tangible equity-to-assets
ratio....................... 12.51 12.15 15.82 17.26 17.26
Average equity to average
assets (10)................. 13.90 13.53 16.52 17.49 18.37
----------------
(1) Net income divided by average total assets.
(2) Net income divided by average total equity.
(3) Difference between weighted average yield on interest-earning assets and
weighted average cost of interest-bearing liabilities.
(4) Net interest income (before provision for loan losses) as a percentage
of average interest-earning assets.
(5) Other expenses (excluding federal income tax expense) divided by the sum
of net interest income and noninterest income.
(6) Calculation includes Employee Stock Ownership Plan ("ESOP") shares not
committed to be released.
(7) Calculation excludes ESOP shares not committed to be released.
(8) Calculation subtracts goodwill and core deposit intangible from the
equity component.
(9) Loans receivable includes loans held for sale and is before the
allowance for loan losses.
(10) Average total equity divided by average total assets.
47
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations
------------------------------------------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
Management's Discussion and Analysis of Financial Condition and Results of
Operations is intended to assist in understanding the consolidated financial
condition and results of operations of the Company. The information contained
in this section should be read in conjunction with the Consolidated Financial
Statements and accompanying notes thereto included in Item 8 of this Annual
Report on Form 10-K.
Special Note Regarding Forward-Looking Statements
Management's Discussion and Analysis and Results of Operations and other
portions of this Form 10-K contain certain "forward-looking statements"
concerning future operations of the Company. Management desires to take
advantage of the "safe harbor" provisions of the Private Securities Litigation
Reform Act of 1995 and is including this statement for the express purpose of
availing the Company of the protections of such safe harbor with respect to
all "forward-looking statements" contained in this Annual Report. The Company
has used "forward-looking statements" to describe future plans and strategies,
including its expectations of the Company's future financial results.
Management's ability to predict results or the effect of future plans or
strategies is inherently uncertain. Factors which could affect actual results
include interest rate trends, the general economic climate in the Company's
market area and the country as a whole, the ability of the Company to control
expenses, deposit flows, demand for mortgages and other loans, real estate
values, vacancy rates, competition, loan delinquency rates, and changes in
federal and state regulation. These factors should be considered in
evaluating the "forward-looking statements," and undue reliance should not be
placed on such statements. The Company does not undertake to update any
"forward-looking statement" that may be made on behalf of the Company.
Critical Accounting Policies
The Company has established various accounting policies that govern the
application of accounting principles generally accepted in the United States
of America ("GAAP") in the preparation of the Company's Consolidated Financial
Statements. The Company has identified two policies, that as a result of
judgments, estimates and assumptions inherent in those policies, are critical
to an understanding of the Company's Consolidated Financial Statements. These
policies relate to the methodology for the determination of the allowance for
loan losses and the valuation of mortgage servicing rights ("MSRs"). These
policies and the judgments, estimates and assumptions are described in greater
detail in subsequent sections of Management's Discussion and Analysis
contained herein and in the notes to the Consolidated Financial Statements
contained in Item 8 of this Form 10-K. In particular, Note 1 of the Notes to
Consolidated Financial Statements, "Summary of Significant Accounting
Policies," generally describes the Company's accounting policies. Management
believes that the judgments, estimates and assumptions used in the preparation
of the Company's Consolidated Financial Statements are appropriate given the
factual circumstances at the time. However, given the sensitivity of the
Company's Consolidated Financial Statements to these critical policies, the
use of other judgments, estimates and assumptions could result in material
differences in the Company's results of operations or financial condition.
Allowance for Loan Losses. The allowance for loan losses is maintained at
a level sufficient to provide for probable loan losses based on evaluating
known and inherent risks in the portfolio. The allowance is based upon
management's comprehensive analysis of the pertinent factors underlying the
quality of the loan portfolio. These factors include changes in the amount
and composition of the loan portfolio, actual loan loss experience, current
economic conditions, and detailed analysis of individual loans for which full
collectibility may not be assured. The detailed analysis includes methods to
estimate the fair value of loan collateral and the existence of potential
alternative sources of repayment. The appropriate allowance for loan loss
level is estimated based upon factors and trends identified by management at
the time the consolidated financial statements are prepared.
48
Mortgage Servicing Rights. Mortgage servicing rights are capitalized when
acquired through the origination of loans that are subsequently sold with
servicing rights retained and are amortized to servicing income on loans sold
in proportion to and over the period of estimated net servicing income. The
value of MSRs at the date of the sale of loans is determined based on the
discounted present value of expected future cash flows using key assumptions
for servicing income and costs and prepayment rates on the underlying loans.
The estimated fair value is periodically evaluated for impairment by
comparing actual cash flows and estimated cash flows from the servicing assets
to those estimated at the time servicing assets were originated. The effect
of changes in market interest rates on estimated rates of loan prepayments
represents the predominant risk characteristic underlying the MSRs' portfolio.
The Company's methodology for estimating the fair value of MSRs is highly
sensitive to changes in assumptions. For example, the determination of fair
value uses anticipated prepayment speeds. Actual prepayment experience may
differ and any difference may have a material effect on the fair value. Thus,
any measurement of MSRs' fair value is limited by the conditions existing and
assumptions as of the date made. Those assumptions may not be appropriate if
they are applied at different times.
New Accounting Pronouncements
For a discussion of new accounting pronouncements and their impact on the
Company, see Note 1 of the Notes to the Consolidated Financial Statements
contained in "Item 8, Financial Statements and Supplementary Data."
Operating Strategy
The Company is a holding company which operates primarily through its
subsidiary, the Bank. The Bank is a community-oriented bank which has
traditionally offered a wide variety of savings products to its retail
customers while concentrating its lending activities on real estate loans.
The primary elements of the Bank's operating strategy include:
Emphasize Residential Mortgage Lending and Residential Construction
Lending. The Bank has historically attempted to establish itself as a niche
lender in its primary market areas by focusing a part of its lending
activities on the origination of loans secured by one- to four-family
residential dwellings, including an emphasis on loans for the construction of
residential dwellings. In an effort to meet the credit needs of borrowers in
its primary areas, the Bank actively originates one- to four-family mortgage
loans that do not qualify for sale in the secondary market under FHLMC
guidelines. The Bank has also been an active participant in the secondary
market, originating residential loans for sale to the FHLMC on a servicing
retained basis. The Bank occasionally retains fixed-rate one- to four-family
mortgage loans in its portfolio for yield and asset-liability management
purposes.
Diversify Primary Market Area by Expanding Branch Office Network. In an
effort to lessen its dependence on the Grays Harbor County market whose
economy has historically been tied to the timber and fishing industries, the
Bank has opened branch offices in Pierce, King, Thurston and Kitsap Counties.
Pierce, King, Thurston and Kitsap Counties contain the Olympia, Bremerton, and
Seattle-Tacoma metropolitan areas and their economies are more diversified
with the presence of government, aerospace and computer technology industries.
In October 2004, the Bank continued its geographic diversification by
acquiring two branches in Lewis County as part of a seven-branch acquisition.
Limit Exposure to Interest Rate Risk. In recent years, a majority of the
loans that the Bank has retained in its portfolio generally have periodic
interest rate adjustment features or have b en relatively short-term in
nature. Loans originated for portfolio retention primarily have included ARM
loans and short-term construction loans. Longer term fixed-rate mortgage
loans have generally been originated for sale in the secondary market.
Management believes that the interest rate sensitivity of these adjustable-
rate and short-term loans more closely match the interest rate sensitivity of
the Bank's funding sources than other longer duration assets with fixed-
interest rates.
Emphasize the Origination of Commercial Real Estate and Commercial
Business Loans. The Bank established a business banking division in 1998 for
the purpose of increasing the Bank's origination of commercial real estate and
commercial business loans. Originally, three lenders were hired to staff the
division. Currently, a Division Manager and seven lenders are active in the
origination of commercial real estate and commercial business loans.
49
Increase the Consumer Loan Portfolio. In 2001 the Bank hired a consumer
loan specialist to increase the origination of consumer loans. The consumer
loans generated since that time have been secured primarily by real estate.
The Bank expects to continue expanding its portfolio of consumer loans.
Pursue Low Cost Core Deposits and Deposit Related Fee Income. The Bank
has placed an emphasis on attracting commercial and personal checking
accounts. These transactional accounts typically provide a lower cost of
funding than certificates of deposit accounts and generate non-interest fee
income. The Bank implemented a checking account acquisition program in 2000
to increase these transactional accounts. On October 9, 2004, the Bank
increased its transaction account base by acquiring seven branches and the
related deposits.
Market Risk and Asset and Liability Management
General. Market risk is the risk of loss from adverse changes in market
prices and rates. The Company's market risk arises primarily from interest
rate risk inherent in its lending, investment, deposit and borrowing
activities. The Bank, like other financial institutions, is subject to
interest rate risk to the extent that its interest-earning assets reprice
differently than its interest-bearing liabilities. Management actively
monitors and manages its interest rate risk exposure. Although the Bank
manages other risks, such as credit quality and liquidity risk, in the normal
course of business management considers interest rate risk to be its most
significant market risk that could potentially have the largest material
effect on the Bank's financial condition and results of operations. The Bank
does not maintain a trading account for any class of financial instruments nor
does it engage in hedging activities or derivative instruments. Furthermore,
the Bank is not subject to foreign currency exchange rate risk or commodity
price risk.
Qualitative Aspects of Market Risk. The Bank's principal financial
objective is to achieve long-term profitability while reducing its exposure to
fluctuating market interest rates. The Bank has sought to reduce the exposure
of its earnings to changes in market interest rates by attempting to manage
the difference between asset and liability maturities and interest rates. The
principal element in achieving this objective is to increase the interest-rate
sensitivity of the Bank's interest-earning assets by retaining in its
portfolio, short-term loans and loans with interest rates subject to periodic
adjustments. The Bank relies on retail deposits as its primary source of
funds. Management believes retail deposits, compared to brokered deposits,
reduce the effects of interest rate fluctuations because they generally
represent a more stable source of funds. As part of its interest rate risk
management strategy, the Bank promotes transaction accounts and certificates
of deposit with terms of up to six years.
The Bank has adopted a strategy that is designed to substantially match
the interest rate sensitivity of assets relative to its liabilities. The
primary elements of this strategy involve originating ARM loans for its
portfolio, maintaining residential construction loans as a portion of total
net loans receivable because of their generally shorter terms and higher
yields than other one- to four-family residential mortgage loans, matching
asset and liability maturities, investing in short-term securities,
originating fixed-rate loans for retention or sale in the secondary market,
and retaining the related mortgage servicing rights.
Sharp increases or decreases in interest rates may adversely affect the
Bank's earnings. Management of the Bank monitors the Bank's interest rate
sensitivity through the use of a model provided for the Bank by FIMAC
Solutions, LLC ("FIMAC"), a company that specializes in providing the
financial services industry interest risk rate risk and balances sheet
management services. Based on a rate shock analysis prepared by FIMAC, an
immediate increase in interest rates of 200 basis points would increase the
Bank's projected net interest income by approximately 0.4%, primarily because
a larger portion of the Bank's interest rate sensitive assets than interest
rate sensitive liabilities would reprice within a one year period. Similarly,
an immediate 200 basis point decrease in interest rates would negatively
affect net interest income by approximately 5.4%, as repricing would have the
opposite effect. See "Quantitative Aspects of Market Risk" below for
additional information. Management has sought to sustain the match between
asset and liability maturities and rates, while maintaining an acceptable
interest rate spread. Pursuant to this strategy, the Bank actively originates
adjustable-rate loans for retention in its loan portfolio. Fixed-rate
mortgage loans with maturities greater than seven years generally are
originated for the immediate or future resale in the secondary mortgage
market. At September 30, 2006, adjustable-rate mortgage loans and
adjustable-rate mortgage-backed securities constituted $302.8 million or
67.6%, of the Bank's total combined mortgage loan and mortgage-backed
securities portfolio. Although the Bank has sought to
50
originate ARM loans, the ability to originate such loans depends to a great
extent on market interest rates and borrowers' preferences. Particularly in
lower interest rate environments, borrowers often prefer fixed-rate loans.
Consumer loans and construction and land development loans typically have
shorter terms and higher yields than permanent residential mortgage loans, and
accordingly reduce the Bank's exposure to fluctuations in interest rates. At
September 30, 2006, the construction and land development, and consumer loan
portfolios amounted to $146.9 million and $48.6 million, or 29.9% and 9.9% of
total loans receivable (including loans held for sale), respectively.
Quantitative Aspects of Market Risk. The model provided for the Bank by
FIMAC estimates the changes in net portfolio value ("NPV") and net interest
income in response to a range of assumed changes in market interest rates.
The model first estimates the level of the Bank's NPV (market value of assets,
less market value of liabilities, plus or minus the market value of any
off-balance sheet items) under the current rate environment. In general,
market values are estimated by discounting the estimated cash flows of each
instrument by appropriate discount rates. The model then recalculates the
Bank's NPV under different interest rate scenarios. The change in NPV under
the different interest rate scenarios provides a measure of the Bank's
exposure to interest rate risk. The following table is provided by FIMAC
based on data at September 30, 2006.
Net Interest Income Current Market Value
Projected ------------------------------ ------------------------------
Interest Rate Estimated $ Change % Change Estimated $ Change % Change
Scenario Value from Base from Base Value from Base from Base
------------- --------- --------- --------- -------- --------- ---------
(Dollars in thousands)
+300 $25,066 $ 126 0.50% $ 84,428 $ (7,397) (8.06)%
+200 25,048 108 0.43 86,936 (4,889) (5.32)
+100 24,997 57 0.23 89,413 (2,412) (2.63)
BASE 24,940 -- -- 91,825 -- --
-100 24,502 (438) (1.76) 92,811 986 1.07
-200 23,600 (1,340) (5.37) 91,984 159 0.17
-300 22,395 (2,545) (10.20) 90,569 (1,256) (1.37)
---------------
(1) Does not include loan fees, which are included in interest income on the
financial statements.
(2) Includes BOLI income, which is included in non-interest income on the
financial statements.
Computations of prospective effects of hypothetical interest rate changes
are based on numerous assumptions, including relative levels of market
interest rates, loan repayments and deposit decay, and should not be relied
upon as indicative of actual results. Furthermore, the computations do not
reflect any actions management may undertake in response to changes in
interest rates.
In the event of a 200 basis point decrease in interest rates, the Bank
would be expected to experience a 0.2% increase in NPV and a 5.4% decrease in
net interest income. In the event of a 200 basis point increase in interest
rates, a 5.3% decrease in NPV and a 0.4% increase in net interest income would
be expected. Based upon the modeling described above, the Bank's asset and
liability structure generally results in decreases in net interest income in a
declining interest rate scenario and increases in net interest income in a
rising rate scenario. This structure also generally results in decreases in
NPV in a rising rate environment and increases in NVP when rates decrease by
200 basis points or less.
As with any method of measuring interest rate risk, certain shortcomings
are inherent in the method of analysis presented in the foregoing table. For
example, although certain assets and liabilities may have similar maturities
or periods to repricing, they may react in different degrees to changes in
market interest rates. Also, the interest rates on certain types of assets
and liabilities may fluctuate in advance of changes in market interest rates,
while interest rates on other types may lag behind changes in market rates.
Additionally, certain assets have features which restrict changes in interest
rates on a short-term basis and over the life of the asset. Further, in the
event of a change in interest rates,
51
expected rates of prepayments on loans and early withdrawals from certificates
could possibly deviate significantly from those assumed in calculating the
table.
Comparison of Financial Condition at September 30, 2006 and September 30, 2005
The Company's total assets increased 4.4% to $577.1 million at September
30, 2006 from $552.8 million at September 30, 2005 primarily attributable to a
$36.5 million increase in net loans receivable. This increase was partially
offset by an $8.2 million decrease in investment and mortgage-backed
securities and a $5.8 million decrease in cash and due from financial
institutions, interest bearing deposits in banks and federal funds sold.
This asset growth was primarily funded by a $19.4 million increase in
deposits.
The Company's capital increased by $4.7 million during the year primarily
due to retained net income and funds received from stock option exercises.
The Company also continued to manage its capital level through stock
repurchases and dividends to shareholders. During the year the Company
repurchased 108,600 shares of its stock for $3.7 million and paid $2.5 million
in dividends to its shareholders.
A more detailed explanation of the changes in significant balance sheet
categories follows.
Cash and Due from Financial Institutions, Interest Bearing Deposits in
Banks, and Federal Funds Sold: Cash and due from financial institutions,
interest bearing deposits in banks and federal funds sold decreased to $22.9
million at September 30, 2006 from $28.7 million at September 30, 2005 as a
portion of the funds held in these liquid accounts were used to fund loan
growth.
Investments and Mortgage-backed Securities and FHLB Stock: Investments and
mortgage-backed securities (including FHLB stock) decreased by $8.2 million to
$87.2 million at September 30, 2006 from $95.4 million at September 30, 2005,
as a portion of these funds were used to fund loan growth. For additional
details on investments and mortgage-backed securities see, "Item 1, Business -
Investment Activities" and Note 3 of the Notes to the Consolidated Financial
Statements contained in "Item 8, Financial Statements and Supplementary Data."
Loans Receivable and Loans Held for Sale, Net of Allowance for Loan
Losses: Net loans receivable, including loans held for sale, increased by
$36.5 million to $424.6 million at September 30, 2006 from $388.1 million
at September 30, 2005. The increase in the portfolio was primarily a result
of $17.9 million increase in construction loans (net of undisbursed portions),
a $12.8 million increase in commercial real estate loans, a $6.9 million
increase in consumer loans and a $4.6 million increase in land loans.
Partially offsetting these increases were decreases of $3.1 million in one- to
four-family mortgage loans and $2.5 million in multi-family loans.
Loan originations totaled $256.3 million for the year ended September 30,
2006 compared to $230.0 million for the year ended September 30, 2005. The
Bank sold loans totaling $26.4 million during the year ended September 30,
2006, compared to $26.9 million ($25.4 million in fixed rate one- to
four-family mortgage loans and $1.5 million in credit card loans) during the
year ended September 30, 2005. For additional information on loans, see "Item
1, Business - Lending Activities" and Note 4 of the Notes to Consolidated
Financial Statements contained in "Item 8, Financial Statements and
Supplementary Data."
Premises and Equipment: Premises and equipment increased $868,000 to $16.7
million at September 30, 2006 from $15.9 million at September 30, 2005. This
increase was primarily attributable to remodeling costs associated with
several branch and administrative facilities. For additional information on
premises and equipment, see "Item 2, Properties" and Note 6 of the Notes to
Consolidated Financial Statements contained in "Item 8, Financial Statements
and Supplementary Data."
Other Real Estate Owned: Other real estate owned ("OREO") and other
repossessed items decreased $494,000 to $15,000 at September 30, 2006 from
$509,000 at September 30, 2005. The balance decreased as several properties
were sold during the year. The OREO balance of $15,000 at September 30, 2006
consisted of one land parcel.
52
For additional information on OREOs, see "Item 1, Business Lending Activities
- Nonperforming Assets" and Note 7 of the Notes to Consolidated Financial
Statements contained in "Item 8, Financial Statements and Supplementary Data."
Goodwill and Core Deposit Intangible ("CDI"): The amortized value of
goodwill and CDI decreased $328,000 to $7.2 million at September 30, 2006 from
$7.5 million at September 30, 2005 due to scheduled amortization of CDI. The
Bank recorded goodwill and CDI in connection with the October 2004 acquisition
of seven branches and related deposits. For additional information on
Goodwill and CDI, see Note 1 and Note 8 of the Notes to Consolidated Financial
Statements contained in "Item 8, Financial Statements and Supplementary Data."
Deposits: Deposits increased by $19.4 million to $431.1 million at
September 30, 2006 from $411.7 million at September 30, 2005. The $19.4
million deposit increase is comprised of a $28.2 million increase in
certificate of deposit accounts and a $6.1 million increase in non-interest
bearing accounts. These increases were partially offset by a $6.9 million
decrease in money market accounts, a $4.0 million increase in savings
accounts, and a $4.0 million decrease in N.O.W. checking accounts. For
additional information on deposits, see "Item 1, Business - Deposit Activities
and Other Sources of Funds" and Note 9 of the Notes to Consolidated Financial
Statements contained in "Item 8, Financial Statements and Supplementary Data."
Federal Home Loan Bank Advances: FHLB advances increased $408,000 to
$62.8 million at September 30, 2006 from $62.4 million at September 30, 2005.
For additional information on borrowings, see "Item 1, Business - Deposit
Activities and Other Sources of Funds - Borrowings" and Notes 10 and 11 of the
Notes to Consolidated Financial Statements contained in "Item 8, Financial
Statements and Supplementary Data."
Shareholders' Equity: Total shareholders' equity increased by $4.7 million
to $79.4 million at September 30, 2006 from $74.6 million at September 30,
2005, primarily as a result of net income of $8.2 million and a $2.5 million
increase to additional paid in capital from the exercise of stock options and
the vesting associated with the Bank's benefit plans. Also increasing
shareholders' equity was a decrease of $535,000 in the equity components
related to unearned shares issued to the ESOP and MRDP. Partially offsetting
these increases to shareholders' equity were the repurchase of 108,600 shares
of the Company's stock for $3.7 million, the payment of $2.5 million in
dividends to shareholders, and a $130,000 increase in accumulated other
comprehensive loss.
On April 7, 2005, the Company announced a plan to repurchase up to 5% of
the Company's outstanding shares, or 187,955 shares. This represents the
Company's 13th stock repurchase plan. As of September 30, 2006, the Company
had repurchased 136,450 of these shares at an average price of $31.85.
Cumulatively, the Company has repurchased 3,475,721 (52.6%) of the 6,612,500
shares that were issued when the Company went public in January 1998 at an
average price of $15.97 per share.
Comparison of Operating Results for the Years Ended September 30, 2006 and
2005
The Company's net income increased by 23.3% to $8.16 million for the year
ended September 30, 2006 from $6.62 million for the year ended September 30,
2005. Diluted earnings per share increased by 23.1% to $2.24 for the year
ended September 30, 2006 from $1.82 for the year ended September 30, 2005.
The improved results were primarily a result of increased net interest income
and increased non-interest income, which were partially offset by higher
non-interest expenses.
The increased net interest income was primarily a result of a larger
interest earning asset base, an increased interest rate spread due to the
increasing interest rate environment, an increase in prepayment penalties
(which are recorded as interest income), and an increase in the level of
non-accrual interest collected.
The increased non-interest income was primarily a result of increased fees
from the sale of non-deposit investment products, increased service charges on
deposits, and increased ATM fees. These increases were partially offset by a
decrease in gains from loan sales.
53
Partially offsetting the increased net interest income and non-interest
income was an increase in non-interest expenses. The increased expenses were
primarily a result of increased salary and benefit expenses due to a larger
employee base, annual salary adjustments, and increased health insurance
costs.
A more detailed explanation of the income statement categories is
presented below.
Net Income: Net income for the year ended September 30, 2006 increased by
$1.54 million to $8.16 million, or $2.24 per diluted share ($2.32 per basic
share) from $6.62 million, or $1.82 per diluted share ($1.90 per basic share)
for the year ended September 30, 2005. The $0.42 increase in diluted earnings
per share for the year ended September 30, 2006 was primarily the result of a
$2.45 million ($1.62 million net of income tax - $0.45 per diluted share)
increase in net interest income after provision for loan losses and a $171,000
($113,000 net of income tax - $0.03 per diluted share) increase in
non-interest income. These items were partially offset by a $360,000
($238,000 net of income tax - $0.06 per diluted share) increase in
non-interest expense.
Net Interest Income: Net interest income increased by $2.31 million to
$24.64 million for the year ended September 30, 2006 from $22.33 million for
the year ended September 30, 2005, primarily due to a larger interest earning
asset base, an increased interest rate spread, a $327,000 increase in
prepayment penalties (which are recorded as interest income), and the
collection of $162,000 in non-accrual interest. The collection of the
prepayment penalties and the non-accrual interest increased the yearly net
interest margin by approximately 10 basis points. Total interest income
increased $4.51 million to $35.45 million for the year ended September 30,
2006 from $30.94 million for the year ended September 30, 2005 as average
total interest earning assets increased by $16.58 million. The yield on
interest earning assets increased to 7.06% for the year ended September 30,
2006 from 6.37% for the year ended September 30, 2005. Total interest expense
increased by $2.20 million to $10.81 million for the year ended September 30,
2006 from $8.61 million for the year ended September 30, 2005 as average
interest bearing liabilities increased by $4.69 million. The average rate
paid on interest bearing liabilities increased to 2.57% for the year ended
September 30, 2006 from 2.07% for the year ended September 30, 2005. The net
interest margin increased to 4.91% for the year ended September 30, 2006 from
4.60% for the year ended September 30, 2005.
Provision for Loan Losses: The Bank did not make a provision for loan
losses during the year ended September 30, 2006 as credit quality factors
improved. This compares to a provision for loan losses of $141,000. The
provision for loan losses decreased primarily due to a decrease in the level
of loans classified as substandard and an increase in the level of net
recoveries. The Bank had a net recovery of $23,000 for the year ended
September 30, 2006 compared to a net charge-off of $33,000 for the year ended
September 30, 2005. The net charge-offs (recoveries) to average outstanding
loans ratio was (0.01%) for the year ended September 30, 2006 and 0.01% for
the year ended September 30, 2005.
The Bank has established a comprehensive methodology for determining the
provision for loan losses. On a quarterly basis the Bank performs an analysis
taking into consideration pertinent factors underlying the quality of the loan
portfolio. These factors include changes in the amount and composition of the
loan portfolio, historical loss experience for various loan segments, changes
in economic conditions, delinquency rates, a detailed analysis of individual
loans on non-accrual status, and other factors to determine the level of
allowance for loan losses needed. The allowance for loan losses increased
$23,000 to $4.12 million at September 30, 2006 from $4.10 million at September
30, 2005. Although there was a decrease in loans classified as substandard,
the Company decided to maintain the current level of the allowance for loan
losses primarily due to a larger loan portfolio, which increased by $36.5
million to $424.6 million at September 30, 2006, from $388.1 million at
September 30, 2005.
Based on the comprehensive methodology, management deemed the allowance
for loan losses of $4.12 million at September 30, 2006 (0.96% of loans
receivable and 5,152.50% of non-performing loans) adequate to provide for
probable losses based on an evaluation of known and inherent risks in the loan
portfolio at that date. While the Bank believes it has established its
existing allowance for loan losses in accordance with GAAP, there can be no
assurance that regulators, in reviewing the Bank's loan portfolio, will not
request the Bank to increase significantly its allowance for loan losses. In
addition, because future events affecting borrowers and collateral cannot be
predicted with certainty, there can be no assurance that the existing
allowance for loan losses is adequate or that substantial increases will not
be
54
necessary should the quality of any loans deteriorate. Any material increase
in the allowance for loan losses would adversely affect the Bank's financial
condition and results of operations. For additional information, see "Item 1,
Business - Lending Activities - Allowance for Loan Losses."
Non-interest Income: Total non-interest income increased by $171,000 to
$6.24 million for the year ended September 30, 2006 from $6.07 million for the
year ended September 30, 2005, primarily due to a $217,000 increase in fees
from the sale of non-deposit investment products, a $159,000 increase in
service charges on deposits, and a $155,000 increase in ATM transaction fees.
These increases were partially offset by a $342,000 decrease in gains from
loan sales. Income from loan sales was larger in the period a year ago in
part due to the sale of the Bank's credit card portfolio in December 2004,
which resulted in a gain of $264,000.
Non-interest Expense: Total non-interest expense increased by $360,000
to $18.90 million for the year ended September 30, 2006 from $18.54 million
for the year ended September 30, 2005. Non-interest expense was higher in the
current year primarily due to a $548,000 increase in salary and benefit
expense and a $196,000 increase in premises and equipment expense. The
increased salary and benefit expenses were primarily attributable to a larger
employee base, annual salary adjustments, and increased health insurance
costs. The increased premises and equipment expenses were primarily due to
increased building and equipment maintenance costs. These increases were
partially offset by a $182,000 decrease in real estate operation expenses (due
to gains from the sale of OREO properties) and a $109,000 decrease in
advertising expenses. The Company's efficiency ratio improved to 61.19% for
the year ended September 30, 2006 from 65.27% for the year ended September 30,
2005.
Provision for Income Taxes: The provision for income taxes increased
$724,000 to $3.83 million for the year ended September 30, 2006 from $3.11
million for the year ended September 30, 2005 primarily as a result of
increased income before taxes. The Company's effective tax rate was 31.95%
for the year ended September 30, 2006 and 31.93% for the year ended September
30, 2005.
Comparison of Operating Results for the Years Ended September 30, 2005 and
September 30, 2004
The Company's net income increased by 18.4% to $6.62 million for the year
ended September 30, 2005 from $5.59 million for the year ended September 30,
2004. Diluted earnings per share increased by 24.7% to $1.82 for the year
ended September 30, 2005 from $1.46 for the year ended September 30, 2004.
The improved results were primarily a result of increased net interest income
and increased non-interest income, which were partially offset by higher
non-interest expenses.
The increased net interest income was largely a result of an increased
loan portfolio and an increased investment securities portfolio. These
portfolio increases were primarily funded by the net cash received in
connection with the acquisition of seven branch offices and related deposits
in October 2004. The acquired deposit base represents a valuable low cost
funding source for the Bank as a majority of the deposits consist of checking,
savings, and money market accounts. Net interest income was increased as the
Bank was successful in deploying a substantial portion of the net cash
received from the deposit acquisition into loans and investment securities.
The increase in non-interest income was primarily a result of increased
service charges from deposits and increased ATM transaction fees. These
increases were largely a result of an increased transaction account base
attributable to the branch acquisition. Non-interest income was also
increased during the year as a result of a $264,000 gain from the sale of the
Bank's credit card portfolio.
Partially offsetting the increased net interest income and non-interest
income was increased non-interest expenses as the Bank operated with a larger
branch network and employee base as a result of the branch acquisition. The
Company also incurred approximately $253,000 in compliance costs attributable
to Section 404 of the Sarbanes-Oxley Act of 2002 during the year ended
September 30, 2005.
A more detailed explanation of the income statement categories is
presented below.
55
Net Income: Net income for the year ended September 30, 2005 increased
$1.03 million to $6.62 million, or $1.82 per diluted share ($1.90 per basic
share) from $5.59 million, or $1.46 per diluted share ($1.54 per basic share)
for the year ended September 30, 2004. The $0.36 increase in diluted earnings
per share for the year ended September 30, 2005 was primarily the result of a
$3.11 million ($2.05 million net of income tax - $0.53 per diluted share)
increase in net interest income after provision for loan losses, a $1.50
million ($988,000 net of income tax - $0.26 per diluted share) increase in
non-interest income, and a lower number of weighted average shares outstanding
which increased diluted earnings per share by approximately $0.08. These items
were partially offset by a $2.96 million ($1.95 million net of income tax -
$0.51 per diluted share) increase in non-interest expense.
Net Interest Income: Net interest income increased $3.08 million to $22.33
million for the year ended September 30, 2005 from $19.25 million for the year
ended September 30, 2004, primarily as a result of increased interest income
from a larger interest earning asset base. Total interest income increased
$4.37 million to $30.94 million for the year ended September 30, 2005 from
$26.57 million for the year ended September 30, 2004 as average total interest
earning assets increased by $73.76 million. The increased interest earning
asset balances were primarily a result of investing the funds received in
connection with the October 2004 acquisition of deposits into loans and
investment securities. The increased interest earning balances were partially
offset by a reduction in the yield on assets. The yield on earning assets
decreased to 6.37% for the year ended September 30, 2005 from 6.45% for the
year ended September 30, 2004. The decrease in yield was partially
attributable to a change in the composition of interest earning assets as
investment securities comprised a higher percentage of the total interest
earning asset base during 2005. Also partially offsetting the increased
interest income was an increase in interest expense as average interest
bearing deposits and borrowings increased. Total interest expense increased
by $1.28 million to $8.61 million for the year ended September 30, 2005 from
$7.33 million for the year ended September 30, 2004 as average interest
bearing liabilities increased $75.33 million. As a result of these changes
the net interest margin decreased to 4.60% for the year ended September 30,
2005 from 4.67% for the year ended September 30, 2004.
Provision for Loan Losses: The provision for loan losses decreased to
$141,000 for the year ended September 30, 2005 from $167,000 for the year
ended September 30, 2004. The provision for loan losses was lower primarily as
a result of changes in the composition of the portfolio, a decrease in the
level of loans classified as substandard, and a decrease in the level of
actual charge-offs. For the years ended September 30, 2005 and 2004, net
charge-offs were $33,000 and $67,000. The net charge-offs to average
outstanding loans ratio was 0.01% for the year ended September 30, 2005 and
0.02% for the year ended September 30, 2004.
The Bank has established a comprehensive methodology for determining the
provision for loan losses. On a quarterly basis the Bank performs an analysis
taking into consideration pertinent factors underlying the quality of the loan
portfolio. These factors include changes in the amount and composition of the
loan portfolio, historical loss experience for various loan segments, changes
in economic conditions, delinquency rates, a detailed analysis of individual
loans on non-accrual status, and other factors to determine the level of
allowance for loan losses needed. The allowance for loan losses increased by
$108,000 to $4.10 million at September 30, 2005 from $3.99 million at
September 30, 2004. The increased level of the allowance for loan losses was
primarily attributable to a larger loan portfolio (loans receivable and loans
held for sale), which increased by $43.5 million to $388.1 million at
September 30, 2005 from $344.6 million at September 30, 2004. Partially
offsetting the increased allowance due to loan portfolio growth, were
decreases in the level of loans classified as substandard and changes in the
category composition of the loan portfolio. The Bank's $1.5 million credit
card portfolio, which historically had the highest charge-off rate, was sold
in December 2004.
Based on the comprehensive methodology, management deemed the allowance
for loan losses of $4.10 million at September 30, 2005 (1.05% of loans
receivable and 140.09% of non-performing loans) adequate to provide for
probable losses based on an evaluation of known and inherent risks in the loan
portfolio at that date. While the Bank believes it has established its
existing allowance for loan losses in accordance with GAAP, there can be no
assurance that regulators, in reviewing the Bank's loan portfolio, will not
request the Bank to increase significantly its allowance for loan losses. In
addition, because future events affecting borrowers and collateral cannot be
predicted with certainty, there can be no assurance that the existing
allowance for loan losses is adequate or that substantial increases will not
be necessary should the quality of any loans deteriorate. Any material
increase in the allowance for loan losses would
56
adversely affect the Bank's financial condition and results of operations.
For additional information, see "Item 1, Business - Lending Activities
Allowance for Loan Losses."
Non-interest Income: Total non-interest income increased by $1.49 million
to $6.07 million for the year ended September 30, 2005 from $4.58 million for
the year ended September 30, 2004, primarily as a result of an $895,000
increase in service charges on deposits, a $235,000 increase in ATM
transaction fees, a $155,000 increase in income from loan sales (gain on sale
of loans and servicing income on loans sold) and an $81,000 distribution from
one of the Bank's ATM network associations. The increased service charges on
deposits and the increased ATM transaction fees were primarily a result of the
increased transaction account base acquired through the branch acquisition in
October 2004. The increased income from loan sales was primarily attributable
to $264,000 gain from the sale of the Bank's credit card portfolio. The
increased income from the credit card portfolio is partially offset by a
$109,000 decrease in income from the sale and servicing income on fixed rate
one- to four-family mortgages. The ATM network association distribution was
cash consideration paid to network association members in connection with the
association's merger.
Non-interest Expense: Total non-interest expense increased by $2.96
million to $18.54 million for the year ended September 30, 2005 from $15.58
million for the year ended September 30, 2004, as the Company operated with a
larger branch network as a result of the acquisition of seven branch offices
and the associated employees in October 2004. The increase was primarily a
result of a $1.40 million increase in salaries and employee benefits, a
$367,000 core deposit intangible amortization expense, a $350,000 increase in
premises and equipment expenses, a $186,000 increase in postage and courier
expense, a $69,000 increase in ATM operating fees and $142,000 in expenses
associated with the branch acquisition in October 2004. The increased
employee expenses were primarily attributable to the larger employee base
resulting from the branch acquisition, annual salary adjustments, and
increased medical insurance costs. The Company also incurred approximately
$253,000 in compliance related costs attributable to Section 404 of the
Sarbanes-Oxley Act of 2002 during the year ended September 30, 2005. The
Company's efficiency ratio decreased slightly to 65.27% for the year ended
September 30, 2005 from 65.38% for the year ended September 30, 2004.
Provision for Income Taxes: The provision for income taxes increased
$613,000 to $3.11 million for the year ended September 30, 2005 from $2.49
million for the year ended September 30, 2004 primarily as a result of
increased income before taxes. The Company's effective tax rate was 31.9% for
the year ended September 30, 2005 and 30.8% for the year ended September 30,
2005. The increase in the effective tax rate was primarily a result of a
decrease in the percentage of tax exempt income during the current year and
tax adjustments relating to the Company's branch acquisition.
Average Balances, Interest and Average Yields/Cost
The earnings of the Company depend largely on the spread between the yield
on interest-earning assets and the cost of interest-bearing liabilities, as
well as the relative amount of the Company's interest-earning assets and
interest- bearing liability portfolios.
The following table sets forth, for the periods indicated, information
regarding average balances of assets and liabilities as well as the total
dollar amounts of interest income from average interest-earning assets and
interest expense on average interest-bearing liabilities and average yields
and costs. Such yields and costs for the periods indicated are derived by
dividing income or expense by the average daily balance of assets or
liabilities, respectively, for the periods presented.
57
Year Ended September 30,
---------------------------------------------------------------------------------------
2006 2005 2004
--------------------------- --------------------------- ---------------------------
Interest Interest Interest
Average and Yield/ Average and Yield/ Average and Yield/
Balance Dividends Cost Balance Dividends Cost Balance Dividends Cost
------- --------- ------ ------- --------- ------ ------- --------- ------
(Dollars in thousands)
Interest-earning
assets:
Loans receivable
(1)(2).............. $399,811 $31,397 7.85% $378,113 $ 27,514 7.28% $338,752 $24,501 7.23%
Mortgage-backed and
investment
securities (3)...... 55,373 2,152 3.89 54,541 1,962 3.60 22,376 934 4.17
FHLB stock and equity
securities (3)...... 36,882 1,436 3.89 37,904 1,093 2.88 39,183 1,021 2.61
Federal funds sold... 8,414 389 4.62 11,653 282 2.42 577 8 1.39
Interest-bearing
deposits............ 1,714 78 4.55 3,405 85 2.50 10,970 107 0.98
-------- ------- -------- ------- -------- -------
Total interest-earning
assets.............. 502,194 35,452 7.06 485,616 30,936 6.37 411,858 26,571 6.45
Non-interest-earning
assets.............. 52,037 52,786 37,845
-------- -------- --------
Total assets......... $554,231 $538,402 $449,703
======== ======== ========
Interest-bearing
liabilities:
Savings accounts..... $ 62,255 442 0.71% $ 61,798 438 0.71% $ 48,243 342 0.71%
Money market
accounts............ 43,204 711 1.65 50,337 626 1.24 38,558 439 1.14
NOW accounts......... 91,507 684 0.75 95,471 657 0.69 70,195 544 0.77
Certificates of
deposit............. 168,578 6,068 3.60 148,483 3,701 2.53 126,521 2,843 2.25
Short-term
borrowings(4)....... 4,664 218 4.67 5,875 236 4.02 633 12 1.90
Long-term
borrowings (5)...... 51,109 2,691 5.27 54,662 2,951 5.40 57,145 3,145 5.50
-------- ------- -------- ------- -------- -------
Total interest
bearing liabilities. 421,317 10,814 2.57 416,626 8,609 2.07 341,295 7,325 2.15
Non-interest bearing
liabilities......... 55,870 48,916 34,115
-------- -------- --------
Total liabilities.... 477,187 465,542 375,410
Shareholders' equity. 77,044 72,860 74,293
-------- -------- --------
Total liabilities
and shareholders'
equity.............. $554,231 $538,402 $449,703
======== ======== ========
Net interest income.. $24,638 $22,327 $19,246
======= ======= =======
Interest rate spread. 4.49% 4.30% 4.30%
====== ====== ======
Net interest
margin (6).......... 4.91% 4.60% 4.67%
====== ====== ======
Ratio of average
interest-earning
assets to average
interest-bearing
liabilities......... 119.20% 116.56% 120.68%
====== ====== ======
_________________
(1) Does not include interest on loans 90 days or more past due. Includes
loans originated for sale. Amortized net deferred loan fees, late fees,
extension fees and prepayment penalties (2006, $2,137; 2005, $2,146; and
2004, $1,718) included with interest and dividends.
(2) Average balance includes nonaccrual loans.
(footnotes continued on following page)
58
(3) For purposes of the computation of average yield on investments available
for sale, historical cost balances were utilized, therefore the yield
information does not give effect to changes in fair value that are
reflected as a component of shareholders' equity.
(4) Includes FHLB advances with original maturities of less than one year and
other short-term borrowings-repurchase agreements.
(5) Includes FHLB advances with original maturities of one year or greater.
(6) Net interest income divided by total average interest earning assets.
Rate/Volume Analysis
The following table sets forth the effects of changing rates and volumes
on net interest income on the Company. Information is provided with respect
to the (i) effects on interest income attributable to changes in volume
(changes in volume multiplied by prior rate), and (ii) effects on interest
income attributable to changes in rate (changes in rate multiplied by prior
volume), and (iii) the net change (sum of the prior columns). Changes in
rate/volume have been allocated to rate and volume variances based on the
absolute values of each.
Year Ended September 30, Year Ended September 30,
2006 Compared to Year 2005 Compared to Year
Ended September 30, 2005 Ended September 30, 2004
Increase (Decrease) Increase (Decrease)
Due to Due to
------------------------- --------------------------
Net Net
Rate Volume Change Rate Volume Change
------ ------ ------ ------ ------ ------
(In thousands)
Interest-earning assets:
Loans receivable (1)...$2,252 $1,631 $3,883 $ 150 $ 2,863 $3,013
Investments and
mortgage-backed
securities............ 161 29 190 (145) 1,173 1,028
FHLB stock and equity
securities............ 373 (30) 343 106 (34) 72
Federal funds sold..... 202 (95) 107 1 273 274
Interest-bearing
deposits.............. 48 (55) (7) 87 (109) (22)
Total net change in
income on interest-
earning assets........ 3,036 1,480 4,516 199 4,166 4,365
Interest-bearing
liabilities:
Savings accounts....... 1 3 4 -- 96 96
NOW accounts........... 55 (28) 27 (66) 179 113
Money market
accounts.............. 182 (97) 85 35 152 187
Certificate accounts... 1,964 403 2,367 219 639 858
Short-term borrowings.. 69 (87) (18) 27 197 224
Long-term borrowings... (72) (188) (260) (59) (135) (194)
------ ------ ------ ----- ------- ------
Total net change in
expense on interest-
bearing liabilities... 2,199 6 2,205 156 1,128 1,284
------ ------ ------ ----- ------- ------
Net change in net
interest income.......$ 837 $1,474 $2,311 $ 43 $ 3,038 $3,081
====== ====== ====== ===== ======= ======
-------------
(1) Excludes interest on loans 90 days or more past due. Includes loans
originated for sale.
59
Liquidity and Capital Resources
The Company's primary sources of funds are customer deposits, proceeds
from principal and interest payments on loans, the sale of loans, maturing
securities and FHLB advances. While the maturity and scheduled amortization
of loans are a predictable source of funds, deposit flows and mortgage
prepayments are greatly influenced by general interest rates, economic
conditions and competition.
The Bank must maintain an adequate level of liquidity to ensure the
availability of sufficient funds to fund loan originations and deposit
withdrawals, to satisfy other financial commitments and to take advantage of
investment opportunities. The Bank generally maintains sufficient cash and
short-term investments to meet short-term liquidity needs. At September 30,
2006, the Bank's regulatory liquidity ratio (net cash, and short-term and
marketable assets, as a percentage of net deposits and short-term liabilities)
was 12.43%. At September 30, 2006, the Bank maintained an uncommitted credit
facility with the FHLB-Seattle that provided for immediately available
advances up to an aggregate amount equal to 30% of total assets, limited by
available collateral, under which $62.8 million was outstanding. The Bank
also maintained a $10 million overnight borrowing line with Pacific Coast
Banker's Bank. At September 30, 2006, the Bank did not have an outstanding
balance on this borrowing line.
Liquidity management is both a short and long-term responsibility of the
Bank's management. The Bank adjusts its investments in liquid assets based
upon management's assessment of (i) expected loan demand, (ii) projected loan
sales, (iii) expected deposit flows, and (iv) yields available on interest-
bearing deposits. Excess liquidity is invested generally in interest-bearing
overnight deposits and other short-term government and agency obligations. If
the Bank requires funds beyond its ability to generate them internally, it has
additional borrowing capacity with the FHLB, Pacific Coast Banker's Bank and
collateral for repurchase agreements.
The Bank's primary investing activity is the origination of mortgage
loans, which includes construction and land development loans. During the
years ended September 30, 2006, 2005, and 2004, the Bank originated $215.8
million, $190.3 million, and $172.4 million of mortgage loans, respectively.
At September 30, 2006, the Bank had loan commitments totaling $39.2 million
and undisbursed loans in process totaling $59.3 million. The Bank anticipates
that it will have sufficient funds available to meet current loan commitments.
Certificates of deposit that are scheduled to mature in less than one year
from September 30, 2006 totaled $153.9 million. Historically, the Bank has
been able to retain a significant amount of its deposits as they mature.
The Bank's liquidity is also affected by the volume of loans sold and loan
principal payments. During the years ended September 30, 2006, 2005, and
2004, the Bank sold $26.4 million, $25.4 million, and $35.7 million in fixed
rate, one- to four-family mortgage loans. The Bank also sold $1.5 million in
credit card loans during the year ended September 30, 2005. During the years
ended September 30, 2006, 2005 and 2004, the Bank received $177.0 million,
$160.8 million, and $133.9 million in principal repayments.
The Bank's liquidity has been impacted by increases in deposit levels.
During the years ended September 30, 2006, 2005 and 2004, deposits increased
by $19.4 million, $92.1 million, and $11.9 million. On October 9, 2004, the
Bank acquired $86.3 million in deposits by acquiring seven branches.
Investment and mortgage-backed securities and interest bearing deposits
decreased to $89.5 million at September 30, 2006 from $98.4 million at
September 30, 2005.
Federally-insured state-chartered banks are required to maintain minimum
levels of regulatory capital. Under current FDIC regulations, insured
state-chartered banks generally must maintain (i) a ratio of Tier 1 leverage
capital to total assets of at least 3.0% (4.0% to 5.0% for all but the most
highly rated banks), (ii) a ratio of Tier 1 capital to risk weighted assets of
at least 4.0% and (iii) a ratio of total capital to risk weighted assets of at
least 8.0%. At September 30, 2006, the Bank was in compliance with all
applicable capital requirements. For additional details see Note 20 of the
Notes to Consolidated Financial Statements contained in "Item 8, Financial
Statements and Supplementary Data" and "Item 1, Business - Regulation of the
Bank - Capital Requirements."
60
Contractual obligations. The following table presents, as of September
30, 2006, the Company's significant fixed and determinable contractual
obligations, within the categories described below, by payment date or
contractual maturity. These contractual obligations, except for the operating
lease obligations are included in the Consolidated Balance Sheet. The payment
amounts represent those amounts contractually due at September 30, 2006.
Payments due by period
--------------------------------------------------
After After
1 year 3 years
Within through through After
Contractual obligations Total 1 year 3 years 5 years 5 years
------- --------- --------- --------- ---------
(In thousands)
Short-term debt
obligations.............. $29,947 $29,947 $ -- $ -- $ --
Long-term debt
obligations.............. 33,761 9,064 19,697 -- 5,000
Operating lease
obligations.............. 16 5 11 -- --
------- --------- --------- --------- ---------
Total contractual
obligations............. $63,724 $39,016 $19,708 $ -- $ 5,000
======= ========= ========= ========= =========
Effect of Inflation and Changing Prices
The consolidated financial statements and related financial data presented
herein have been prepared in accordance with accounting principles generally
accepted in the United States of America which require the measurement of
financial position and operating results in terms of historical dollars,
without considering the change in the relative purchasing power of money over
time due to inflation. The primary impact of inflation on the operation of
the Company is reflected in increased operating costs. Unlike most industrial
companies, virtually all the assets and liabilities of a financial institution
are monetary in nature. As a result, interest rates generally have a more
significant impact on a financial institution's performance than do general
levels of inflation. Interest rates do not necessarily move in the same
direction or to the same extent as the prices of goods and services.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
--------------------------------------------------------------------
The information contained under "Item 7, Management's Discussion and
Analysis of Financial Condition and Results of Operations - Market Risk and
Asset and Liability Management" of this Form 10-K is incorporated herein by
reference.
61
Item 8. Financial Statements and Supplementary Data
----------------------------------------------------
Management's Report on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate
internal control over financial reporting. Internal control over financial
reporting is a process designed to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements
for external purposes in accordance with generally accepted accounting
principles. The Company's internal control over financial reporting includes
those policies and procedures that (i) pertain to the maintenance of records
that, in reasonable detail, accurately and fairly reflect the transactions and
dispositions of the assets of the Company; (ii) provide reasonable assurance
that transactions are recorded as necessary to permit preparation of financial
statements in accordance with generally accepted accounting principles, and
that receipts and expenditures of the Company are being made only in
accordance with authorizations of management and directors of the Company; and
(iii) provide reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use, or disposition of the Company's assets that
could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate.
Management conducted an evaluation of the effectiveness of internal
control over financial reporting based on the framework in Internal Control --
Integrated Framework issued by the Committee of Sponsoring Organizations of
the Treadway Commission. Based on this evaluation, management concluded that
the Company's internal control over financial reporting was effective as of
September 30, 2006. Management's assessment of the effectiveness of the
Company's internal control over financial reporting has been audited by
McGladrey & Pullen, LLP, an independent registered public accounting firm, as
stated in their report which is included herein.
62
Report of Independent Registered Public Accounting Firm on Internal Control
Over Financial Reporting
[McGladrey & Pullen Letterhead]
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
Timberland Bancorp, Inc.
Hoquiam, Washington
We have audited management's assessment, included in the accompanying Internal
Control Assessment, that Timberland Bancorp, Inc. and Subsidiary maintained
effective internal control over financial reporting as of September 30, 2006,
based on criteria established in Internal Control -- Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO). Timberland Bancorp, Inc. and Subsidiary's management is responsible
for maintaining effective internal control over financial reporting and for
its assessment of the effectiveness of internal control over financial
reporting. Our responsibility is to express an opinion on management's
assessment and an opinion on the effectiveness of the Company's internal
control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating management's assessment, testing
and evaluating the design and operating effectiveness of internal control, and
performing such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable basis for our
opinion.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles. A company's internal
control over financial reporting includes those policies and procedures that:
(1) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets
of the company; (2) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles, and that receipts
and expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and (3) provide
reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the company's assets that could have a
material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.
63
In our opinion, management's assessment that Timberland Bancorp, Inc. and
Subsidiary maintained effective internal control over financial reporting as
of September 30, 2006, is fairly stated, in all material respects, based on
criteria established in Internal Control -- Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also
in our opinion, Timberland Bancorp, Inc. and Subsidiary maintained, in all
material respects, effective internal control over financial reporting as of
September 30, 2006, based on criteria established in Internal Control --
Integrated Framework issued by the Committee of Sponsoring Organizations of
the Treadway Commission (COSO).
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated financial
statements of Timberland Bancorp, Inc. and Subsidiary and our report dated
December 5, 2006 expressed an unqualified opinion.
/s/McGladrey & Pullen LLP
Seattle, Washington
December 5, 2006
64
TIMBERLAND BANCORP, INC. AND SUBSIDIARY
Index to Consolidated Financial Statements
Page
----
Report of Independent Registered Public Accounting Firm............. 66
Consolidated Balance Sheets as of September 30, 2006 and 2005....... 67
Consolidated Statements of Income For the Years Ended
September 30, 2006, 2005, and 2004................................ 68
Consolidated Statements of Shareholders' Equity For the
Years Ended September 30, 2006, 2005 and 2004..................... 69
Consolidated Statements of Cash Flows For the Years Ended
September 30, 2006, 2005 and 2004................................. 70
Consolidated Statements of Comprehensive Income For the
Years Ended September 30, 2006, 2005 and 2004..................... 72
Notes to Consolidated Financial Statements.......................... 73
65
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
Timberland Bancorp, Inc.
Hoquiam, Washington
We have audited the consolidated balance sheets of Timberland Bancorp, Inc.
and Subsidiary as of September 30, 2006 and 2005, and the related consolidated
statements of income, shareholders' equity, cash flows and comprehensive
income for each of the three years in the period ended September 30, 2006.
These consolidated financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provided a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Timberland
Bancorp, Inc. and Subsidiary as of September 30, 2006 and 2005, and the
results of their operations and their cash flows for each of the three years
in the period ended September 30, 2006, in conformity with U.S. generally
accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of Timberland
Bancorp, Inc. and Subsidiary's internal control over financial reporting as of
September 30, 2006, based on criteria established in Internal Control --
Integrated Framework issued by the Committee of Sponsoring Organizations of
the Treadway Commission (COSO) and our report dated December 5, 2006 expressed
an unqualified opinion on management's assessment of the effectiveness of
Timberland Bancorp's internal control over financial reporting and an
unqualified opinion on the effectiveness of Timberland Bancorp's internal
control over financial reporting.
As discussed in Note 1 to the financial statements, the Company adopted the
provisions of the Financial Accounting Standards Board's Statement of
Financial Standards No. 123 (revised 2004), Share-Based Payment in fiscal year
2006.
/s/ McGladrey & Pullen, LLP
Seattle, Washington
December 5, 2006
66
Consolidated Balance Sheets
------------------------------------------------------------------------------
(Dollars in Thousands)
Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
2006 2005
Assets
Cash equivalents:
Cash and due from financial institutions $ 14,870 $ 20,015
Interest-bearing deposits in other banks 2,519 2,868
Federal funds sold 5,400 5,635
22,789 28,518
Certificate of deposits ("CDs") held for investment 100 200
Mortgage-backed securities - held to maturity
(market value $73 and $101) 75 104
Investments and mortgage-backed securities -
available for sale 81,408 89,595
Federal Home Loan Bank ("FHLB") stock (at cost) 5,705 5,705
Loans receivable, net of allowance for loan losses
of $4,122 and $4,099 422,196 385,754
Loans held for sale 2,449 2,355
424,645 388,109
Premises and equipment, net 16,730 15,862
Other real estate owned and other repossessed items 15 509
Accrued interest receivable 2,806 2,294
Bank owned life insurance ("BOLI") 11,951 11,502
Goodwill 5,650 5,650
Core deposit intangible ("CDI") 1,506 1,834
Mortgage servicing rights 932 928
Other assets 2,775 1,955
Total assets $577,087 $552,765
Liabilities and shareholders' equity
Liabilities
Deposits:
Demand, non-interest-bearing $ 57,905 $ 51,791
Interest-bearing 373,156 359,874
Total deposits 431,061 411,665
FHLB advances 62,761 62,353
Other borrowings: repurchase agreements 947 781
Other liabilities and accrued expenses 2,953 3,324
Total liabilities 497,722 478,123
Commitments and contingencies (See Note 18) - - - -
Shareholders' equity
Preferred stock, $0.01 par value; 50,000,000 shares
authorized; none issued - - - -
Common stock, $0.01 par value; 50,000,000 shares
authorized;
2006 - 3,757,676 shares issued and outstanding
2005 - 3,759,937 shares issued and outstanding 38 38
Additional paid-in capital 20,888 22,040
Unearned shares issued to Employee Stock Ownership
Plan ("ESOP") (3,305) (3,833)
Unearned shares issued to Management Recognition
and Development Plan ("MRDP") (188) - -
Retained earnings 62,933 57,268
Accumulated other comprehensive loss (1,001) (871)
Total shareholders' equity 79,365 74,642
Total liabilities and shareholders' equity $577,087 $552,765
See notes to consolidated financial statements.
67
Consolidated Statements of Income
------------------------------------------------------------------------------
(Dollars in Thousands, Except Per Share Amounts)
Timberland Bancorp, Inc. and Subsidiaries
Years Ended September 30, 2006, 2005 and 2004
2006 2005 2004
Interest and dividend income
Loans receivable $31,397 $27,514 $24,501
Investments and mortgage-backed securities 2,152 1,962 934
Dividends from investments 1,436 1,093 1,021
Interest-bearing deposits in banks 467 367 115
Total interest and dividend income 35,452 30,936 26,571
Interest expense
Deposits 7,905 5,422 4,168
FHLB advances - short term 2,691 3,096 3,148
FHLB advances - long term 169 60 9
Other borrowings - repurchase agreements 49 31 - -
Total interest expense 10,814 8,609 7,325
Net interest income 24,638 22,327 19,246
Provision for loan losses - - 141 167
Net interest income after provision for
loan losses 24,638 22,186 19,079
Non-interest income
Service charges on deposits 2,981 2,822 1,927
ATM transaction fees 1,026 871 636
BOLI net earnings 449 430 462
Gain on sale of loans, net 386 728 642
Servicing income on loans sold 425 379 310
Escrow fees 120 141 140
Fee income from non-deposit investment sales 286 69 28
Loss on sale of securities available for
sale, net - - - - (6)
Other 571 633 437
Total non-interest income 6,244 6,073 4,576
Non-interest expense
Salaries and employee benefits 10,744 10,196 8,794
Premises and equipment 2,425 2,229 1,879
Advertising 688 797 729
Other real estate owned expense (income) (178) 4 (3)
ATM expenses 428 465 396
Postage and courier 486 529 343
Amortization of CDI 328 367 - -
State and local taxes 564 436 343
Professional fees 793 714 541
Other 2,618 2,799 2,553
Total non-interest expense 18,896 18,536 15,575
Income before federal income taxes 11,986 9,723 8,080
Federal income taxes 3,829 3,105 2,492
Net income $ 8,157 $ 6,618 $ 5,588
Earnings per common share
Basic $ 2.32 $ 1.90 $ 1.54
Diluted 2.24 1.82 1.46
See notes to consolidated financial statements.
68
Consolidated Statements of Shareholders' Equity
------------------------------------------------------------------------------
(Dollars in Thousands)
Timberland Bancorp, Inc. and Subsidiaries
Years Ended September 30, 2006, 2005 and 2004
Accumulated
Other
Unearned Unearned Compre-
Additional Shares Shares hensive
Common Stock Paid-in Issued to Issued to Retained Income
Shares Amount Capital ESOP MRDP Earnings (Loss) Total
Balance, September 30,
2003 4,251,680 $ 43 $ 33,775 ($4,891) ($1,182) $49,699 $ 167 $77,611
Net income - - - - - - - - - - 5,588 - - 5,588
Repurchase of common stock (482,016) (5) (11,074) - - - - - - - - (11,079)
Exercise of stock options 112,406 1 1,747 - - - - - - - - 1,748
Cash dividends
($.57 per share) - - - - - - - - - - (2,320) - - (2,320)
Earned ESOP shares - - 283 529 - - - - - - 812
Earned MRDP shares - - 136 - - 645 - - - - 781
Change in fair value of
securities available for
sale, net of tax - - - - - - - - - - - - (324) (324)
Balance,
September 30, 2004 3,882,070 39 24,867 (4,362) (537) 52,967 (157) 72,817
Net income - - - - - - - - - - 6,618 - - 6,618
Repurchase of common stock (174,434) (2) (4,062) - - - - - - - - (4,064)
Exercise of stock options 52,301 1 813 - - - - - - - - 814
Cash dividends ($.61 per
share) - - - - - - - - - - (2,317) - - (2,317)
Earned ESOP shares - - 293 529 - - - - - - 822
Earned MRDP shares - - 129 - - 537 - - - - 666
Change in fair value of
securities available for
sale, net of tax - - - - - - - - - - - - (714) (714)
Balance,
September 30, 2005 3,759,937 $ 38 $22,04 ($3,833) $- - $57,268 ($871) $74,642
Net income - - - - - - - - - - 8,157 - - 8,157
Issuance of MRDP shares 6,000 - - 195 - - (195) - - - - - -
Repurchase of common stock (108,600) (1) (3,700) - - - - - - - - (3,701)
Exercise of stock options 100,339 1 1,827 - - - - - - - - 1,828
Cash dividends ($.66 per
share) - - - - - - - - - - (2,492) - - (2,492)
Earned ESOP shares - - 480 528 - - - - - - 1,008
Earned MRDP shares - - (4) - - 7 - - - - 3
Stock option compensation
exp. - - - - 50 - - - - - - - - 50
Change in fair value of
securities available for
sale, net of tax - - - - - - - - - - - - (130) (130)
Balance,
September 30, 2006 3,757,676 $ 38 $20,888 ($3,305) ($188) $62,933 ($1,001) $79,365
See notes to consolidated financial statements.
69
Consolidated Statements of Cash Flows
------------------------------------------------------------------------------
(Dollars in Thousands)
Timberland Bancorp, Inc. and Subsidiaries
Years Ended September 30, 2006, 2005 and 2004
2006 2005 2004
Cash flows from operating activities
Net income $ 8,157 $ 6,618 $ 5,588
Non-cash revenues, expenses, gains and
losses included in net income:
Depreciation 998 933 812
Deferred federal income taxes 226 64 69
Amortization of core deposit intangible 328 367 - -
Earned ESOP shares 528 529 529
Earned MRDP shares 7 537 645
Stock option compensation expense 50 - - - -
Stock option tax effect less excess tax
benefit 113 186 386
FHLB stock dividends - - (23) (228)
Gain on sale of other real estate
owned, net (158) (5) (81)
Loss on sale of securities available
for sale - - - - 6
Gain on sale of loans (386) (728) (642)
(Gain) loss on sale of premises and
equipment (37) 13 - -
Provision for loan and other real estate
owned losses - - 161 206
Loans originated for sale (26,153) (26,528) (35,350)
Proceeds from loans held for sale 26,445 25,247 36,383
Proceeds from credit card portfolio sale - - 264 - -
BOLI net earnings (449) (430) (462)
Net change in accrued interest receivable
and other assets, and other liabilities
and accrued expenses (1,906) 397 (357)
Net cash provided by operating activities 7,663 7,602 7,504
Cash flows from investing activities
Net (increase) decrease in CD's held for
investment 100 (1) - -
Activity in securities held to maturity:
Maturities and prepayments 27 62 105
Activity in securities available for sale:
Sales - - - - 1,600
Maturities and prepayments 7,960 8,140 10,006
Purchases - - (38,977) (17,965)
Increase in loans receivable, net (36,398) (42,272) (23,453)
Additions to premises and equipment (1,924) (837) (1,296)
Purchase of branches, net of cash and cash
equivalents - - 76,630 - -
Proceeds from sale of other real estate
owned 680 549 1,138
Proceeds from the disposition of premises
and equipment 95 6 - -
Net cash provided (used) by investing
activities (29,460) 3,300 (29,865)
(continued)
See notes to consolidated financial statements.
70
Consolidated Statements of Cash Flows
------------------------------------------------------------------------------
(concluded) (Dollars in Thousands)
Timberland Bancorp, Inc. and Subsidiaries
Years Ended September 30, 2006, 2005 and 2004
2006 2005 2004
Cash flows from financing activities
Increase in deposits $ 19,396 $ 5,600 $ 11,898
Net decrease in FHLB advances - long term (20,592) (583) (6,669)
Net increase (decrease) in FHLB
advances - short term 21,000 (2,485) 10,485
Net increase in repurchase agreements 166 781 - -
Proceeds from exercise of stock options 1,221 628 1,362
ESOP tax effect 480 293 283
MRDP tax effect (4) 129 136
Stock option excess tax benefit 494 - - - -
Repurchase of common stock (3,701) (4,064) (11,079)
Payment of dividends (2,492) (2,317) (2,320)
Net cash provided (used) by financing
activities 15,968 (2,018) 4,096
Net increase (decrease) in cash
equivalents (5,729) 8,884 (18,265)
Cash equivalents
Beginning of year 28,518 19,634 37,899
End of year $ 22,789 $28,518 $ 19,634
Supplemental disclosures of cash flow
information
Income taxes paid $ 3,755 $ 2,370 $ 2,095
Interest paid 10,496 8,362 7,107
Supplemental disclosures of non-cash
investing and financing activities
Market value adjustment of securities
held for sale, net of tax ($130) ($ 714) ($ 324)
Loans transferred to other real estate
owned 28 625 344
Financed sale of other real estate owned - - - - 169
Shares issued to MRDP 195 - - - -
Supplemental disclosures of branch purchase
Premium paid for deposits $ - - ($ 7,848) $ - -
Fair value of assets acquired - - (2,064) - -
Deposits assumed - - 86,495 - -
Other liabilities assumed - - 47 - -
Net cash provided by branch purchase $ - - $76,630 $ - -
See notes to consolidated financial statements.
71
Consolidated Statements of Comprehensive Income
------------------------------------------------------------------------------
(Dollars in Thousands)
Timberland Bancorp, Inc. and Subsidiaries
Years Ended September 30, 2006, 2005 and 2004
2006 2005 2004
Comprehensive income
Net income $8,157 $ 6,618 $5,588
Change in fair value of
securities available for sale, net of tax (130) (714) (324)
Total comprehensive income $8,027 $ 5,904 $5,264
See notes to consolidated financial statements.
72
Notes to Consolidated Financial Statements
------------------------------------------------------------------------------
Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 1 - Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of Timberland
Bancorp, Inc. ("Company"); its wholly owned subsidiary, Timberland Bank
("Bank"); and the Bank's wholly owned subsidiary, Timberland Service Corp.
All significant intercompany transactions and balances have been eliminated.
Nature of Operations
The Company is a bank holding company which operates primarily through its
subsidiary, the Bank. The Bank was established in 1915 and, through its 21
branches located in Grays Harbor, Pierce, Thurston, Kitsap, King and Lewis
counties in Washington State, attracts deposits from the general public, and
uses those funds, along with other borrowings, to provide residential real
estate, construction and land development, commercial real estate, consumer
and commercial business loans to borrowers in western Washington, and to
invest in investment securities and mortgage-backed securities.
Consolidated Financial Statement Presentation
The consolidated financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America and
practices within the banking industry. The preparation of consolidated
financial statements requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities, and the disclosure
of contingent assets and liabilities, as of the date of the balance sheet, and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates. Material estimates that are
particularly susceptible to significant change in the near term relate to the
determination of the allowance for loan losses and the valuation of mortgage
servicing rights.
Certain prior year amounts have been reclassified to conform to the 2006
presentation with no change to net income or shareholders' equity previously
reported.
Segment Reporting
The Company has one reportable operating segment which is defined as community
banking in western Washington under the operating name Timberland Bank.
(continued)
73
Notes to Consolidated Financial Statements
------------------------------------------------------------------------------
Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 1 - Summary of Significant Accounting Policies (continued)
Investments and Mortgage-Backed Securities - Available for Sale
Debt and equity securities that may be sold in response to changes in market
interest rates, prepayment rates, need for liquidity, and changes in the
availability of and the yield of alternative investments, are considered
securities available for sale, and are reported at fair value. Unrealized
gains and losses are excluded from earnings, and are reported as a separate
component of shareholders' equity, net of the related deferred tax effect,
entitled "Accumulated other comprehensive income (loss)." Realized gains and
losses on securities available for sale, determined using the specific
identification method, are included in earnings. Amortization of premiums and
accretion of discounts are recognized in interest income over the period to
maturity.
Investments and Mortgage-Backed Securities - Held to Maturity
Debt securities for which the Company has the positive intent and ability to
hold to maturity are reported at cost, adjusted for amortization of premiums
and accretion of discounts, which are recognized in interest income using the
interest method.
Declines in the fair value of individual securities held to maturity and
available for sale below their cost that are other than temporary would result
in write-downs of the individual securities to their fair value. Management
evaluates individual securities for other than temporary impairment on a
quarterly basis based on the securities' current credit quality, interest
rates, term to maturity and management's intent and ability to hold the
securities until the net book value is recovered. Any other than temporary
declines in fair value are recognized in the statement of income as realized
losses.
Federal Home Loan Bank Stock
The Company, as a member of the Federal Home Loan Bank of Seattle ("FHLB"), is
required to maintain an investment in capital stock of the FHLB in an amount
equal to the greater of 1% of its outstanding home loans or 5% of advances
from the FHLB. The recorded amount of FHLB stock equals its fair value
because the shares can only be redeemed by the FHLB at the $100 per share par
value.
Loans Held for Sale
Mortgage loans originated and intended for sale in the secondary market are
stated in the aggregate at the lower of cost or estimated market value. Net
unrealized losses, if any, are recognized through a valuation allowance by
charges to income. Gains or losses on sales of loans are recognized at the
time of sale. The gain or loss is the difference between the net sales
proceeds and the recorded value of the loans, including any remaining
unamortized deferred loan origination fees.
Loans Receivable
Loans are stated at the amount of unpaid principal, reduced by the undisbursed
portion of construction loans in process, deferred loan origination fees and
an allowance for loan losses.
(continued)
74
Notes to Consolidated Financial Statements
------------------------------------------------------------------------------
Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 1 - Summary of Significant Accounting Policies (continued)
Allowance for Loan Losses
The allowance for loan losses is maintained at a level sufficient to provide
for estimated loan losses based on evaluating known and inherent risks in the
loan portfolio. The allowance is provided based upon management's
comprehensive analysis of the pertinent factors underlying the quality of the
loan portfolio. These factors include changes in the amount and composition
of the loan portfolio, delinquency levels, actual loan loss experience,
current economic conditions, and detailed analysis of individual loans for
which full collectibility may not be assured. The detailed analysis includes
methods to estimate the fair value of loan collateral and the existence of
potential alternative sources of repayment. The allowance consists of
specific, general and unallocated components. The specific component relates
to loans that are deemed impaired. For such loans that are also classified as
impaired, an allowance is established when the discounted cash flows (or
collateral value or observable market price) of the impaired loan is lower
than the recorded value of that loan. The general component covers
non-classified loans and classified loans that are not evaluated individually
for impairment and is based on historical loss experience adjusted for
qualitative factors. An unallocated component is maintained to cover
uncertainties that could affect management's estimate of probable losses. The
unallocated component of the allowance reflects the margin of imprecision
inherent in the underlying assumptions used in the methodologies for
estimating specific and general losses in the portfolio. The appropriateness
of the allowance for losses on loans is estimated based upon these factors and
trends identified by management at the time financial statements are prepared.
In accordance with Statement of Financial Accounting Standards ("SFAS" or
"Statement") No. 114, Accounting by Creditors for Impairment of a Loan, and
SFAS No. 118, an amendment of SFAS No. 114, a loan is considered impaired when
it is probable that a creditor will be unable to collect all amounts
(principal and interest) due according to the contractual terms of the loan
agreement. Smaller balance homogenous loans, such as residential mortgage
loans and consumer loans, may be collectively evaluated for potential loss.
When a loan has been identified as being impaired, the amount of the
impairment is measured by using discounted cash flows, except when, as an
alternative, the current fair value of the collateral, reduced by costs to
sell, is used. When the measurement of the impaired loan is less than the
recorded investment in the loan (including accrued interest and net deferred
loan origination fees or costs), an impairment is recognized by creating or
adjusting an allocation of the allowance for loan losses. Uncollected accrued
interest is reversed against interest income. If ultimate collection of
principal is in doubt, all cash receipts on impaired loans are applied to
reduce the principal balance.
A provision for loan losses is charged against income and is added to the
allowance for loan losses based on quarterly comprehensive analyses of the
loan portfolio. The allowance for loan losses is allocated to certain loan
categories based on the relative risk characteristics, asset classifications
and actual loss experience of the loan portfolio. While management has
allocated the allowance for loan losses to various loan portfolio segments,
the allowance is general in nature and is available for the loan portfolio in
its entirety.
The ultimate recovery of all loans is susceptible to future market factors
beyond the Bank's control. These factors may result in losses or recoveries
differing significantly from those provided in the consolidated financial
statements. In addition, regulatory agencies, as an integral part of their
examination process, periodically review the Bank's allowance for loan losses,
and may require the Bank to make additions to the allowance based on their
judgment about information available to them at the time of their
examinations.
Interest on Loans and Loan Fees
Interest on loans is accrued daily based on the principal amount outstanding.
Allowances are established for uncollected interest on loans for which the
interest is determined to be uncollectible. Generally, all loans past due
(based on contractual terms) 90 days or more are placed on non-accrual status
and internally classified as substandard. Any interest income accrued at that
time is reversed. Subsequent collections are applied proportionately to past
due principal and interest, unless collectibility of principal is in doubt, in
which case all payments are applied to principal. Loans are removed from
non-accrual status only when the loan is deemed current, and the
collectibility of principal and interest is no longer doubtful, or on one- to
four-family loans, when the loan is less than 90 days delinquent.
(continued)
75
Notes to Consolidated Financial Statements
------------------------------------------------------------------------------
Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 1 - Summary of Significant Accounting Policies (continued)
Interest on Loans and Loan Fees (concluded)
The Bank charges fees for originating loans. These fees, net of certain loan
origination costs, are deferred and amortized to income, on the level-yield
basis, over the loan term. If the loan is repaid prior to maturity, the
remaining unamortized deferred loan origination fee is recognized in income at
the time of repayment.
Mortgage Servicing Rights
Mortgage servicing rights are capitalized when acquired through the
origination of loans that are subsequently sold with the servicing rights
retained and are amortized to servicing income on loans sold in proportion to
and over the period of estimated net servicing income. The value of mortgage
servicing rights at the date of the sale of loans is determined based on the
discounted present value of expected future cash flows using key assumptions
for servicing income and costs and prepayment rates on the underlying loans.
The estimated fair value is periodically evaluated for impairment by comparing
actual cash flows and estimated future cash flows from the servicing assets to
those estimated at the time servicing assets were originated. Fair values are
estimated using discounted cash flows based on current market rates of
interest. For purposes of measuring impairment, the rights must be stratified
by one or more predominant risk characteristics of the underlying loans. The
Company stratifies its capitalized mortgage servicing rights based on product
type, interest rate and term of the underlying loans. The amount of
impairment recognized is the amount, if any, by which the amortized cost of
the rights for each stratum exceed their fair value.
Goodwill
Goodwill is initially recorded when the purchase price paid for an acquisition
exceeds the estimated fair value of the net identified tangible and intangible
assets acquired. Goodwill is presumed to have an indefinite useful life and
is analyzed, at least annually, for impairment. An annual review is performed
at the end of the third quarter of each fiscal year, or more frequently if
indicators of potential impairment exist, to determine if the recorded
goodwill is impaired. If the fair value exceeds the recorded value, goodwill
is not considered impaired and no additional analysis is necessary. As of
September 30, 2006, there have been no events or changes in the circumstances
that would indicate a potential impairment.
Core Deposit Intangible
The core deposit intangible ("CDI") is amortized to non-interest expense using
an accelerated method over a ten-year period.
Premises and Equipment
Premises and equipment are recorded at cost. Depreciation is computed on the
straight-line method over the following estimated useful lives: buildings and
improvements - up to 40 years; furniture and equipment - three to seven years;
and automobiles - five years. The cost of maintenance and repairs is charged
to expense as incurred. Gains and losses on dispositions are reflected in
earnings.
(continued)
76
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 1 - Summary of Significant Accounting Policies (continued)
Other Real Estate Owned and Other Repossessed Items
Other real estate owned and other repossessed items consist of properties or
assets acquired through or in lieu of foreclosure, and are recorded initially
at the lower of cost or fair value of the properties less estimated costs of
disposal. Costs relating to development and improvement of the properties or
assets are capitalized while costs relating to holding the properties or
assets are expensed.
Valuations are periodically performed by management, and an allowance for
losses is established by a charge to earnings if the recorded value of a
property exceeds its estimated net realizable value.
Transfers of Financial Assets
Transfers of financial assets are accounted for as sales when control over the
assets has been surrendered. Control over transferred assets is deemed to be
surrendered when (1) the assets have been isolated from the Company, (2) the
transferee obtains the right (free of conditions that constrain it from taking
advantage of that right) to pledge or exchange the transferred assets, and (3)
the Company does not maintain effective control over the transferred assets
through an agreement to repurchase them before their maturity.
Income Taxes
The Company files a consolidated federal income tax return with its
subsidiaries. Prior to fiscal year 1997, the Bank qualified under provisions
of the Internal Revenue Code which permitted, as a deduction from taxable
income, an allowance for bad debts based on a percentage of taxable income.
In 1996, the percentage-of-income bad debt deduction for federal tax purposes
was eliminated. In addition, federal tax bad debt reserves which had been
accumulated since October 1, 1988, that exceeded the reserves which would have
been accumulated based on actual experience, are subject to recapture over a
six-year recapture period. As of September 30, 2005, all federal tax bad debt
reserves had been recaptured.
Deferred federal income taxes result from temporary differences between the
tax basis of assets and liabilities, and their reported amounts in the
consolidated financial statements. These will result in differences between
income for tax purposes and income for financial reporting purposes in future
years. As changes in tax laws or rates are enacted, deferred tax assets and
liabilities are adjusted through the provision for income taxes.
Employee Stock Ownership Plan
The Bank sponsors a leveraged Employee Stock Ownership Plan ("ESOP"). The
ESOP is accounted for in accordance with the American Institute of Certified
Public Accountants Statement of Position 93-6, Employers' Accounting for
Employee Stock Ownership Plan. Accordingly, the debt of the ESOP is recorded
as other borrowed funds of the Bank, and the shares pledged as collateral are
reported as unearned shares issued to the employee stock ownership trust on
the consolidated balance sheets. The debt of the ESOP is with the Company and
is thereby eliminated in the consolidated financial statements. As shares are
released from collateral, compensation expense is recorded equal to the
average market price of the shares for the period, and the shares become
available for earnings per share calculations.
(continued)
77
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 1 - Summary of Significant Accounting Policies (continued)
Cash Equivalents and Cash Flows
The Company considers amounts included in the balance sheets' captions "Cash
and due from financial institutions", "Interest-bearing deposits in other
banks" and "Federal funds sold" to be cash equivalents. Cash flows from
loans, deposits, FHLB advances - short term, FHLB advances - long term, and
other borrowings - repurchase agreements are reported net.
Advertising
Costs for advertising and marketing are expensed as incurred.
Stock-Based Compensation
Prior to October 1, 2005, the Company accounted for stock-based compensation
expense using the intrinsic value method as required by Accounting Principals
Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, and as
permitted by SFAS No. 123, Accounting for Stock-Based Compensation. No
compensation expense for stock options was reflected in net income for the
fiscal years ended September 30, 2005 and 2004, as all stock options granted
had an exercise price equal to the market price of the underlying common stock
at the date of the grant.
On October 1, 2005, the Company adopted SFAS No. 123(R) which requires
measurement of the compensation cost for all stock-based awards based on the
grant-date fair value and recognition of compensation cost over the service
period of stock-based awards. The fair value of stock options is determined
using the Black-Scholes valuation model, which is consistent with the
Company's valuation methodology previously utilized for options in footnote
disclosure required under SFAS No. 123. The Company has adopted SFAS No.
123(R) using the modified prospective method, which provides for no
restatement of prior periods and no cumulative adjustment to equity accounts.
It also provides for expense recognition, for both new and existing
stock-based awards.
As a result of adopting SFAS No. 123(R) on October 1, 2005, the Company's
income before federal income taxes and net income were reduced by $50,000 and
$33,000, respectively, and basic and diluted earnings per share for the fiscal
year ended September 30, 2006 were each reduced by $0.01.
(continued)
78
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 1 - Summary of Significant Accounting Policies (continued)
As required under SFAS No. 123(R), the reported net income and earnings per
share for the fiscal years ended September 30, 2005 and 2004 have been
presented below to reflect the impact had the Company been required to
recognize compensation cost based on the fair value at the grant date for
stock options. The pro forma amounts are as follows (dollars in thousands,
except per share amounts)
2005 2004
Net income, as reported $6,618 $5,588
Less total stock-based compensation expense determined
under fair value method for all qualifying awards, net
of tax 256 172
Pro forma net income $6,362 $5,416
Earnings Per Share
Basic:
As reported $ 1.90 $ 1.54
Pro forma 1.83 1.49
Diluted:
As reported 1.82 1.46
Pro forma 1.76 1.41
The Company's stock compensation plans are described more fully in Note 16.
Earnings Per Share
Basic earnings per share exclude dilution and are computed by dividing net
income by the weighted average number of common shares outstanding. Diluted
earnings per share reflect the potential dilution that could occur if common
shares were issued under the Company's stock option plans and Management
Recognition and Development Plan ("MRDP").
Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements,
which defines fair value, establishes a framework for measuring fair value
under Generally Accepted Accounting Principles ("GAAP"), and expands
disclosures about fair value measurements. This Statement applies under other
accounting pronouncements that require or permit fair value measurements.
This Statement is effective for financial statements issued for fiscal years
beginning after November 15, 2007, and interim periods within those fiscal
years. Management is assessing the impact of adoption of SFAS 157 on the
Company's consolidated financial statements.
In September 2006, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 108 ("SAB 108"), Considering the Effects of Prior Year
Misstatements When Quantifying Misstatements in Current Year Financial
Statements, providing guidance on quantifying financial statement misstatement
and implementation (e.g., restatement or cumulative effect to assets,
liabilities and retained earnings) when first applying this guidance. SAB 108
is effective for the Company for all financial statements issued after
November 15, 2006 and is not expected to have a material effect on the
Company's consolidated financial statements.
(continued)
79
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 1 - Summary of Significant Accounting Policies (concluded)
In June 2006, the FASB issued Interpretation No. 48, Accounting for
Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109
("FIN 48"). The interpretation prescribes a recognition threshold and
measurement attribute for the financial statement recognition and measurement
of a tax position taken or expected to be taken in a tax return. The new
interpretation is effective for fiscal years beginning after December 15,
2006. The Company will adopt the provisions of FIN 48 on October 1, 2007 and
is currently evaluating the guidance contained in FIN 48 to determine the
effect adoption of the guidance will have on the Company's consolidated
financial statements.
In March 2006, FASB issued SFAS No. 156, Accounting for Servicing of Financial
Assets. SFAS No. 156 amends Statement No. 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities, to require
all separately recognized servicing assets and servicing liabilities to be
initially measured at fair value, if practicable. SFAS No. 156 also permits
servicers to subsequently measure each separate class of servicing assets and
servicing liabilities at fair value rather than at the lower of cost or
market. For those companies that elect to measure their servicing assets and
liabilities at fair value, SFAS No. 156 requires the difference between the
recorded value and fair value at the date of adoption to be recognized as a
cumulative effect adjustment to retained earnings as of the beginning of the
fiscal year in which the election is made. The Company will adopt SFAS No.
156 beginning in the first quarter of 2007. The Company is currently
assessing the impact of adopting SFAS No. 156 but does not expect the standard
to have a material impact on the Company's consolidated financial statements.
In May 2005, FASB issued SFAS No. 154, Accounting Changes for Error
Corrections. SFAS No. 154 provides guidance on the accounting for and
reporting of accounting changes and error corrections. It establishes, unless
impracticable, retrospective application as the required method for reporting
a change in accounting principle in the absence of explicit transaction
requirements specific to the newly adopted accounting principle. SFAS No. 154
is effective for accounting changes and corrections of errors made in the
fiscal years ending after December 15, 2005. The Company adopted SFAS No. 154
in 2006 and it did not have a material effect on the Company's consolidated
financial statements.
Note 2 - Restricted Assets
Federal Reserve Board regulations require that the Bank maintain certain
minimum reserve balances on hand or on deposit with the Federal Reserve Bank,
based on a percentage of transaction account deposits. During the year ended
September 30, 2006, the Bank obtained approval from the Federal Reserve Board
to internally reclassify a portion of certain transaction accounts as savings
accounts which allowed the Bank to reduce its reserve requirement. The amount
of the reserve requirement balance for the years ended September 30, 2006 and
2005 was approximately $517,000 and $10.2 million, respectively.
80
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 3 - Investments and Mortgage-Backed Securities
Investments and mortgage-backed securities have been classified according to
management's intent (in thousands):
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
September 30, 2006
Held to Maturity
Mortgage-backed securities $ 75 $- - ($2) $ 73
Available for Sale
Mortgage-backed securities $17,989 $ 14 ($400) $17,603
Mutual funds 32,938 - - (851) 32,087
U.S. agency securities 31,997 - - (279) 31,718
Total $82,924 $ 14 ($1,530) $81,408
September 30, 2005
Held to Maturity
Mortgage-backed securities $ 104 $- - ($3) $ 101
Available for Sale
Mortgage-backed securities $23,990 $ 78 ($333) $23,735
Mutual funds 32,939 - - (774) 32,165
U.S. agency securities 33,986 - - (291) 33,695
Total $90,915 $ 78 ($1,398) $89,595
(continued)
81
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 3 - Investments and Mortgage-Backed Securities (concluded)
The fair value of temporarily impaired securities, the amount of unrealized
losses and the length of time these unrealized losses existed as of September
30, 2006 are as follows (in thousands):
Less Than 12 Months 12 Months or Longer Total
Fair Unrealized Fair Unrealized Fair Unrealized
Description of Securities Value Losses Value Losses Value Losses
Mutual funds $ - - $ - - $32,087 ($851) $32,087 ($851)
Mortgage-backed securities 181 (1) 16,107 (399) 16,288 (400)
U.S. agency securities - - - - 31,718 (279) 31,718 (279)
Total $181 ($1) $79,912 ($1,529) $80,093 ($1,530)
The Company has evaluated these securities and has determined that the decline
in their value is temporary and is not related to any company or industry
specific event. The unrealized losses are generally due to increases in the
market interest rate environment. The fair value the mortgage-backed
securities and the U.S. agency securities is expected to recover at the
securities approach their maturity date and/or as market interest rates
change. The fair value of the mutual funds is expected to recover when
interest rates stabilize or begin to decline and the yield curve regains a
steeper slope. The Company has the ability and intent to hold the investments
until the market value recovers.
Mortgage-backed and agency securities pledged as collateral for public fund
deposits, federal treasury tax and loan deposits, FHLB collateral, retail
repurchase agreements and other non-profit organization deposits totaled
$49,513,000 and $56,516,000 at September 30, 2006 and 2005, respectively.
The contractual maturities of debt securities at September 30, 2006 are as
follows (in thousands). Expected maturities may differ from scheduled
maturities due to the prepayment of principal or call provisions.
Held to Maturity Available for Sale
---------------- ------------------
Amortized Fair Amortized Fair
Cost Value Cost Value
Due within one year $- - $- - $ 5,998 $ 5,964
Due after one year to five years - - - - 24,519 24,307
Due after five to ten years - - - - 2,127 2,096
Due after ten years 75 73 17,342 16,954
Mutual funds - - - - 32,938 32,087
Total $ 75 $ 73 $82,924 $81,408
There were no gross realized gains or gross realized losses on sales of
securities available for sale for the years ended September 30, 2006 and 2005.
For the year ended September 30, 2004 gross realized losses totaled $6,000 and
there were no gross realized gains on sales of securities available for sale.
82
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 4 - Loans Receivable and Loans Held for Sale
Loans receivable and loans held for sale consisted of the following at
September 30 (in thousands):
2006 2005
Mortgage loans:
One- to four-family $ 96,260 $ 99,408
Multi-family 17,689 20,170
Commercial 137,609 124,849
Construction and land development 146,855 112,470
Land 29,598 24,981
Total mortgage loans 428,011 381,878
Consumer loans:
Home equity and second mortgage 37,435 32,298
Other 11,127 9,330
Total consumer loans 48,562 41,628
Commercial business loans 11,803 12,013
Total loans receivable 488,376 435,519
Less:
Undisbursed portion of construction loans in process 59,260 42,771
Deferred loan origination fees 2,798 2,895
Allowance for loan losses 4,122 4,099
66,180 49,765
Loans receivable, net 422,196 385,754
Loans held for sale (one- to four-family) 2,449 2,355
Total loans receivable and loans held for sale $424,645 $388,109
Certain related parties of the Bank, principally Bank directors and officers,
were loan customers of the Bank in the ordinary course of business during the
years ended September 30, 2006 and 2005. Activity in related party loans
during the years ended September 30 is as follows (in thousands):
2006 2005
Balance, beginning of year $1,395 $1,467
New loans 1,495 1
Repayments (268) (73)
Balance, end of year $2,622 $1,395
(continued)
83
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 4 - Loans Receivable and Loans Held for Sale (concluded)
At September 30, 2006 and 2005, the Bank had non-accruing loans totaling
approximately $80,000 and $2,926,000, respectively. At September 30, 2006 and
2005, no loans were 90 days or more past due and still accruing interest.
Interest income recognized on a cash basis on non-accrual loans for the years
ended September 30, 2006, 2005 and 2004 was $384,000 $189,000 and $43,000,
respectively. The average investment in non-accrual loans for the years ended
September 30, 2006 and 2005 was $1,938,000 and $2,681,000, respectively.
An analysis of the allowance for loan losses for the years ended September 30
follows (in thousands):
2006 2005 2004
Balance, beginning of year $4,099 $3,991 $3,891
Provision for loan losses - - 141 167
Loans charged off (2) (50) (86)
Recoveries 25 17 19
Net charge-offs (23) (33) (67)
Balance, end of year $4,122 $4,099 $3,991
Following is a summary of information related to impaired loans at September
30 (in thousands):
2006 2005
Impaired loans without a valuation allowance $ 80 $2,601
Impaired loans with a valuation allowance - - 325
$ 80 $2,926
Valuation allowance related to impaired loans $- - $ 49
Note 5 - Loan Servicing
Loans serviced for the Federal Home Loan Mortgage Corporation and others are
not included on the consolidated balance sheets. The principal amounts of
those loans at September 30, 2006, 2005 and 2004 were $156,187,000,
$155,864,000 and $165,206,000, respectively.
Following is an analysis of the changes in mortgage servicing rights for the
years ended September 30 (in thousands):
2006 2005 2004
Balance, at beginning of year $ 928 $ 930 $1,017
Additions 241 200 273
Amortization (237) (202) (360)
Balance, end of year $ 932 $ 928 $ 930
(continued)
84
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 5 - Loan Servicing (concluded)
At September 30, 2006, 2005 and 2004 the fair value of mortgage servicing
rights totaled $1,891,000, $1,433,000 and $1,718,000, respectively. The fair
values for 2006, 2005, and 2004 were estimated using premium rates of 9.59%,
9.62% and 9.34% and prepayment speed factors of 204, 313 and 250,
respectively. There was no valuation allowance at September 30, 2006, 2005 or
2004.
Note 6 - Premises and Equipment
Premises and equipment consisted of the following at September 30 (in
thousands):
2006 2005
Land $ 3,760 $ 3,760
Buildings and improvements 13,169 12,508
Furniture and equipment 5,506 5,175
Property held for future expansion 299 293
Construction and purchases in progress 890 426
23,624 22,162
Less accumulated depreciation 6,894 6,300
Total premises and equipment $16,730 $15,862
The Bank leases premises under operating leases. Rental expense of leased
premises was $207,000, $199,000, and $171,000 for September 30, 2006, 2005
and 2004, respectively, which is included in premises and equipment expense.
Minimum net rental commitments under noncancellable leases having an original
or remaining term of more than one year for future years ending September 30
are as follows (in thousands):
2007 $223
2008 218
2009 159
2010 150
2011
- -
Total minimum payments required $750
Certain leases contain renewal options from five to ten years and escalation
clauses based on increases in property taxes and other costs.
85
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 7 - Real Estate Owned and Other Repossessed Items
Real estate owned and other repossessed items consisted of the following at
September 30 (in thousands):
2006 2005
Real estate acquired through foreclosure $15 $509
Items acquired through repossession - - - -
Total real estate owned and other repossessed items $15 $509
Note 8 - Core Deposit Intangibles ("CDI")
During the year ended September 30, 2005, the Company recorded a core deposit
intangible of $2,201,000 in connection with the October 2004 acquisition of
seven branches and related deposits. Net unamortized core deposit intangible
totaled $1,506,000 and $1,834,000 at September 30, 2006 and 2005,
respectively. Amortization expense related to the core deposit intangible for
the years ended September 30, 2006 and 2005 was $328,000 and $367,000,
respectively.
Amortization expense for the core deposit intangible for future years ending
September 30 is estimated to be as follows (in thousands):
2007 $ 285
2008 249
2009 217
2010 190
2011 167
After 2012 398
Total $1,506
86
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 9 - Deposits
Deposits consisted of the following at September 30 (in thousands):
2006 2005
Non-interest-bearing $ 57,905 $ 51,791
NOW checking 89,509 93,478
Savings 60,235 64,274
Money market accounts 42,378 49,295
Certificates of deposit 181,034 152,827
Total deposits $431,061 $411,665
Certificates of deposit of $100,000 or greater totaled $52,851,000 and
$35,209,000 at September 30, 2006 and 2005, respectively.
Scheduled maturities of certificates of deposit for future years ending
September 30 are as follows (in thousands):
2007 $153,939
2008 20,037
2009 3,978
2010 2,303
2011 729
Thereafter 48
Total $181,034
Interest expense by account type is as follows for the years ended September
30 (in thousands):
2006 2005 2004
NOW checking $ 684 $ 657 $ 544
Savings 442 438 342
Money market accounts 711 625 439
Certificates of deposit 6,068 3,702 2,843
Total $7,905 $5,422 $4,168
87
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 10 - Other Borrowings - Repurchase Agreements
Other borrowings at September 30, 2006 and 2005 consisted of overnight
repurchase agreements with customers totaling $947,000 and $781,000,
respectively.
Information concerning repurchase agreements is summarized as follows at
September 30, (dollars in thousands):
2006 2005
Average daily balance during the period $ 1,148 $ 1,345
Average daily interest rate during the period 4.27% 2.30%
Maximum month-end balance during the period $ 1,895 $ 2,102
Weighted average rate at end of period 5.01% 3.14%
Securities underlying the agreements at the
end of period:
Carrying value $ 2,606 $ 1,803
Fair value 2,606 1,803
The securities underlying the agreements at September 30, 2006 were under the
Company's control in safekeeping at third-party financial institutions.
Note 11 - Federal Home Loan Bank ("FHLB") Advances and Other Borrowing Lines
The Bank has long- and short-term borrowing lines with the FHLB of Seattle
with total credit on the lines equal to 30% of the Bank's total assets,
limited by available collateral. Borrowings are considered short-term when
the original maturity is less than one year. FHLB advances consisted of the
following at September 30 (in thousands):
2006 2005
Short-term $ 29,000 $ 8,000
Long-term 33,761 54,353
Total $ 62,761 $ 62,353
Information concerning short-term FHLB advances is summarized as follows at
September 30 (dollars in thousands):
2006 2005
Average daily balance during the period $ 3,516 $ 4,529
Average daily interest rate during the period 4.18% 4.53%
Maximum month-end balance during the period $ 29,000 $ 98,000
Weighted average rate at end of the period 5.49% 3.79%
(continued)
88
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 11 - Federal Home Loan Bank ("FHLB") Advances and Other Borrowing Lines
(concluded)
The short-term borrowings as of September 30, 2006 mature at various dates
through January 2007 and bear interest at rates ranging from 5.35% to 5.69%.
The long-term borrowings mature at various dates through January 2016 and bear
interest at rates ranging from 4.16% to 6.18%. Advances totaling $4,761,000
have monthly payments aggregating $5,000 plus interest. Under the Advances,
Security and Deposit Agreement, virtually all of the Bank's assets, not
otherwise encumbered, are pledged as collateral for advances. Principal
reductions due for future years ending September 30 are as follows (in
thousands):
2007 $ 38,064
2008 15,069
2009 4,628
2010 - -
2011 - -
Thereafter 5,000
$ 62,761
In addition, the Bank has a $10,000,000 overnight borrowing line with Pacific
Coast Banker's Bank. The borrowing line may be reduced or withdrawn at any
time. As of September 30, 2006 and 2005 the Bank did not have any outstanding
advances on this borrowing line.
Note 12 - Other Liabilities and Accrued Expenses
Other liabilities and accrued expenses were comprised of the following at
September 30 (in thousands):
2006 2005
Accrued deferred compensation and profit
sharing plans payable $ 541 $ 1,077
Accrued interest payable on deposits, FHLB
advances and other borrowings 1,026 708
Accounts payable and accrued expenses - other 1,386 1,539
Total other liabilities and accrued expenses $ 2,953 $ 3,324
Note 13 - Federal Income Taxes
The Bank previously qualified under provisions of the Internal Revenue Code
that permitted federal income taxes to be computed after a deduction for
additions to bad debt reserves. Accordingly, retained earnings include
approximately $2,200,000 for which no provision for federal income taxes has
been made. If in the future this portion of retained earnings is used for any
purpose other than to absorb bad debt losses, federal income taxes at the
current applicable rates would be imposed.
(continued)
89
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 13 - Federal Income Taxes (continued)
The components of the provision for income taxes at September 30 are as
follows (in thousands):
2006 2005 2004
Current $3,603 $3,041 $2,423
Deferred 226 64 69
Total federal income taxes $3,829 $3,105 $2,492
The components of the Company's prepaid federal income taxes and net deferred
tax assets included in other assets as of September 30 are as follows (in
thousands):
2006 2005
Prepaid federal income taxes $ 777 $ 259
Net deferred tax assets 877 1,054
Total $ 1,654 $ 1,313
The components of the Company's deferred tax assets and liabilities at
September 30 are as follows (in thousands):
2006 2005
Deferred Tax Assets
Accrued interest on loans $ 1 $ 53
Accrued vacation 145 127
Deferred compensation 79 89
Unearned ESOP shares 420 420
Allowance for loan losses 1,454 1,466
CDI 141 77
Unearned MRDP shares 2 - -
Net unrealized securities losses 498 449
Stock option compensation expense 12 - -
Total deferred tax assets 2,752 2,681
Deferred Tax Liabilities
FHLB stock dividends 906 906
Depreciation 243 281
Goodwill 264 132
Certificate of deposit valuation 25 19
Mortgage servicing rights 326 289
Prepaid expenses 111 - -
Total deferred tax liabilities 1,875 1,627
Net deferred tax assets $ 877 $1,054
(continued)
90
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 13 - Federal Income Taxes (concluded)
The provision for federal income taxes for the years ended September 30
differs from that computed at the statutory corporate tax rate as follows
(dollars in thousands):
2006 2005 2004
Amount Percent Amount Percent Amount Percent
Taxes at statutory
rate $4,195 35.0% $3,403 35.0% $2,828 35.0%
BOLI income (157) (1.3) (151) (1.6) (162) (2.0)
Other - net (209) (1.8) (147) (1.5) (174) (2.2)
Federal income taxes $3,829 31.9% $3,105 31.9% $2,492 30.8%
Note 14 - Profit Sharing Plans
The Bank has established a 401(k) profit sharing plan for employees who meet
the eligibility requirements set forth in the plan. Eligible employees may
contribute up to the maximum established by the Internal Revenue Service.
Contributions by the Bank are at the discretion of the board of directors.
Bank contributions totaled $558,000, $641,000 and $524,000 for the years ended
September 30, 2006, 2005 and 2004, respectively.
In addition, the Bank has an employee bonus plan based primarily on net
income. Bonuses accrued for the years ended September 30, 2006, 2005 and 2004
totaled $354,000, $215,000 and $175,000, respectively.
Note 15 - Employee Stock Ownership Plan ("ESOP")
In 1998, the Bank established an ESOP that benefits employees with at least
one year of service who are 21 years of age or older. The ESOP may be funded
by Bank contributions in cash or stock. Employee vesting occurs over six
years. The amount of the annual contribution is discretionary, except that it
must be sufficient to enable the ESOP to service its debt. All dividends
received by the ESOP are used to pay debt service. As of September 30, 2006,
37,477 ESOP shares had been distributed to participants.
In January 1998, the ESOP borrowed $7,930,000 from the Company to purchase
529,000 shares of common stock of the Company. The loan is being repaid
primarily from the Company's contributions to the ESOP over 15 years. The
interest rate on the loan is 8.5%. The balance of the loan at September 30,
2006 was $4,506,000.
Shares held by the ESOP as of September 30 were classified as follows:
2006 2005 2004
Unallocated shares 220,415 255,682 290,949
Shares released for allocation 271,108 240,836 217,159
Total ESOP shares 491,523 496,518 508,108
(continued)
91
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 15 - Employee Stock Ownership Plan (concluded)
The approximate fair market value of the Bank's unallocated shares at
September 30, 2006, 2005 and 2004, was $7,737,000, $5,932,000 and $6,829,000,
respectively. Compensation expense recognized under the ESOP was $683,000,
$516,000 and $524,000 for the years ended September 30, 2006, 2005 and 2004,
respectively.
Note 16 - Stock Compensation Plans
Stock Options Plans
-------------------
Under the Company's stock option plans (1999 Stock Option Plan and 2003 Stock
Option Plan), the Company may grant options for up to 811,250 shares of common
stock to employees, officers and directors. Shares issued may be purchased in
the open market or may be issued from authorized and unissued shares. The
exercise price of each option equals the fair market value of the Company's
stock on the date of grant. The options vest over a ten-year period, which
may be accelerated if the Company meets certain performance criteria.
Generally, options vest in annual installments of 10% on each of the ten
anniversaries from the date of grant and if the Company meets three of four
established performance criteria the vesting is accelerated to 20% for that
year. These four performance criteria are: (i) generating a return on assets
which exceeds that of the median of all thrifts in the 12th FHLB District
having assets within $250 million of the Company; (ii) generating an
efficiency ratio which is less than that of the median of all thrifts in the
12th FHLB District having assets within $250 million of the Company; (iii)
generating a net interest margin which exceeds the median of all thrifts in
the 12th FHLB District having assets within $250 million of the Company; and
(iv) increasing the Company's earnings per share over the prior fiscal year.
The Company performs the accelerated vesting analysis in February of each year
based on the results of the most recently completed fiscal year. At September
30, 2006, options for 139,208 shares are available for future grant under
these plans.
The Company uses the Black-Scholes option pricing model to estimate the fair
value of stock-based awards with the weighted average assumptions noted in the
following table. The risk-free interest rate is based on the U.S. Treasury
rate of a similar term as the stock option at the particular grant date. The
expected life is based on historical data, vesting terms, and estimated
exercise dates. The expected dividend yield is based on the most recent
quarterly dividend on an annualized basis. The expected volatility is based
on historical volatility of the Company's stock price.
Expected
Risk-Free Expected Dividend Expected
Interest Rate Life (Years) Yield Volatility
Fiscal 2006 NA NA NA NA
Fiscal 2005 NA NA NA NA
Fiscal 2004 3.6% 8 2.4% 21.5%
There were no options granted during the fiscal years ended September 30, 2006
or 2005. The weighted average fair value of options granted during the fiscal
year ended September 30, 2004 was $5.25.
(continued)
92
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 16 - Stock Compensation Plans (continued)
Stock option activity is summarized in the following table:
Weighted
Average
Number of Exercise
Shares Price
Outstanding September 30, 2003 500,119 $12.75
Grants 28,338 23.06
Options exercised (112,406) 12.11
Forfeited (1,339) 12.00
Outstanding September 30, 2004 414,712 13.63
Options exercised (52,301) 12.01
Outstanding September 30, 2005 362,411 13.86
Options exercised (100,339) 12.18
Outstanding September 30, 2006 262,072 14.51
The weighted average grant date fair value of shares granted during the year
ended September 30, 2006 was $5.25 per share. The total fair value of shares
that vested during the years ended September 30, 2006, 2005 and 2004 was
$65,000, $192,000 and $605,000, respectively.
A summary of unvested options as of September 30, 2006 and changes during the
year ended September 30, 2006 were as follows:
Total Unvested Options
----------------------
Weighted
Average
Fair
Shares Value
Unvested options, beginning of period 38,840 $4.17
Vested 16,336 4.00
Unvested options, end of period 22,504 $4.29
Proceeds, related tax benefits realized from options exercised and intrinsic
value of options exercised for the years ended September 30 were as follows
(in thousands):
2006 2005 2004
Proceeds from options exercised $1,221 $628 $1,362
Related tax benefit recognized 607 186 386
Intrinsic value of options exercised 1,785 613 1,202
(continued)
93
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 16 - Stock Compensation Plans (continued)
Additional information regarding options outstanding at September 30, 2006 is
as follows:
Options Outstanding Options Exercisable
----------------------------------- -------------------------------
Weighted Weighted
Weighted Average Weighted Average
Range of Average Remaining Average Remaining
Exercise Exercise Contractual Exercise Contractual
Prices Number Price Life (Years) Number Price Life (Years)
$12.00 -
12.38 162,555 $12.01 2.4 162,055 $12.01 2.4
13.59 -
14.90 33,339 14.70 4.7 30,005 14.70 4.7
15.20 -
15.96 7,000 15.61 5.5 2,500 15.60 5.5
19.05 28,340 19.05 6.4 14,170 19.05 6.4
22.92-
23.25 30,838 23.06 7.3 30,838 23.06 7.3
262,072 $14.51 3.8 239,568 $14.22 3.6
The aggregate intrinsic value of all options outstanding at September 30, 2006
was $5.40 million. The aggregate intrinsic value of all options that were
exercisable at September 30, 2006 was $5.00 million.
Management Recognition and Development Plan ("MRDP")
---------------------------------------------------
In November 1998, the Board of Directors adopted the MRDP. In January 1999,
shareholders approved the adoption of the MRDP for the benefit of employees,
officers and directors of the Company. The objective of the MRDP is to retain
personnel of experience and ability in key positions by providing them with a
proprietary interest in the Company.
The MRDP allows for the issuance to participants of up to 264,500 shares of
the Company's common stock. Shares issued may be purchased in the open market
or may be issued from authorized and unissued shares. During the year ended
September 30, 2001 the Company awarded 204,927 shares under the MRDP to
employees, officers and directors. These 204,927 shares were all vested by
September 30, 2005. During the year ended September 30, 2006 the Company
awarded 6,000 shares to employees. These 6,000 shares had a weighted-average
grant date fair value of $32.44 per share and were unvested at September 30,
2006. No shares were awarded during the years ended September 30, 2005 and
2004. Awards under the MRDP were made in the form of restricted shares of
common stock that are subject to restrictions on the transfer of ownership.
Compensation expense in the amount of the fair value of the common stock at
the date of the grant to the plan participants is recognized over a five-year
vesting period, with 20% vesting on each of the five anniversaries from the
date of the grant. Compensation expense related to the MRDP was $8,000,
$556,000 and $691,000 for the years ended September 30, 2006, 2005 and 2004,
respectively. At September 30, 2006, there were 53,573 shares available for
future grant under the MRDP.
(continued)
94
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 16 - Stock Compensation Plans (concluded)
Expense for Stock Compensation Plans
------------------------------------
Compensation expense recorded in the financial statements for all stock-based
plans were as follows for the years ended September 30 follows (in thousands):
2006 2005 2004
Stock options $ 50 $ - - $ - -
MRDP stock grants 8 556 691
Less: related tax benefit recognized (20) (189) (235)
$ 38 $ 367 $ 456
The compensation expense yet to be recognized for stock based awards that been
awarded but not vested for the years ending September 30 is as follows (in
thousands):
Stock
Stock Grants Total
Options (MRDP) Awards
2007 $ 27 $ 39 $ 66
2008 5 39 44
2009 2 39 41
2010 1 39 40
2011 -- 33 33
Note 17 - Deferred Compensation/Non-Competition Agreement and Employee
Severance Compensation Agreement
The Bank has a deferred compensation/non-competition arrangement with its
former chief executive officer, which provides monthly payments of $2,000 per
month upon retirement. Payments under this agreement began in March 2004 and
will continue until his death, at which time payments will continue to his
surviving spouse until the earlier of her death or for 60 months. The present
value of the payments as of September 30, 2006 and 2005, $177,000 and
$201,000, respectively, has been accrued under the agreement and is included
in other liabilities on the consolidated balance sheets.
In connection with the January 1998 mutual to stock conversion, the Bank
adopted an Employee Severance Compensation Plan, which expires in ten years,
to provide benefits to eligible employees in the event of a change in control
of the Company or the Bank (as defined in the plan). In general, all
employees with two or more years of service will be eligible to participate in
the plan. Under the plan, in the event of a change in control of the Company
or the Bank, eligible employees who are terminated or who terminate employment
(but only upon the occurrence of events specified in the plan) within 12
months of the effective date of a change in control would be entitled to a
payment based on years of service with the Bank. The maximum payment for any
eligible employee would be equal to 24 months of their current compensation.
95
Notes to Consolidated Financial Statements
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Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 18 - Commitments and Contingencies
The Bank is party to financial instruments with off-balance-sheet risk in the
normal course of business to meet the financing needs of its customers. These
financial instruments include commitments to extend credit. These instruments
involve, to varying degrees, elements of credit risk not recognized on the
consolidated balance sheets.
The Bank's exposure to credit loss in the event of nonperformance by the other
party to the financial instrument for commitments to extend credit is
represented by the contractual amount of those instruments. The Bank uses the
same credit policies in making commitments as it does for on-balance-sheet
instruments. A summary of the Bank's commitments at September 30 is as
follows (in thousands):
2006 2005
Undisbursed portion of construction
loans in process (see Note 4) $59,260 $42,771
Undisbursed lines of credit 18,479 14,876
Commitments to extend credit 20,695 18,374
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition established in the contract. Since
commitments may expire without being drawn upon, the total commitment amounts
do not necessarily represent future cash requirements. The Bank evaluates
each customer's creditworthiness on a case-by-case basis. The amount of
collateral obtained, if deemed necessary by the Bank upon extension of credit,
is based on management's credit evaluation of the party. Collateral held
varies, but may include accounts receivable, inventory, property and
equipment, residential real estate, and income-producing commercial
properties.
Because of the nature of its activities, the Company is subject to various
pending and threatened legal actions which arise in the ordinary course of
business. In the opinion of management, liabilities arising from these
claims, if any, will not have a material effect on the financial position of
the Company.
Note 19 Significant Concentrations of Credit Risk
Most of the Bank's lending activity is with customers located in the state of
Washington and involves real estate. At September 30, 2006, the Bank had
$467,895,000 (including $59,260,000 of undisbursed construction loan proceeds)
in loans secured by real estate, which represents 95.3% of the total loan
portfolio. The real estate loan portfolio is primarily secured by one- to
four-family properties, multi-family properties, undeveloped land, and a
variety of commercial real estate property types. At September 30, 2006,
there were no concentrations of real estate loans to a specific industry or
secured by a specific collateral type that equaled or exceeded 20% of the
Bank's total loan portfolio, other than loans secured by one-to four-family
properties. The ultimate collectibility of a substantial portion of the loan
portfolio is susceptible to changes in economic and market conditions in the
region and the impact of those changes on the real estate market. The Bank
typically maintains loan-to-value ratios of no greater than 90% on real estate
loans.
The Bank believes its lending policies and procedures adequately minimize the
potential exposure to such risks and that adequate provisions for loan losses
are provided for all known and inherent risks. Collateral and / or guarantees
are required for all loans.
96
Notes to Consolidated Financial Statements
------------------------------------------------------------------------------
Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 20 - Regulatory Matters
The Company and the Bank are subject to various regulatory capital
requirements administered by the federal banking agencies. Failure to meet
minimum capital requirements can initiate certain mandatory and possibly
additional discretionary actions by regulators that, if undertaken, could have
a direct material effect on the Company's consolidated financial statements.
Under capital adequacy guidelines of the regulatory framework for prompt
corrective action, the Bank must meet specific capital adequacy guidelines
that involve quantitative measures of the Bank's assets, liabilities and
certain off-balance-sheet items as calculated under regulatory accounting
practices. The Bank's capital classification is also subject to qualitative
judgments by the regulators about components, risk weightings and other
factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Company and the Bank to maintain minimum amounts and ratios as
defined in the regulations (set forth in the table below) of Tier 1 capital to
average assets, and minimum ratios of Tier 1 and total capital to risk-
weighted assets.
At September 30, 2006, the most recent notification from the Bank's regulator
categorized the Bank as well capitalized under the regulatory framework for
prompt corrective action. To be categorized as well capitalized, the Bank
must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage
ratios as set forth in the table. There are no conditions or events since
that notification that management believes have changed the Bank's category.
The Company's and the Bank's actual capital amounts (dollars in thousands) and
ratios are also presented in the table.
To be Well Capital-
ized Under Prompt
Capital Adequacy Corrective Action
Actual Purposes Provisions
Amount Ratio Amount Ratio Amount Ratio
September 30, 2006
Tier 1 capital
(to average assets):
Consolidated $72,360 13.1% $22,151 4.0% N/A N/A
Timberland Bank 63,222 11.5 22,017 4.0 $27,521 5.0%
Tier 1 capital
(to risk-weighted
assets):
Consolidated 72,360 16.6 17,446 4.0 N/A N/A
Timberland Bank 63,222 14.6 17,314 4.0 25,970 6.0
Total capital
(to risk-weighted
assets):
Consolidated 76,482 17.5 34,892 8.0 N/A N/A
Timberland Bank 67,344 15.6 34,627 8.0 43,284 10.0
September 30, 2005
Tier 1 capital
(to average assets):
Consolidated $67,074 12.3% $21,833 4.0% N/A N/A
Timberland Bank 58,224 10.7 21,783 4.0 $27,229 5.0%
Tier 1 capital
(to risk-weighted
assets):
Consolidated 67,074 16.8 15,936 4.0 N/A N/A
Timberland Bank 58,224 14.7 15,838 4.0 23,757 6.0
Total capital
(to risk-weighted
assets):
Consolidated 71,173 17.9 31,873 8.0 N/A N/A
Timberland Bank 62,323 15.7 31,677 8.0 39,596 10.0
(continued)
97
Notes to Consolidated Financial Statements
------------------------------------------------------------------------------
Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 20 - Regulatory Matters (concluded)
Restrictions on Retained Earnings
The Bank is subject to certain restrictions on the amount of dividends that it
may declare without prior regulatory approval.
At the time of conversion of the Bank from a Washington-chartered mutual
savings bank to a Washington-chartered stock savings bank, the Bank
established a liquidation account in an amount equal to its retained earnings
of $23,866,000 as of June 30, 1997, the date of the latest statement of
financial condition used in the final conversion prospectus. The liquidation
account will be maintained for the benefit of eligible withdrawable account
holders who have maintained their deposit accounts in the Bank after
conversion. The liquidation account reduces annually to the extent that
eligible account holders have reduced their qualifying deposits as of each
anniversary date. Subsequent increases will not restore an eligible account
holder's interest in the liquidation account. In the event of a complete
liquidation of the Bank (and only in such an event), eligible depositors who
have continued to maintain accounts will be entitled to receive a distribution
from the liquidation account before any liquidation may be made with respect
to common stock. The Bank may not declare or pay cash dividends if the effect
thereof would reduce its regulatory capital below the amount required for the
liquidation account.
Note 21 - Condensed Financial Information - Parent Company Only
Condensed Balance Sheets - September 30
(In Thousands)
2006 2005
Assets
Cash and due from financial institutions $ 368 $ 229
Interest-bearing deposits in banks 630 414
Investments and mortgage-backed securities
(available for sale) 2,079 2,084
Loan receivable from Bank 4,507 5,032
Investment in Bank 70,211 65,777
Other assets 1,648 1,223
Total assets $79,443 $74,759
Liabilities and shareholders' equity
Accrued expenses $ 78 $ 117
Shareholders' equity 79,365 74,642
Total liabilities and shareholders' equity $79,443 $74,759
(continued)
98
Notes to Consolidated Financial Statements
------------------------------------------------------------------------------
Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 21 - Condensed Financial Information - Parent Company Only (continued)
Condensed Statements of Income - Years Ended September 30
(In Thousands)
2006 2005 2004
Operating income
Interest-bearing deposits in banks $ 27 $ 11 $ 9
Interest on loan receivable from Bank 411 454 494
Dividends on investments 91 66 63
Loss on sale of investment securities
available for sale - - - - (6)
Dividends from Bank 4,500 5,029 9,169
Total operating income 5,029 5,560 9,729
Non-Operating Income 3 - - - -
Operating expenses 465 507 507
Income before income taxes and equity
in undistributed income of Bank 4,567 5,053 9,222
Income taxes (benefit) (91) (96) (77)
Income before equity in undistributed income
of Bank 4,658 5,149 9,299
Equity in undistributed income of bank
(dividends in excess of income of bank) 3,499 1,469 (3,711)
Net income $8,157 $6,618 $5,588
(continued)
99
Notes to Consolidated Financial Statements
------------------------------------------------------------------------------
Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 21 - Condensed Financial Information - Parent Company Only (concluded)
Condensed Statements of Cash Flows - Years Ended September 30
(In Thousands)
2006 2005 2004
Cash flows from operating activities
Net income $ 8,157 $ 6,618 $ 5,588
Adjustments to reconcile net income to net
cash provided:
(Equity in undistributed
income of Bank) dividends in excess
of income of Bank (3,499) (1,469) 3,711
ESOP shares earned 528 529 529
MRDP shares earned 7 537 645
Stock option compensation expense 50 - - - -
Loss on sale of securities available for
sale - - - - 6
Other, net (462) (340) (480)
Net cash provided by operating activities 4,781 5,875 9,999
Cash flows from investing activities
Investment in Bank (1,062) (1,377) (1,499)
Proceeds from sales of securities available
for sale - - - - 1,600
Principal repayments on loan receivable from
Bank 525 483 444
Net cash provided by (used in) investing
activities (537) (894) 545
Cash flows from financing activities
Proceeds from exercise of stock options 1,221 628 1,362
Repurchase of common stock (3,701) (4,064) (11,079)
Payment of dividends (2,492) (2,317) (2,320)
ESOP tax effect 480 293 283
MRDP tax effect (4) 129 136
Stock option tax effect 607 186 386
Net cash used in financing activities (3,889) (5,145) (11,232)
Net increase (decrease) in cash 355 (164) (688)
Cash equivalents
Beginning of year 643 807 1,495
End of year $ 998 $ 643 $ 807
100
Notes to Consolidated Financial Statements
------------------------------------------------------------------------------
Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 22 - Earnings Per Share Disclosures
Basic earnings per share are computed by dividing net income applicable to
common stock by the weighted average number of common shares outstanding
during the period, without considering any dilutive items. Diluted earnings
per share are computed by dividing net income applicable to common stock by
the weighted average number of common shares and common stock equivalents for
items that are dilutive, net of shares assumed to be repurchased using the
treasury stock method at the average share price for the Company's common
stock during the period. Common stock equivalents arise from assumed
conversion of outstanding stock options and from assumed vesting of shares
awarded but not released under the Company's MRDP. In accordance with
Statement of Position 93- 6, Employers' Accounting for Employee Stock
Ownership Plans, issued by the American Institute of Certified Public
Accountants, shares owned by the Bank's ESOP that have not been allocated are
not considered to be outstanding for the purpose of computing earnings per
share. Information regarding the calculation of basic and diluted earnings
per share for the years ended September 30 is as follows (dollars in
thousands, except per share amounts):
2006 2005 2004
Basic EPS Computation
Numerator - net income $8,157 $6,618 $5,588
Denominator - weighted average common shares
outstanding 3,516,331 3,475,400 3,637,510
Basic EPS $2.32 $1.90 $1.54
Diluted EPS Computation
Numerator - net income $8,157 $6,618 $5,588
Denominator - weighted average common shares
outstanding 3,516,331 3,475,400 3,637,510
Effect of dilutive stock options 124,545 132,732 161,808
Effect of dilutive MRDP shares 72 19,857 28,679
Weighted average common shares outstanding-
assuming dilution 3,640,948 3,627,989 3,827,997
Diluted EPS $2.24 $1.82 $1.46
101
Notes to Consolidated Financial Statements
------------------------------------------------------------------------------
Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 23 - Comprehensive Income
Net unrealized gains and losses included in comprehensive income were computed
as follows for the years ended September 30 (in thousands):
Tax
Before-Tax (Benefit) Net-of-Tax
Amount Expense Amount
2006
Unrealized holding losses arising
during the year ($196) ($66) ($130)
Net unrealized losses ($196) ($66) ($130)
2005
Unrealized holding losses arising
during the year ($1,083) ($369) ($714)
Net unrealized losses ($1,083) ($369) ($714)
2004
Unrealized holding losses arising
during the year ($497) ($169) ($328)
Reclassification adjustment for losses
included in net income 6 2 4
Net unrealized losses ($491) ($167) ($324)
102
Notes to Consolidated Financial Statements
------------------------------------------------------------------------------
Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 24 - Fair Value of Financial Instruments
SFAS No. 107, Disclosures About Fair Value of Financial Instruments, requires
disclosure of estimated fair values for financial instruments. Such estimates
are subjective in nature, and significant judgment is required regarding the
risk characteristics of various financial instruments at a discrete point in
time. Therefore, such estimates could vary significantly if assumptions
regarding uncertain factors were to change. Major assumptions, methods and
fair value estimates for the Company's significant financial instruments are
set forth below:
Cash and Due from Financial Institutions, Interest-Bearing Deposits in
Banks, and Federal Funds Sold
The recorded amount is a reasonable estimate of fair value.
Investments and Mortgage-Backed Securities
The fair value of investments and mortgage-backed securities has been based
on quoted market prices or dealer quotes.
Federal Home Loan Bank Stock
The recorded value of stock holdings approximates fair value.
Loans Receivable and Loans Held for Sale
Fair value of loans is estimated for portfolios of loans with similar
financial characteristics. Fair value is estimated by discounting the
future cash flows using the current rates at which similar loans would be
made to borrowers for the same remaining maturities. Prepayments are based
on the historical experience of the Bank. Loans held for sale has been
based on quoted market prices.
Deposits
The fair value of deposits with no stated maturity date is included at the
amount payable on demand. The fair value of fixed maturity certificates of
deposit is estimated by discounting future cash flows using the rates
currently offered by the Bank for deposits of similar remaining maturities.
Federal Home Loan Bank Advances
The fair value of borrowed funds is estimated by discounting the future
cash flows of the borrowings at a rate which approximates the current
offering rate of the borrowings with a comparable remaining life.
Other Borrowings: Repurchase Agreements
The recorded value of repurchase agreements approximates fair value.
Accrued Interest
The recorded amounts of accrued interest approximate fair value.
Off-Balance-Sheet Instruments
The fair value of commitments to extend credit was estimated using the fees
currently charged to enter into similar agreements, taking into account the
remaining terms of the agreements and the present creditworthiness of the
customers. Since the majority of the Bank's off-balance-sheet instruments
consist of non-fee producing, variable-rate commitments, the Bank has
determined they do not have a distinguishable fair value.
(continued)
103
Notes to Consolidated Financial Statements
------------------------------------------------------------------------------
Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 24 - Fair Value of Financial Instruments (concluded)
The estimated fair value of financial instruments at September 30 were as
follows (in thousands):
2006 2005
Recorded Fair Recorded Fair
Amount Value Amount Value
Financial Assets
Cash and due from financial
institutions and interest-bearing
deposits in banks $17,489 $17,489 $23,083 $23,083
Federal funds sold 5,400 5,400 5,635 5,635
Investments and mortgage-backed
securities 81,483 81,481 89,699 89,696
FHLB stock 5,705 5,705 5,705 5,705
Loans receivable 424,645 416,518 388,109 387,086
Accrued interest receivable 2,806 2,806 2,294 2,294
Financial Liabilities
Deposits $431,061 $431,581 $411,665 $412,115
FHLB advances - short term 29,000 29,000 8,000 8,000
FHLB advances - long term 33,761 33,685 54,353 55,421
Other borrowings: repurchase
agreements 947 947 781 781
Accrued interest payable 1,026 1,026 708 708
The Bank assumes interest rate risk (the risk that general interest rate
levels will change) as a result of its normal operations. As a result, the
fair value of the Bank's financial instruments will change when interest rate
levels change and that change may either be favorable or unfavorable to the
Bank. Management attempts to match maturities of assets and liabilities to
the extent believed necessary to minimize interest rate risk. However,
borrowers with fixed interest rate obligations are less likely to prepay in a
rising interest rate environment and more likely to prepay in a falling
interest rate environment. Conversely, depositors who are receiving fixed
interest rates are more likely to withdraw funds before maturity in a rising
interest rate environment and less likely to do so in a falling interest rate
environment. Management monitors interest rates and maturities of assets and
liabilities, and attempts to minimize interest rate risk by adjusting terms of
new loans, and deposits and by investing in securities with terms that
mitigate the Bank's overall interest rate risk.
Note 25 - Stock Repurchase Plan
In April 2005, the Company initiated a stock repurchase plan for the purchase
of 187,955 shares of stock. As of September 30, 2006, 136,450 shares have
been repurchased.
104
Notes to Consolidated Financial Statements
------------------------------------------------------------------------------
Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 26 - Subsequent Events
On October 24, 2006, the board of directors approved a dividend in the amount
of $0.18 per share to be paid on November 27, 2006 to shareholders of record
as of November 13, 2006.
On October 24, 2006, the Company awarded a total of 1,540 shares under the
MRDP to non-employee directors. The shares have a five-year vesting period.
On November 16, 2006, the Company announced that it had completed the stock
repurchase program referenced in Note 25.
On November 20, 2006, the Company announced that its board of directors had
authorized a stock repurchase plan for the purchase of 186,266 shares of
stock.
Note 27 - Selected Quarterly Financial Data (Unaudited)
The following selected financial data are presented for the quarters ended (in
thousands, except per share amounts):
September 30, June 30, March 31, December 31
2006 2006 2006 2005
Interest and dividend
income $9,283 $9,074 $8,649 $8,446
Interest expense (3,023) (2,786) (2,587) (2,418)
Net interest income 6,260 6,288 6,062 6,028
Provision for loan losses - - - - - - - -
Non-interest income 1,653 1,528 1,508 1,555
Non-interest expense (4,750) (4,791) (4,718) (4,637)
Income before income
taxes 3,163 3,025 2,852 2,946
Federal income taxes 1,019 964 906 940
Net income $2,144 $2,061 $1,946 $2,006
Basic earnings per share $0.610 $0.584 $0.554 $0.572
Diluted earnings per share 0.589 0.564 0.534 0.553
(continued)
105
Notes to Consolidated Financial Statements
------------------------------------------------------------------------------
Timberland Bancorp, Inc. and Subsidiaries
September 30, 2006 and 2005
Note 27 - Selected Quarterly Financial Data (Unaudited) (concluded)
September 30, June 30, March 31, December 31
2005 2005 2005 2004
Interest and dividend
income $8,166 $8,037 $7,430 $7,303
Interest expense (2,443) (2,228) (2,004) (1,934)
Net interest income 5,723 5,809 5,426 5,369
Provision for loan losses (25) (96) (20) - -
Non-interest income 1,647 1,548 1,340 1,538
Non-interest expense (4,640) (4,465) (4,671) (4,760)
Income before income
taxes 2,705 2,796 2,075 2,147
Federal income taxes 867 961 624 653
Net income $1,838 $1,835 $1,451 $1,494
Basic earnings per share $0.533 $0.537 $0.415 $0.420
Diluted earnings per share 0.513 0.513 0.398 0.401
106
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
------------------------------------------------------------------------
Not applicable.
Item 9A. Controls and Procedures
---------------------------------
(a) Evaluation of Disclosure Controls and Procedures: An evaluation of
the Company's disclosure controls and procedures (as defined in Rule 13a-15(e)
of the Securities Exchange Act of 1934 (the "Exchange Act")) was carried out
under the supervision and with the participation of the Company's Chief
Executive Officer, Chief Financial Officer and several other members of the
Company's senior management as of the end of the period covered by this annual
report. The Company's Chief Executive Officer and Chief Financial Officer
concluded that the Company's disclosure controls and procedures as currently
in effect are effective in ensuring that the information required to be
disclosed by the Company in the reports it files or submits under the Act is
(i) accumulated and communicated to the Company's management (including the
Chief Executive Officer and Chief Financial Officer) in a timely manner, and
(ii) recorded, processed, summarized and reported within the time periods
specified in the SEC's rules and forms.
(b) Changes in Internal Controls: There have been no changes in our
internal control over financial reporting (as defined in 13a-15(f) of the Act)
that occurred during the quarter ended September 30, 2006, that has materially
affected, or is reasonably likely to materially affect, our internal control
over financial reporting. The Company continued, however, to implement
suggestions from its internal auditor and independent auditors on ways to
strengthen existing controls. The Company does not expect that its disclosure
controls and procedures and internal controls over financial reporting will
prevent all error and fraud. A control procedure, no matter how well
conceived and operated, can provide only reasonable, not absolute, assurance
that the objectives of the control procedure are met. Because of the inherent
limitations in all control procedures, no evaluation of controls can provide
absolute assurance that all control issues and instances of fraud, if any,
within the Company have been detected. These inherent limitations include the
realities that judgements in decision-making can be faulty, and that
breakdowns in controls or procedures can occur because of simple error or
mistake. Additionally, controls can be circumvented by the individual acts of
some persons, by collusion of two or more people, or by management override of
the control. The design of any control procedure is based in part upon
certain assumptions about the likelihood of future events and there can be no
assurance that any design will succeed in achieving its stated goals under all
potential future conditions; over time, controls become inadequate because of
changes in conditions, or the degree of compliance with the policies or
procedures may deteriorate. Because of the inherent limitations in a
cost-effective control procedure, misstatements due to error or fraud may
occur and not de detected.
Management's Report on Internal Control Over Financial Reporting is
included in this Form 10-K under Part II, Item 8, "Financial Statements and
Supplementary Data."
Item 9B. Other Information
---------------------------
None.
PART III
Item 10. Directors and Executive Officers of the Registrant
------------------------------------------------------------
The information contained under the section captioned "Proposal I -
Election of Directors" is included in the Company's Definitive Proxy Statement
for the 2007 Annual Meeting of Stockholders ("Proxy Statement") and is
incorporated herein by reference.
For information regarding the executive officers of the Company and the
Bank, see "Item 1. Business - Executive Officers."
107
Compliance with Section 16(a) of the Exchange Act
The information contained under the section captioned "Section 16(a)
Beneficial Ownership Reporting Compliance" is included in the Company's Proxy
Statement and is incorporated herein by reference.
Audit Committee Financial Expert
The Company has a separately designated standing Audit Committee, composed
of Directors Warren, Robbel and Smith. Each member of the Audit Committee is
"independent" as defined in the Nasdaq Stock Market listing standards. The
Company's Board of Directors has designated Directors Warren and Robbel as the
Audit Committee financial experts, as defined in the SEC's Regulation S-K.
Directors Warren, Robbel and Smith are independent as that term is used in
Item 7(d)(3)(iv) of Schedule 14A promulgated under the Exchange Act.
Code of Ethics
The Board of Directors ratified its Code of Ethics for the Company's
officers (including its senior financial officers), directors and employees
during the year ended September 30, 2006. The Code of Ethics requires the
Company's officers, directors and employees to maintain the highest standards
of professional conduct. The Company's Code of Ethics was filed as an exhibit
to its Annual Report on Form 10-K for the year ended September 30, 2003.
Item 11. Executive Compensation
----------------------------------
The information contained under the sections captioned "Executive
Compensation," "Directors' Compensation" and "Compensation Committee
Interlocks and Insider Participation" is included in the Company's Proxy
Statement and is incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters
------------------------------------------------------------------------------
(a) Security Ownership of Certain Beneficial Owners.
The information contained under the section captioned "Security Ownership
of Certain Beneficial Owners and Management" is included in the Company's
Proxy Statement and is incorporated herein by reference.
(b) Security Ownership of Management.
The information contained under the sections captioned "Security Ownership
of Certain Beneficial Owners and Management" and "Proposal I - Election of
Directors" is included in the Company's Proxy Statement and are incorporated
herein by reference.
(c) Changes In Control.
The Company is not aware of any arrangements, including any pledge by any
person of securities of the Company, the operation of which may at a
subsequent date result in a change in control of the Company.
108
(d) Equity Compensation Plan Information. The following table
summarizes share and exercise price information about the Company's equity
compensation plans as of September 30, 2006.
Number of securities
remaining available
for future
Number of securities Weighted-average issuance under
to be issued upon exercise price of equity compensation
exercise of outstanding plans (excluding
outstanding options, options, warrants, securities reflected
Plan category warrants and rights and rights in column (a))
--------------- ------------------- ----------------- --------------------
(a) (b) (c)
Equity compensation
plans approved by
security holders:
Management
Recognition and
Development Plan... -- $ -- 53,573
1999 Stock Option
Plan............... 249,941 14.09 1,339
2003 Stock Option
Plan............... 12,131 23.25 137,869
Equity compensation
plans not approved
by security
holders.............. - -- --
--------- ----------
Total............... 262,072 $ 14.51 192,781
========= =========== ==========
Item 13. Certain Relationships and Related Transactions
--------------------------------------------------------
The information contained under the section captioned "Certain
Relationships and Related Transactions" is included in the Company's Proxy
Statement and is incorporated herein by reference.
Item 14. Principal Accounting Fees and Services
------------------------------------------------
The information contained under the section captioned "Independent
Auditors" is included in the Company's Proxy Statement and is incorporated
herein by reference.
PART IV
Item 15. Exhibits and Financial Statement Schedules
----------------------------------------------------
(a) Exhibits
3.1 Articles of Incorporation of the Registrant (1)
3.2 Bylaws of the Registrant (1)
3.3 Amendment to Bylaws(2)
10.1 Employee Severance Compensation Plan (3)
10.2 Employee Stock Ownership Plan (3)
10.3 1999 Stock Option Plan (4)
10.4 2003 Stock Option Plan (5)
10.5 Form of Incentive Stock Option Agreement (6)
10.6 Form of Non-qualified Stock Option Agreement (6)
10.7 Management Recognition and Development Plan (4)
10.8 Form of Management Recognition and Development Award
Agreement (6)
14 Code of Ethics (7)
21 Subsidiaries of the Registrant
23 Consent of Accountants
109
31.1 Certification of Chief Executive Officer Pursuant to
Section 302 of the Sarbanes-Oxley Act
31.2 Certification of Chief Financial Officer Pursuant to
Section 302 of the Sarbanes-Oxley Act
32 Certification Pursuant to Section 906 of the Sarbanes-Oxley
Act
--------------
(1) Filed as an exhibit to the Registrant's Registration Statement on Form
S-1 (333-35817).
(2) Incorporated by reference to the Registrant's Annual Report on Form 10-K
for the year ended September 30, 2002.
(3) Incorporated by reference to the Registrant's Quarterly Report on Form
10-Q for the quarter ended December 31, 1997.
(4) Incorporated by reference to Exhibit 99 included in the Registrant's
Registration Statement on Form S-8 (333-32386)
(5) Incorporated by reference to Exhibit 99.2 included in the Registrant's
Registration Statement on Form S-8 (333-1161163)
(6) Incorporated by reference to the Registrant's Annual Report on Form 10-K
for the year ended September 30, 2005.
(7) Incorporated by reference to the Registrant's Annual Report on Form 10-K
for the year ended September 30, 2003.
110
SIGNATURES
Pursuant to the requirements of section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
TIMBERLAND BANCORP, INC.
Date: December 5, 2006
By:/s/Michael R. Sand
-------------------------------------
Michael R. Sand
President and Chief Executive Officer
Pursuant to the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.
SIGNATURES TITLE DATE
----- ------
/s/Michael R. Sand President, Chief Executive Officer December 5, 2006
---------------------- and Director
Michael R. Sand (Principal Executive Officer)
/s/Clarence E. Hamre Chairman of the Board December 5, 2006
----------------------
Clarence E. Hamre
/s/Dean J. Brydon Chief Financial Officer December 5, 2006
---------------------- (Principal Financial and
Dean J. Brydon Accounting Officer)
/s/Andrea M. Clinton Director December 5, 2006
----------------------
Andrea M. Clinton
/s/David A. Smith Director December 5, 2006
----------------------
David A. Smith
/s/Harold L. Warren Director December 5, 2006
----------------------
Harold L. Warren
/s/Jon C. Parker Director December 5, 2006
----------------------
Jon C. Parker
/s/James C. Mason Director December 5, 2006
----------------------
James C. Mason
/s/Ronald A. Robbel Director December 5, 2006
----------------------
Ronald A. Robbel
111
EXHIBIT INDEX
Exhibit No. Description of Exhibit
----------- -----------------------------------------------------
21 Subsidiaries of the Registrant
23 Consent of Accountants
31.1 Certification of Chief Executive Officer Pursuant to Section
302 of the Sarbanes-Oxley Act
31.2 Certification of Chief Financial Officer Pursuant to Section
302 of the Sarbanes-Oxley Act
32 Certification Pursuant to Section 906 of the Sarbanes-Oxley
Act
Exhibit 21
Subsidiaries of the Registrant
Parent
--------------------------------
Timberland Bancorp, Inc.
Percentage Jurisdiction or
Subsidiaries of Ownership State of Incorporation
---------------------------------- ----------------- -----------------------
Timberland Bank 100% Washington
Timberland Service Corporation (1) 100% Washington
-----------
(1) This corporation is a wholly-owned subsidiary of Timberland Bank.
Exhibit 23
Consent of Accountants
CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
We consent to the incorporation by reference in Registration Statements No.
333-32386 and No. 333-116163 on Form S-8 of Timberland Bancorp, Inc. of our
reports dated December 5, 2006, relating to the consolidated financial
statements and the effectiveness of internal control over financial reporting
of Timberland Bancorp, Inc. which appear in this Form 10-K for the year ended
September 30, 2006.
/s/McGladrey & Pullen, LLP
MCGLADREY & PULLEN, LLP
Seattle, Washington
December 13, 2006
Exhibit 31.1
Certification Required
by Rules 13a-15 and 15d-15 under the Securities Exchange Act of 1934
I, Michael R. Sand, certify that:
1. I have reviewed this Annual Report on Form 10-K of Timberland Bancorp,
Inc.;
2. Based on my knowledge, this report does not contain any untrue statement
of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered
by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this report;
4. The registrant's other certifying officer(s) and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal
control over financial reporting (as defined in Exchange Act Rules
13a-15(f) and 15d-15(f)) for the registrant and have:
(a) Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made known
to us by others within those entities, particularly during the
period in which this report is being prepared;
(b) Designed such internal control over financial reporting, or caused
such internal control over financial reporting to be designed under
our supervision, to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally
accepted accounting principles;
(c) Evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions about
the effectiveness of the disclosure controls and procedures, as of
the end of the period covered by this report based on such
evaluation; and
(d) Disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter (the registrant's fourth
fiscal quarter in the case of an annual report) that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. The registrant's other certifying officer(s) and I have disclosed, based
on our most recent evaluation of internal control over financial
reporting, to the registrant's auditors and the audit committee of the
registrant's board of directors (or persons performing the equivalent
functions):
(a) All significant deficiencies and material weaknesses in the design
or operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant's ability to
record, process, summarize and report financial information; and
(b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal control over financial reporting.
Date: December 5, 2006
/s/Michael R. Sand
----------------------------
Michael R. Sand
Chief Executive Officer
Exhibit 31.2
Certification Required
by Rules 13a-15 and 15d-15 under the Securities Exchange Act of 1934
I, Dean J. Brydon, certify that:
1. I have reviewed this Annual Report on Form 10-K of Timberland Bancorp,
Inc.;
2. Based on my knowledge, this report does not contain any untrue statement
of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered
by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this report;
4. The registrant's other certifying officer(s) and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal
control over financial reporting (as defined in Exchange Act Rules
13a-15(f) and 15d-15(f)) for the registrant and have:
(a) Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made known
to us by others within those entities, particularly during the
period in which this report is being prepared;
(b) Designed such internal control over financial reporting, or caused
such internal control over financial reporting to be designed under
our supervision, to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally
accepted accounting principles;
(c) Evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions about
the effectiveness of the disclosure controls and procedures, as of
the end of the period covered by this report based on such
evaluation; and
(d) Disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter (the registrant's fourth
fiscal quarter in the case of an annual report) that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. The registrant's other certifying officer(s) and I have disclosed, based
on our most recent evaluation of internal control over financial
reporting, to the registrant's auditors and the audit committee of the
registrant's board of directors (or persons performing the equivalent
functions):
(a) All significant deficiencies and material weaknesses in the design
or operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant's ability to
record, process, summarize and report financial information; and
(b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal control over financial reporting.
Date: December 5, 2006
/s/Dean J. Brydon
------------------------------
Dean J. Brydon
Chief Financial Officer
Exhibit 32
CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER
OF TIMBERLAND BANCORP, INC.
PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
The undersigned hereby certify, pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 and in connection with this Annual Report on Form
10-K, that:
1. the report fully complies with the requirements of Sections 13(a) and
15(d) of the Securities Exchange Act of 1934, as amended, and
2. the information contained in the report fairly presents, in all
material respects, the Company's financial condition and results of
operations, as of the dates and for the periods presented in the
financial statements included in such report.
/s/Michael R. Sand /s/Dean J. Brydon
---------------------------- -------------------------------
Michael R. Sand Dean J. Brydon
Chief Executive Officer Chief Financial Officer
Dated: December 5, 2006