10-K 1 k08.txt HORIZON FINANCIAL CORP. FORM 10-K 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 March 31, 2008 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number: 0-27062 Horizon Financial Corp. ------------------------------------------------------------------------------ (Exact name of registrant as specified in its charter) Washington 91-1695422 -------------------------------------------- --------------------------- (State or other jurisdiction of (I.R.S. Employer I.D. Number) incorporation or organization) 1500 Cornwall Avenue, Bellingham, Washington 98225 -------------------------------------------- --------------------------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (360) 733-3050 --------------------------- Securities registered pursuant to Section 12(b) of the Act: Common Stock, par value $1.00 per share The NASDAQ Stock Market LLC -------------------------------------------- --------------------------- (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 or 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 whether 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 other information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K. YES X NO ___ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act (Check one): Large accelerated filer ___ Accelerated filer X Non-accelerated filer ___ Smaller reporting company ____ 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 voting stock 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 under the symbol "HRZB" on September 30, 2007, was $245,866,507 (12,133,595 shares at $20.28 per share). As of June 3, 2008, the registrant had 11,895,801 shares of common stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE 1. Portions of the registrant's Proxy Statement for the 2008 Annual Meeting of Stockholders. (Part III). HORIZON FINANCIAL CORP. 2008 ANNUAL REPORT ON FORM 10-K TABLE OF CONTENTS Page PART I. Item 1. Business General.................................................. 1 Lending Activities....................................... 1 Investment Activities.................................... 13 Real Estate Development Subsidiary....................... 16 Bank Owned Life Insurance................................ 16 Deposit Activities and Other Sources of Funds............ 16 Competition.............................................. 19 Personnel................................................ 19 Regulation and Supervision............................... 21 Taxation................................................. 25 Available Information.................................... 27 Item 1A. Risk Factors.............................................. 27 Item 1B. Unresolved Staff Comments................................. 32 Item 2. Properties................................................. 33 Item 3. Legal Proceedings.......................................... 35 Item 4. Submission of Matters to a Vote of Security Holders........ 35 PART II. Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.......... 35 Item 6. Selected Financial Data.................................... 38 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations........................ 39 Forward Looking Statements............................... 39 General.................................................. 40 Business Strategy........................................ 40 Operating Strategy....................................... 40 Critical Accounting Estimates............................ 41 Critical Accounting Policies............................. 43 Comparison of Financial Condition at March 31, 2008 and March 31, 2007...................................... 44 Comparison of Operating Results for the Years Ended March 31, 2008 and March 31, 2007....................... 48 Comparison of Operating Results for the Years Ended March 31, 2007 and March 31, 2006....................... 51 Average Balances, Interest and Yields/Costs.............. 54 Rate/Volume Analysis..................................... 55 Liquidity and Capital Resources.......................... 55 Quantitative and Qualitative Disclosures About Market Risk.................................................... 56 Contractual Obligations.................................. 57 Off-Balance Sheet Arrangements........................... 57 Impact of Inflation...................................... 57 Recent Accounting Pronouncements......................... 58 Item 7A. Quantitative and Qualitative Disclosures About Market Risk.................................................... 58 Item 8. Financial Statements and Supplementary Data................ 59 (continued on following page) (i) Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure........................ 91 Item 9A. Controls and Procedures................................... 91 Item 9B. Other Information......................................... 91 PART III. Item 10. Directors, Executive Officers and Corporate Governance.... 92 Item 11. Executive Compensation.................................... 92 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters................ 92 Item 13. Certain Relationships and Related Transactions, and Director Independence..................................... 93 Item 14. Principal Accounting Fees and Services.................... 93 PART IV. Item 15. Exhibits and Financial Statement Schedules.................. 93 (ii) PART I Item 1. Business ----------------- General ------- Horizon Financial Corp. ("Horizon Financial"or the "Corporation") was formed under Washington law on May 22, 1995, and became the holding company for Horizon Bank ("Horizon Bank" or the "Bank") effective October 13, 1995. At March 31, 2008, the Corporation had total assets of $1.4 billion, total deposits of $1.0 billion and total equity of $128.3 million. The Corporation'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 organized in 1922 as a Washington State chartered mutual savings and loan association and converted to a federal mutual savings and loan association in 1934. In 1979, the Bank converted to a Washington State chartered mutual savings bank, the deposits of which are insured by the Federal Deposit Insurance Corporation ("FDIC"). On August 12, 1986, the Bank converted to a Washington state chartered stock savings bank under the name "Horizon Bank, a savings bank." Effective March 1, 2000, the Bank changed its name to its current name, "Horizon Bank." The Bank became a member of the Federal Home Loan Bank ("FHLB") of Seattle in December 1998. Effective August 1, 2005, the Bank converted from a Washington chartered savings bank organized under Title 32 of the Revised Code of Washington ("RCW") to a Washington chartered commercial bank organized under Title 30 of the RCW. The Bank's operations are conducted through 19 full-service office facilities, four commercial loan centers, and four real estate loan centers, located in Whatcom, Skagit, Snohomish, and Pierce counties in Northwest Washington. The Bank opened commercial banking/loan centers in Bellingham and Everett, Washington, and expanded its operations in Burlington, Washington during the first quarter of fiscal 2004. In November 2004, the Bank opened a full service office in Marysville, Washington. In April 2005, the Bank opened a full service office in Lakewood, Washington, located in Pierce County, just south of Tacoma. The Bank opened a full service regional facility in June 2006, which replaced the Bank's existing office and commercial banking center in south Everett. During the third quarter of fiscal 2007, the Bank entered into a lease agreement to open a branch in Puyallup, Washington, which opened in June of 2007, to expand its presence in Pierce County. Lending Activities ------------------ General. The Bank's loan portfolio, net totaled $1.2 billion at March 31, 2008, representing approximately 86% of its total assets. On that date, 12.3% of net loans receivable consisted of loans secured by mortgages on one-to-four family residential properties, 3.8% consisted of loans secured by mortgages on multi-family residential properties, and 80.9% consisted of construction and land development loans, commercial loans and commercial real estate loans. The balance of the Bank's outstanding loans at that date consisted of secured and unsecured consumer loans and loans secured by savings deposits. The Bank originates both fixed rate and adjustable rate mortgages ("ARMs") secured by residential and commercial real estate. A substantial portion of the Bank's loan portfolio is secured by real estate located in the Bank's primary market area, which the Bank considers to be Whatcom, Skagit, Snohomish and Pierce counties in Washington. In addition, the Bank's portfolio contains a large amount of construction and land development loans, which are being adversely impacted by the slow housing market. This concentration of credit risk could have a material adverse effect on the Bank's financial condition and results of operations to the extent there is a material deterioration in the counties' economic and real estate values. In order to enable it to make the yields on its loan portfolio and investments more interest rate sensitive, the Bank has implemented a number of measures. Those measures include the: (i) origination of long-term, fixed-rate 1 mortgage loans when such loans are written to specifications promulgated by the Federal Home Loan Mortgage Corporation ("Freddie Mac") and qualify for sale in the secondary market, (ii) origination of ARM loans on residential and commercial properties subject to market conditions, (iii) origination of variable rate commercial and consumer loans, and (iv) increased emphasis on originating shorter term loans for its portfolio, and selling much of its long-term mortgage loan production into the secondary market. The following table provides selected data relating to the composition of the Bank's loan portfolio by type of loan at the dates indicated. The changes represented in the table below reflect the changes in the Bank's lending strategies, which began in 1999 when the Bank shifted its focus from a traditional thrift institution to that of a community commercial bank. As part of this shift in strategy, the Bank began selling much of its one-to-four family loan production into the secondary market on a servicing released basis. In addition, as repayments were received on its one-to-four family loan portfolio, the funds were used to support the growth in the commercial loan categories, as shown in the table below. At March 31, ---------------------------------------------------------------------------------------- 2008 2007 2006 2005 2004 --------------- --------------- --------------- --------------- --------------- Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent ------ ------- ------ ------- ------ ------- ------ ------- ------ ------- (Dollars in thousands) Type of Loan: First mortgage loans: One-to-four family residential..... $165,824 13.9% $149,885 14.2 % $148,515 16.2% $167,454 20.8% $173,908 26.4% One-to-four family construction.... 35,303 3.0 28,576 2.7 20,971 2.3 16,464 2.1 14,165 2.2 Participations sold............ (54,269) (4.6) (54,592) (5.2) (56,546) (6.2) (65,125) (8.1) (74,279)(11.3) ---------- ------ ---------- ------ -------- ------ -------- ------ -------- ----- Subtotal...... 146,858 12.3 123,869 11.7 112,940 12.3 118,793 14.8 113,794 17.3 Construction and land development..... 486,535 40.8 405,348 38.4 262,358 28.6 162,726 20.2 132,436 20.1 Multi-family residential..... 45,049 3.8 52,727 5.0 70,080 7.6 73,397 9.1 53,344 8.1 Commercial real estate.......... 300,109 25.2 292,212 27.7 314,299 34.2 312,722 38.9 250,340 38.0 Commercial loans. 177,685 14.9 146,265 13.9 123,445 13.4 109,387 13.6 87,233 13.2 Home equity secured......... 47,351 4.0 45,307 4.3 44,001 4.8 33,762 4.2 25,539 3.9 Other consumer loans........... 7,005 0.6 5,031 0.5 5,571 0.6 5,961 0.7 5,662 0.9 ---------- ------ ---------- ------ -------- ------ -------- ------ -------- ----- Subtotal......1,063,734 89.3 946,890 89.8 819,754 89.2 697,955 86.7 554,554 84.2 ---------- ------ ---------- ------ -------- ------ -------- ------ -------- ----- Total loans outstanding..1,210,592 101.6 1,070,759 101.5 932,694 101.5 816,748 101.5 668,348 101.5 Less: Loan loss reserve......... (19,114) (1.6) (15,889) (1.5) (14,184) (1.5) (11,767) (1.5) (10,122) (1.5) ---------- ------ ---------- ------ -------- ------ -------- ------ -------- ----- Net loans receivable.....$1,191,478 100.0% $1,054,870 100.0% $918,510 100.0% $804,981 100.0% $658,226 100.0% ========== ====== ========== ====== ======== ====== ======== ====== ======== =====
Loan Maturity. The following table sets forth certain information at March 31, 2008 regarding the dollar amount of loans maturing in the Bank's portfolio based on their contractual terms to maturity. Demand loans and overdrafts are reported as due in one year or less. Loan balances are net of undisbursed loan proceeds, unearned discounts, unearned income and allowance for loan losses. Due After Due Within 1 Through Due Over 1 Year 5 Years 5 Years After March After March After March 31, 2008 31, 2008 31, 2008 Total ----------- ----------- ----------- ------ (In thousands) Construction and land development.............. $447,181 $ 33,215 $ 972 $481,368 Commercial real estate.... 164,030 93,141 34,936 292,107 Multi-family residential.............. 20,626 21,845 2,820 45,291 Commercial loans.......... 132,272 33,702 5,136 171,108 One-to-four family construction............. 35,303 - -- 35,303 One-to-four family residential, home equity, and other consumer loans.................... 66,662 32,486 67,153 163,301 ----------- ----------- ----------- ---------- Total.................. $866,074 $214,389 $111,015 $1,191,478 =========== =========== =========== ========== 2 The following table sets forth the dollar amount of all loans due more than one year after March 31, 2008 which have fixed interest rates and have floating or adjustable interest rates. Loan balances are net of undisbursed loan proceeds, unearned discounts, unearned income, and allowance for loan losses. Adjustable Fixed Rates Rates Total ----------- ---------- ---------- (In thousands) Construction and land development.......................... $ 28,953 $ 5,234 $ 34,187 Commercial real estate................ 45,353 82,724 128,077 Multi-family real estate.............. 4,183 20,482 24,665 Commercial loans...................... 27,444 11,392 38,836 One-to-four family construction....... - -- -- One-to-four family residential, home equity, and other consumer loans..... 94,901 4,738 99,639 ---------- ---------- ---------- Total.............................. $ 200,834 $ 124,570 $ 325,404 ========== ========== ========== Multi-Family and Commercial Real Estate Lending. Commercial real estate loans, including multi-family, totaled $345.2 million, or 29.0% of net loans receivable at March 31, 2008. The Bank originates commercial real estate loans primarily secured by owner-occupied business facilities, apartment buildings, warehouses, mini-storage facilities, industrial use buildings, office and medical office buildings, hospitality facilities, commercial land development and retail shopping centers located in its market area. Commercial real estate loans typically range in principal amount from $500,000 to $10.0 million. At March 31, 2008, the largest commercial real estate loan on one property had an outstanding balance of $16.0 million and is secured by a destination resort and surrounding real estate located in the Bank's market area. At March 31, 2008, the Bank had three other loans with net balances in excess of $10.0 million, which are secured by commercial real estate. All of these loans were performing according to their terms at March 31, 2008. Commercial adjustable rate mortgage loans are originated with rates which generally adjust annually after an initial period ranging from one to five years. These adjustable rate mortgage loans have generally utilized Prime or FHLB Advance Rates as indices, with principal and interest payments fully amortizing over terms of 15 to 25 years, and are generally due in ten years. The Bank has also originated fixed rate commercial loans due in five to 10 years, (with amortization terms of ten to 25 years), along with 15 year fully amortizing loans. Commercial real estate loans originated with interest rates fixed for the initial three, five and ten year terms generally contain prepayment penalties during their fixed rate period ranging from 1.0% to 5.0% of the loan's outstanding balance. The Bank requires appraisals or evaluations on all properties securing commercial real estate loans. The Bank considers the quality and location of the real estate, the credit 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 1.20 times for originated loans secured by income producing commercial properties. The Bank generally obtains loan guarantees from financially capable parties based on a review of personal financial statements, or if the borrower is a corporation, the Bank also generally obtains personal guarantees from corporate principals based on a review of the principals 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 such loans may be affected by adverse conditions in the real estate market or the economy. If we foreclose on a commercial and multi-family real estate loan, our holding period for the collateral typically is longer than for one-to-four family residential mortgage loans because there are fewer potential purchasers of the collateral. Additionally, commercial and multi-family real estate loans generally have relatively large balances compared to residential mortgage loans. Accordingly, if we make any errors 3 in judgment in the collectibility of our commercial and multi-family real estate loans, any resulting charge-offs may be larger on a per loan basis than those incurred with our residential or other consumer loans. The Bank seeks to minimize these risks by limiting the maximum loan-to-value ratio to 80% and carefully reviewing the financial condition of the borrower, the quality of the collateral and the management of the property securing the loan. Because of the Bank's commitment to its pricing and profitability targets, the balances in the multi-family loan portfolio declined in this aggressively priced arena during the year. Construction and Land Development Loans. Construction lending provides the Bank the opportunity to achieve higher interest rates and fees with shorter terms to maturity than does its other real estate lending activities. Construction lending, however, generally involves a higher degree of risk than permanent financing for a finished residence or commercial building, because of the inherent difficulty in estimating both the estimated cost of the project, the property's value at completion and the market demand for the property upon completion. If the estimated cost of construction proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to complete the project. The nature of these loans is such that they are generally more difficult to evaluate and monitor. To address this risk, and because of the level of construction loans in the Bank's portfolio, the Bank has personnel dedicated specifically to monitoring the progress of its construction projects, and making on-site inspections of the property. The Bank also has an experienced appraisal staff, and members of senior management with related appraisal education and experience, who review appraisals utilized by the Bank in analyzing prospective construction projects. In addition, in an effort to monitor the available inventory in its markets, the Bank also regularly reviews the overall building and development activity in its markets. Also, to mitigate the risks related to construction lending, the Bank primarily deals with experienced builders, with acceptable credit histories, sound financial statements and a proven track record in the industry. In addition, the Bank utilizes the services of experienced inspectors to monitor the progress and draw process in the more complex construction projects. Finally, members of the Bank's senior management and loan committees also have a significant amount of experience in the areas of construction lending, appraisals, and loan underwriting, further mitigating the Bank's risk in this area. The Bank actively originates construction loans through both its Mortgage Loan Division and its Commercial Loan Division. The Bank's Mortgage Loan Division generally oversees the single family custom construction loans, and to a lesser extent, speculative construction loans (i.e., loans for homes that do not have a contract with a buyer for the purchase of the home upon completion of the construction) to smaller contractors building a limited number of speculative homes per year. These construction loans are further broken down in the first two lines of the table below (speculative construction one-to-four family and custom construction one-to-four family). The Bank's Commercial Lending Division is responsible for the speculative construction projects for the Bank's larger builders (including large one-to-four family developments), in addition to the Bank's multi-family construction loans, non-residential commercial construction loans, and the Bank's land development loans. At March 31, 2008 and 2007, the composition of the Bank's construction loan portfolio was as follows: At March 31, ---------------------------------------------- 2008 2007 -------------------- --------------------- Amount (1) Percent Amount (1) Percent --------- ------- --------- ------- (Dollars in thousands) Speculative construction one-to-four family........... $ 27,206 5.21% $ 16,597 3.82% Custom/presold construction one-to-four family........... 8,097 1.55 11,979 2.76 Commercial/speculative construction one-to-four family....................... 236,536 45.33 177,602 40.93 Commercial construction multi family....................... 11,732 2.25 6,986 1.61 Commercial construction- nonresidential............... 59,541 11.41 47,490 10.94 Land development.............. 178,726 34.25 173,270 39.94 --------- ------- --------- ------- Total....................... $521,838 100.00% $433,924 100.00% ========= ======= ========= ======= __________ (1) Includes loans in process. 4 Speculative construction one-to-four family loans increased 63.9% from March 31, 2007 to $27.2 million at March 31, 2008. These loans are made to home builders who generally build one or two speculative construction homes per year, and the increased activity in this period was a result of an active real estate market in the Bank's markets. Because of the nature of these loans, a buyer for these homes is found by the builder either during the construction phase or shortly after completion of the home's construction. The Bank generally includes interest reserves in the construction loan amount; however, there is no assurance that this amount will be sufficient to cover all interest expense for the life of the loan. If a buyer is not found in a timely manner, the builder will incur additional interest, marketing and other expenses until the home is sold. As a result, these loans carry a higher degree of risk than loans on homes already completed and custom construction loans (discussed below) for which there is a buyer. Custom construction for one-to-four family loans decreased 32.4% from the prior year to $8.1 million at March 31, 2008. Unlike speculative construction loans, custom construction loans are made to customers who have entered into a contract with a builder to build them a custom home. The construction portion of these loans are generally for a period of one year or less, and the Bank generally commits to the long-term take-out financing for the customer at the time the construction loan is originated. As a result, the risk for custom construction loans is generally less than for speculative construction loans. Commercial speculative construction one-to-four family residential loans increased 33.2% from the prior year to $236.5 million at March 31, 2008. Commercial speculative construction loans include loans made to the Bank's larger contractors, who build a significant number of speculative construction one-to-four family homes each year. The Bank has established relationships with experienced builders in this regard, which, along with an active residential market in the Pacific Northwest, resulted in this significant year over year growth in this portion of the Bank's construction portfolio. The Bank generally limits the loan to value to 85% of the discounted value of the completed dwellings, and further manages its risk by limiting the number of homes that can be under construction at any one time, when appropriate. The commercial construction multi-family portion of the Bank's portfolio increased 68.0% from the prior year, to $11.7 million at March 31, 2008. The Bank's relationships are more heavily concentrated with one-to-four family contractors and developers than multi-family contractors at this time. These loans are generally for the construction of apartment units in the Bank's primary market areas. Non-residential commercial construction loans increased 25.4% from the prior year to $59.5 million at March 31, 2008. These loans are made for a variety of non-residential real estate properties, including but not necessarily limited to the retail properties, owner occupied commercial real estate, office space, mini-storage facilities, hospitality related uses, and other non-residential uses. These loans are generally made to the ultimate end user of the property (i.e., these loans are more similar to custom construction than speculative construction loans). However, as a result of the inherent risks noted above, these loans carry higher risks than completed properties. Non-residential commercial construction loans receive the same degree of monitoring by the Bank as other construction loans contained in the Bank's loan portfolio, to mitigate the inherent risks of these loans. Land development loans increased 3.1% from the prior year, to $178.7 million at March 31, 2008. This has been a significant part of the Bank's strategy in each of its markets, and fiscal 2008 was a successful year of growth in this category. Most of these loans carry interest rates tied to the Prime rate, which allows the Bank to fund the loans profitability with short-term borrowings. In addition to the Bank's extensive experience in this area (see the discussion regarding the Bank's subsidiary, Westward Financial Services, contained in the section entitled "-- Real Estate Development Subsidiary), the Bank has continued to expand its expertise by hiring additional members of senior management dedicated to monitoring this portion of the Bank's lending activities. In addition, the Bank has developed relationships with some of the area's strongest real estate developers, which has played a significant part of the Bank's success in this area. This, however, does not mitigate the inherent risks in this type of lending. While the Bank generally limits its exposure to 75% of the discounted value of the completed lots, it can take a year or more to complete a large development, therefore increasing the risk to the Bank and its valuations used at the time the loan is closed. During the period from the time the loan is closed until the lots are developed, the market conditions can change significantly, exposing the Bank to additional risks in the event the lots can not ultimately be sold at or near the values estimated at 5 the time of the appraisal. The Bank's management regularly monitors the housing demand in its markets, home and finished lot prices, and related measures in its efforts to mitigate this risk. However, no assurances are made that these or other measures can or will fully mitigate such risks. Currently, the demand for building lots is minimal in the Bank's markets, as a result of the slow housing market and the high levels of inventory in both finished homes and developed lots. The vast majority of the Bank's construction loan activity is concentrated in the Pacific Northwest. While the Pacific Northwest is not experiencing the dramatic declines seen in other parts of the country, the market is slowing and the Bank's performance is being adversely impacted. If the market does not improve, it will likely have a significant impact on the Bank's performance, especially in these higher risk construction lending categories. Commercial Loans. The Bank's loan portfolio also includes a wide range of commercial loans to small and medium sized businesses. This portfolio presently includes lines of credit with floating rates and maturities of one year or less and term loans for the purchase of equipment, real estate and other operating purposes with maturities generally not exceeding ten years. These loans are secured by a variety of business assets including equipment, real estate, accounts receivable and inventory. These types of loans constituted $177.7 million, or approximately 14.9% of the Bank's net loan portfolio at March 31, 2008. The majority of these loans carry personal guarantees. Under certain conditions, the Bank also offers unsecured credit to qualified borrowers. Commercial lending carries increased risks compared to residential mortgage lending as a result of the heavy reliance upon the future income of the borrower and the uncertain liquidation value of the collateral. In the event of default, the liquidation of collateral is often insufficient to cover the outstanding debt. To mitigate these inherent risks, the Bank combines a conservative lending policy with experienced lending personnel responsible for the ongoing management and monitoring of their assigned accounts. One-to-Four Family Residential Loans. In the past, a significant lending activity of the Bank was the granting of conventional loans to enable borrowers to purchase existing homes or construct new homes. The Bank's real estate loan portfolio also includes loans on two-to-four family dwellings, and loans made to purchase or refinance improved buildings to be used for residential housing. At March 31, 2008, approximately 12.3% of the Bank's net loans receivable consisted of loans secured by one-to-four residential real estate. The Bank's lending practices generally limit the maximum loan-to-value ratio on one-to-four family residential mortgage loans to 97% of the appraised value as determined by an independent appraiser, with the condition that private mortgage insurance generally be required on any home loans with loan-to-value ratios in excess of 80% of the appraised value. The Bank places this insurance with carriers approved by the Freddie Mac. The coverage generally limits the Bank's exposure to 72% of the loan amount. If private mortgage insurance is required, the borrower pays the premium at loan closing and any recurring premiums through an escrow reserve account established with the Bank for such period of time as the Bank requires the insurance coverage to be in force. The Bank presently originates both fixed-rate and ARMs secured by one-to-four family properties with a loan term not exceeding 30 years. Certain consumer safeguards are built into the ARM instruments used by the Bank, which include limits on annual and lifetime interest rate adjustments. The Bank generally originates these loans in accordance with guidelines established by the secondary market. Consumer Loans. The Bank makes a variety of loans for consumer purposes. Included among these are home equity loans, home equity lines of credit, loans secured by personal property, such as automobiles, boats, and other vehicles, loans secured by deposit accounts, unsecured loans, and loans for mobile homes located in mobile home parks. Horizon Bank offers consumer loans in order to provide a wider range of financial services to its customers and to achieve shorter terms and higher interest rates normally typical of such loans. At March 31, 2008, the Bank held $54.4 million of consumer loans or 4.6% of net loans receivable, approximately $3.7 million of which is unsecured. 6 Consumer loans entail greater risk than do residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciating assets such as automobiles, boats and other vehicles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount that can be recovered on such loans. Consumer loans are made based on an evaluation of the borrower's creditworthiness, including income, other indebtedness, and satisfactory credit history, and the value of the collateral. Designated officers of the Bank or members of the Bank's Loan Committee approve consumer loan requests. Secured loan amounts typically do not exceed 90% of the value of the collateral, or 90% of the appraised value of the residence in the case of home equity loans. Loan Solicitation and Processing. The primary sources for loan originations are attributable to deposit customers, current borrowers, walk-in customers, and referrals from existing customers, real estate agents, real estate developers, and builders. The Bank does not actively utilize mortgage brokers in the origination of loans. The Bank accepts completed loan applications from all of its offices and processing is substantially centralized. Detailed information is obtained to determine the creditworthiness of the borrower and the borrower's ability to repay. Significant items appearing on the loan applications and accompanying material are verified through the use of written credit reports, financial statements, and confirmations. After analysis of the loan application, supporting documents and the property to be pledged as loan security, including an appraisal of the property by either a staff appraiser or an independent fee appraiser, the application is forwarded to the Bank's Loan Committee. Loan approval requires the signatures of two or three members of the Loan Committee depending on the size of the loan. The Loan Committee consists of officers of the Bank who are appointed by the Bank's Board of Directors. The Bank generally requires its mortgage notes to be guaranteed individually by the principals on loans made to entities other than natural persons. Certain lending personnel have been given limited loan approval authority by the Board of Directors. Loan assumption requests of adjustable rate loans are handled by the Bank in a manner similar to new loan requests. Secondary market standards are generally applied to each request and full credit underwriting is required. For fixed rate loans, a sale or transfer of the secured property generally results in the Bank enforcing its due on transfer rights contained in the mortgage instrument. Loan Originations, Purchases and Sales. Currently, the Bank emphasizes the origination of 15 to 30 year fixed rate loans on terms and conditions which will permit them to be sold in the secondary market, while originating ARM loans and shorter term fixed-rate loans for its own portfolio. In addition to originating loans, Horizon Bank may purchase real estate loans in the secondary market. The Bank's purchases in the secondary market depend upon the demand for mortgage credit in the local market area and the inflow of funds from traditional sources. Loan purchases enable the Bank to utilize funds more quickly, particularly where sufficient loan demand is not obtainable locally. The Bank is a qualified servicer for both Freddie Mac and Federal National Mortgage Association ("Fannie Mae"). The Bank's general practice is to close its fixed-rate, one-to-four family residential loans on Freddie Mac loan documents in order to facilitate future sales to Freddie Mac as well as to other institutional investors. From time to time, depending upon interest rates and economic conditions, the Bank has sold participation interests in loans in order to provide additional funds for lending, to generate servicing fee income and to decrease the dollar amount of its intermediate and long-term fixed-rate loans. The sale of loans in the secondary mortgage market reduces the Bank's interest rate risk and allows the Bank to continue to make loans during periods when deposit flows decline or funds are 7 otherwise unavailable for lending purposes. As of March 31, 2008, the Bank was servicing loans for others aggregating approximately $109.0 million for which it generally receives a fee payable monthly of 0.25% to 0.375% per annum of the unpaid balance of each loan. In February 2001, the Bank began selling much of its current loan production on a servicing released basis, and plans to continue doing so for many of the long-term fixed rate loan originations. All sales of loan interests by the Bank are made without right of recourse to the Bank by the buyer of the loan interests in the event of default by the borrower. The Bank also buys and sells portions of commercial loans through participations with other financial institutions. As of March 31, 2008, the Bank was servicing commercial loans for others aggregating approximately $55.0 million for which it generally receives a fee payable monthly of 0.25% to 0.375% per annum of the unpaid balance of each loan. The Bank has numerous options in this regard, and will continue to buy and sell, loan participations to assist its liquidity, concentration and diversification efforts. Loan Commitments. The Bank is a party to financial instruments with off-balance-sheet risk (loan commitments) made in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. Loan commitments involve, to varying degrees, elements of credit and interest-rate risk in excess of the amount recognized in the balance sheet. The contract amounts of those commitments reflect the extent of the Bank's exposure to credit loss from these commitments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. 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. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Because many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment and commercial properties. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. Except for certain long-term guarantees, the majority of guarantees expire in one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral supporting those commitments, for which collateral is deemed necessary, generally amounts to 100% of the commitment amount at March 31, 2008. The following is a summary of the off-balance-sheet financial instruments or contracts outstanding as of the dates indicated. At March 31, ------------------------- 2008 2007 ----------- ----------- (In thousands) Commitments to extend credit.................... $ 361,763 $ 379,549 Credit card arrangements........................ 10,510 10,105 Standby letters of credit....................... 2,047 3,056 Loan Origination and Other Fees. In addition to interest earned on loans, the Bank receives fees for originating loans. Loan origination fees are a percentage of the principal amount of the mortgage loan which are charged to the borrower at the closing of the loan. The Bank's loan origination fees are generally 0% to 2.5% on conventional residential mortgages and 0% to 1.5% for commercial real estate loans. The total amount of deferred loan origination fees and unearned discounts at March 31, 2008 was $4.5 million. Any unamortized loan fees, net of related direct costs, are recognized as income at the time the loan is sold, paid down or paid off. 8 Income from loan origination and commitment fees varies with the volume and type of loans and commitments made and purchased and with competitive conditions in mortgage markets, which in turn responds to the demand for and availability of money. The Bank experiences an increase in loan fee income and other fee income, such as appraisal and loan closing fees, during periods of low interest rates because of the resulting demand for mortgage loans. The Bank also receives other fees and income from charges relating to existing loans, which include late charges, and fees collected in connection with a change in terms or other loan modifications. These fees and charges have not constituted a material source of income. Delinquent Loans, Loans in Foreclosure and Foreclosed Property. Loans are defined as delinquent when any payment of principal and/or interest is past due. While the Bank generally is able to work out a satisfactory repayment schedule with a delinquent borrower, the Bank will usually undertake foreclosure proceedings if the delinquency is not otherwise resolved within 90 days. Property acquired by the Bank as a result of foreclosure or by deed in lieu of foreclosure is classified as "real estate owned" until such time as it is sold or otherwise disposed of. As of March 31, 2008, there were no loans in the loan portfolio over 90 days delinquent and accruing interest and 13 loans on non-accrual status. The Bank had one real estate owned at March 31, 2008. Total non-performing assets represented $12.3 million or 0.88% of total assets at March 31, 2008 compared to $1.0 million or 0.07% of total assets at March 31, 2007. The following table sets forth information with respect to the Bank's non-performing assets at the dates indicated. At March 31, --------------------------------------------- 2008 2007 2006 2005 2004 ------- ------- ------- ------ ------ (Dollars in thousands) Non-accrual loans........... $11,608 $ 226 $ 1,161 $1,481 $ -- Loans 90 days or more delinquent and accruing interest.......... - -- -- - 339 Restructured loans.......... - -- -- - -- Real estate acquired through foreclosure................ 655 725 -- - 63 ------- ------- ------- ------ ------ Total..................... $12,263 $ 951 $ 1,161 $1,481 $ 402 ======= ======= ======= ====== ====== As a percentage of net loans...................... 0.97% 0.02% 0.13% 0.18% 0.06% As a percentage of total assets..................... 0.88% 0.07% 0.10% 0.15% 0.05% Additional interest income which would have been recorded had nonaccruing loans been current in accordance with their original terms was considered immaterial as of March 31, 2008. No interest income was recorded on nonaccrual loans for the year ended March 31, 2008. Potential Problem Loans. At March 31, 2008, the Bank had identified loans totaling $12.1 million which were considered impaired, the majority of which are included in the above non-accrual totals. Two lending relationships contributed to the majority of the increase in these totals, including a residential developer in Snohomish County with inventory consisting of 17 homes (four of which are in escrow with sales pending), eight residential building lots and one commercial development project for a 7.4 acre site in Monroe, Washington. Horizon Financial charged off over $700,000 in the fourth quarter of fiscal 2008 for these projects. Subsequent to March 31, 2008, the Bank accepted a deed in lieu of foreclosure for one property included in the above impairment analysis. Approximately $1.8 million in principal balances were moved to real estate owned and $200,000 was charged against the allowance for loan losses based on the present value calculation of expected cash flows at the time of repossession. Reserve for Losses. The Bank has an active ongoing credit review function. The provision for loan losses is maintained at a level sufficient to provide for probable loan losses based on evaluating known and inherent risks in the loan portfolio. These factors include changes in the size and composition of the loan portfolio, actual loan loss experience, historical industry loan loss experience, current and anticipated economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value 9 of the collateral and guarantees securing the loans. The reserve is based upon factors and trends identified by management at the time financial statements are prepared, but the ultimate recovery of loans is susceptible to future market factors beyond the Bank's control, which may result in losses or recoveries differing significantly from those provided for in the financial statements. The Bank maintains an allowance for credit losses sufficient to absorb losses inherent in the loan portfolio. The Bank has established a systematic methodology to ensure that the allowance is adequate. The Bank reviews the following information, on a quarterly basis, to estimate the necessary additions to its loan loss reserve: * All loans classified during the previous analysis. Current information as to payment history, or actions taken to correct the deficiency are reviewed, and changes are made, as appropriate. If conditions have not improved, the loan classification is reviewed to ensure that the appropriate action is being taken to mitigate loss. * All loans past due on scheduled payments. The Bank reviews all loans that are past due 30 days or more, taking into consideration the borrower, nature of the collateral and its value, the circumstances that have caused the delinquency, and the likelihood of the borrower correcting the conditions that have resulted in the delinquent status. * Composition of the Bank's portfolio. The Bank also analyzes its mix of loans when establishing appropriate allowances for loan losses. For example, reserves for losses on the Bank's one-to-four family mortgage portfolio (on a percentage basis) are lower than the percentage reserve estimates for commercial or credit card loans. Therefore, the Bank's allowance for loan losses is likely to change, as the composition of the Bank's loan portfolio changes. * Current economic conditions. The Bank takes into consideration economic conditions in its market area, the state's economy, and national economic factors that could influence the quality of the loan portfolio in general. * Trends in the Bank's delinquencies. Prior period statistics are reviewed and evaluated to determine if the current conditions warrant changes to the Bank's loan loss allowance. * Historical loss rates. Industry loss rates and the Bank's loss rate experience (where applicable) are also considered when analyzing the adequacy of the Bank's loan loss allowance. As required by Statement of Accounting Standard ("SFAS") No. 114, Accounting by Creditors for Impairment of a Loan, each individual loan, previously classified by management, or newly classified during the quarterly review, is evaluated for loss potential, and a specific amount or percentage deemed to be at risk is added to the overall required reserve amount. For the remaining portion of the portfolio the Bank applies SFAS No. 5, Accounting for Contingencies. A reserve factor is applied to homogeneous loan pools that is consistent with the Bank's experience in that loan pool type or with historical industry experience if management believes such guidelines are more appropriate. The applied percentage is also influenced by other economic factors as noted above. The calculated amount is compared to the actual amount recorded in the allowance at the end of each quarter and a determination is made as to whether the allowance is adequate, yet not excessive. Management increases the amount of the allowance for loan losses by charges to income and decreases the amount by loans charged off (net of recoveries). The following comments represent management's view of the risks inherent in each portfolio category. * One-to-Four Family Residential - Market conditions in the Bank's primary market area have, over the long term, supported a stable or increasing market value of real estate. Absent an overall economic downturn in the economy, experience in this portfolio indicates that losses are minimal provided the property is reasonably maintained, and marketing time to resell the property is relatively short. 10 * Construction and Land Development - This segment of the Bank's portfolio is near the higher end of the risk spectrum as a result of the numerous risks throughout the land development and construction process. In both of these categories, risks are elevated because of difficulties in accurately estimating the total costs of real estate development projects, the value of the completed projects upon completion, and the ultimate demand for the finished lots and dwellings upon completion. In the event the cost estimates prove to be inaccurate, the Bank may be required to advance additional funds to complete the project. Insufficient market demand for the finished products may have a material impact on the Bank's performance if its borrowers are unable to carry their interest obligations in a slow market. This is the case currently, as the slow housing market is adversely impacting the Bank's performance, and if conditions do not improve, future performance may be materially impacted. * Multi-Family Residential - While there have been minimal losses in this segment of the portfolio, the rental market is susceptible to the effects of an economic downturn. Although the Bank monitors loan-to-value ratios, the conditions that would create a default would carry through to a new owner which may require that the Bank discount the property or hold it until conditions improve. * Commercial Real Estate - As with multi-family loans, the classification of commercial real estate loans closely corresponds to economic conditions which will limit the marketability of the property, resulting in higher risk than a loan secured by a single-family residence. Commercial real estate loans have historically been assigned higher reserve levels than one-to-four family residential loans, but lower than commercial business loans. * Commercial Business Loans - These types of loans carry a higher degree of risk, relying on the ongoing success of the business to repay the loan. Collateral for commercial credits is often difficult to secure, and even more difficult to liquidate in the event of a default. If a commercial business loan demonstrates any credit weakness, the reserve is increased to recognize the additional risk. * Consumer Loans - The consumer loan portfolio has a wide range of factors, determined primarily by the nature of the collateral and the credit history and capacity of the borrower. The loans tend to be smaller in principal amount and secured by second deeds of trust, automobiles, boats, and other vehicles. Loans for automobiles, boats, and other vehicles, generally experience higher than average wear in the environment and hold a higher degree of risk of loss in the event of repossession. * Unsecured Credit Cards - As a result of the unsecured nature of these accounts, these types of loans represent the highest degree of risk. The Bank, therefore, uses a higher percentage factor than any other loan classification, when estimating future potential loan losses. Management believes that the allowance for loan losses at March 31, 2008 was adequate at that date. Although management believes that it uses the best information available to make these determinations, future adjustments to the allowance for loan losses may be necessary. 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 significantly increase or decrease 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 Bank's allowance for losses at March 31, 2008 totaled $19.1 million and $15.9 million at March 31, 2007. The Bank's loan loss reserve as of March 31, 2008 and 2007, was 1.60% and 1.51% of net loans receivable, respectively. 11 The following table sets forth an analysis of the Bank's allowance for loan losses for the periods indicated. For each of these periods, management reviewed the changes in the composition and size of the Bank's loan portfolio, along with the economic conditions in effect during each period, using the methodologies presented in the paragraphs above within this section. Year Ended March 31, --------------------------------------------- 2008 2007 2006 2005 2004 ------- ------- ------- ------- ------ (Dollars in thousands) Allowance at beginning of period.................... $15,889 $14,184 $11,767 $10,122 $ 8,506 Provision for loan losses.. 4,100 1,850 2,575 1,700 1,915 ------- ------- ------- ------- ------- Recoveries: First mortgage loans...... - -- -- -- -- Construction and land development............. - -- -- -- -- Commercial real estate.... - -- -- -- -- Multi-family residential.. - -- -- -- -- Commercial loans.......... 16 - 1 168 79 Credit card loans......... 7 41 6 5 6 Other consumer loans...... - 9 - 1 1 ------- ------- ------- ------- ------- Total recoveries......... 23 50 7 174 86 Charge-offs: First mortgage loans...... - -- -- -- -- Construction and land development.............. (702) - -- -- -- Commercial real estate.... - -- -- -- -- Multi-family residential.. - -- -- -- -- Commercial loans.......... (60) (75) (33) (105) (253) Credit card loans......... (51) (51) (54) (104) (124) Other consumer loans...... (85) (69) (78) (20) (8) ------- ------- ------- ------- ------- Total charge-offs......... (898) (195) (165) (229) (385) Net charge-offs......... (875) (145) (158) (55) (299) ------- ------- ------- ------- ------- Allowance at end of period. $19,114 $15,889 $14,184 $11,767 $10,122 ======= ======= ======= ======= ======= Allowance for loan losses as a percentage of net loans receivable at the end of the period..................... 1.60% 1.51% 1.54% 1.46% 1.48% Net charge-offs as a percentage of average loans outstanding during the period.......... 0.08% 0.01% 0.02% 0.01% 0.05% Allowance for loan losses as a percentage of nonperforming assets at end of period.... 155.87% 1,670.06% 1,221.35% 794.53% 2,518.51% 12 The following table sets forth the breakdown of the allowance for loan losses by loan category for the periods indicated. At March 31, --------------------------------------------------------------------------------------- 2008 2007 2006 2005 2004 ---------------- ---------------- --------------- ---------------- ---------------- Percent Percent Percent Percent Percent of Loans of Loans of Loans of Loans of Loans in Each in Each in Each in Each in Each Category Category Category Category Category to Total to Total to Total to Total to Total Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans ------ ----- ------ ----- ------ ----- ------ ----- ------ ----- (Dollars in thousands) First mortgage loans........... $ 1,293 6.8% $1,030 6.5% $ 974 6.9% $ 984 8.4% $ 998 9.9% Construction and land development..... 8,030 42.0 6,321 39.8 4,242 29.9 2,528 21.5 2,179 21.5 Commercial real estate.......... 4,953 25.9 4,557 28.7 5,081 35.8 4,858 41.3 4,118 40.7 Multi-family residential..... 496 2.6 548 3.4 755 5.3 760 6.5 585 5.8 Commercial loans. 3,421 17.9 2,661 16.7 2,329 16.4 1,983 16.9 1,674 16.5 Credit card loans........... 270 1.4 183 1.2 210 1.5 216 1.8 217 2.1 Other consumer loans........... 651 3.4 589 3.7 593 4.2 438 3.7 350 3.5 ------- ------ ------- ------ ------- ------ ------- ------ ------- ------ Total allowance for loan losses......... $19,114 100.0% $15,889 100.0% $14,184 100.0% $11,767 100.0% $10,121 100.0% ======= ====== ======= ====== ======= ====== ======= ====== ======= ======
The Bank had an allowance of $70,000 and $110,000 for real estate acquired through foreclosure at March 31, 2008 and 2007, respectively. There was no allowance for real estate acquired through foreclosure as of March 31, 2006, 2005 and 2004. Investment Activities --------------------- Under Washington law, banks are permitted to own U.S. government and government agency obligations, commercial paper, corporate bonds, mutual fund shares, and debt and equity obligations issued by creditworthy entities, whether traded on public securities exchanges or placed privately for investment purposes. The Bank holds a diverse portfolio of money market instruments, U.S. Treasury obligations, federal agency securities, municipal securities, common stock, preferred stock and corporate notes. The FDIC has adopted the Federal Financial Institutions Examination Council statement of policy on securities activities and accounting procedures. This policy requires that institutions establish prudent policies and strategies for securities activities, identify certain securities trading practices that are unsuitable for an investment portfolio, recommends procedures for selection of a securities dealer, and limits investment in high risk mortgage securities and disproportionately large holdings of long-term zero coupon bonds. The policy addresses concerns about speculative or other non-investment activities in the securities investment portfolios of depository institutions. Speculative securities activities can impair earnings or capital and, in some cases, may cause the failure of the institution. The policy establishes a framework for structuring securities activities and clarifies various accounting issues concerning investment accounts versus trading accounts. The amortized cost of the Bank's investment securities of the type described above at March 31, 2008 was $38.7 million with a market value of $41.2 million compared to an amortized cost of $48.0 million and market value of $53.2 million at March 31, 2007. The Bank also invests in mortgage-backed securities. At March 31, 2008, these securities had an amortized cost of $38.7 million and a market value of $39.1 million compared to an amortized cost and market value of $26.4 at March 31, 2007. The majority of these mortgage-backed securities are backed by government agencies. 13 For further information concerning the Bank's investment securities portfolio, see Notes 3 and 4 of the Notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K. The following table presents the amortized cost of the Bank's investment securities portfolio. The market value of the Bank's investment securities portfolio at March 31, 2008 was approximately $80.4 million. This table also includes interest-bearing deposits and cash equivalents. At March 31, -------------------------------- 2008 2007 2006 --------- ---------- -------- (In thousands) Investment securities: U.S. Government: Available for sale....................... $ 33,107 $ 41,350 $ 45,925 Held to maturity......................... - 370 370 -------- -------- -------- 33,107 41,720 46,295 Mortgage-backed securities(1): Available for sale....................... 38,646 26,220 23,559 Held to maturity......................... 30 148 482 -------- -------- -------- 38,676 26,368 24,041 Other securities(2): Available for sale....................... 5,569 6,325 8,836 Held to maturity......................... - - -- -------- -------- -------- 5,569 6,325 8,836 -------- -------- -------- Total investments........................ 77,352 74,413 79,172 Interest-bearing deposits and cash equivalents............................... 25,324 46,212 33,630 -------- -------- -------- $102,676 $120,625 $112,802 ======== ======== ======== _______ (1) Consists of mortgage-backed securities and collateralized mortgage obligations ("CMOs"). (2) Consists of corporate debt securities, marketable equity securities and mutual funds. At March 31, 2008, 2007 and 2006 the Bank did not have any investment securities (exclusive of obligations of the U.S. government and federal agencies) issued by any one entity with a total book value in excess of 10% of stockholders' equity. 14 The following table sets forth the scheduled maturities, amortized cost, market values and average yields for the Bank's investment securities at March 31, 2008. At March 31, 2008* ------------------------------------------------------------------------------------ 1 Year More than More than More than Total or Less 1 to 5 Years 5 to 10 Years 10 Years Investment Securities ------------- ------------- ------------- ------------- --------------------- Amor- Aver- Amor- Aver- Amor- Aver- Amor- Aver- Amor- Aver- tized age tized age tized age tized age tized Market age Cost Yield Cost Yield Cost Yield Cost Yield Cost Value Yield ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- (Dollars in thousands) U.S. government, agency securities, state and political subdivisions: Available for sale............ $6,726 2.55% $12,212 4.46% $10,171 4.18% $3,998 5.18% $33,107 $33,679 4.07% Held to maturity........ - -- -- -- - -- - -- - - -- ------- ----- ------- ----- ------- ----- ------- ----- ------- ------- ------ 6,726 2.55 12,212 4.46 10,171 4.18 3,998 5.18 33,107 33,679 4.07 Mortgage-backed securities: Available for sale............ - -- 533 5.50 11,360 4.94 26,753 4.78 38,646 39,100 4.84 Held to maturity........ 7 6.39 12 6.67 3 12.62 8 10.55 30 35 8.27 ------- ----- ------- ----- ------- ----- ------- ----- ------- ------- ------ 7 6.39 545 5.52 11,363 4.94 26,761 4.78 38,676 39,135 4.84 Other: Available for sale............ 5,569 6.42 - -- - -- - -- 5,569 7,562 6.42 Held to maturity........ -- -- - -- - -- - -- - - -- ------- ----- ------- ----- ------- ----- ------- ----- ------- ------- ------ 5,569 6.42 - -- - -- - -- 5,569 7,562 6.42 Total............$12,302 4.30% $12,757 4.51% $21,534 4.58% $30,759 4.83% $77,352 $80,376 4.62% ======= ===== ======= ===== ======= ===== ======= ===== ======= ======= ======
15 Real Estate Development Subsidiary ---------------------------------- Westward Financial Services, Inc ("Westward"), a land development company, is a wholly owned subsidiary of the Bank. Westward has been in the real estate development business since the 1970s, primarily focused on residential land development. Westward completed a 110 lot residential development in north Bellingham ("Stoneybrook"), in fiscal 2006. Income attributable to Westward totaled $24,378, $45,932 and $364,668 for fiscal years 2008, 2007 and 2006, respectively. The majority of the lot sales for the "Stoneybrook" development occurred prior to fiscal 2007, which accounts for the differing income amounts in these periods. In October 2004, Westward entered into a real estate development joint venture in Greenbriar Northwest LLC ("GBNW") (50% owned by Westward and 50% by Greenbriar Construction , an established residential land development company headquartered in Bellingham,Washington). This joint venture involves approximately 85 acres of land in south Bellingham and current plans include developing the property into 739 residential units in a new neighborhood to be known as "Fairhaven Highlands." The investment in real estate is recorded as an asset on the Corporation's balance sheet, and the related debt is recorded as a liability. At March 31, 2008, the real estate joint venture has a carrying amount of approximately $17.6 million, with a related borrowing of approximately $22.4 million. One-half of the borrowing expense related to the joint venture is recognized as an expense on the Corporation's financial statements as incurred, with the remainder being capitalized. The Corporation is presently not recognizing any income related to this joint venture, as it is in the early stages of development. For additional details on this joint venture, please see Note 1 - Nature of Operations and Summary of Significant Accounting Policies, of the Notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K. Bank Owned Life Insurance ------------------------- At March 31, 2008, the Bank held $20.3 million in bank owned life insurance ("BOLI"), compared to $19.4 million at March 31, 2007. These policies are with Northwestern Mutual Life, Mass Mutual and New York Life, three of the highest rated BOLI providers. All three of these firms continue to receive high ratings from AM Best, Fitch, Standard & Poors and Moodys. Deposit Activities and Other Sources of Funds --------------------------------------------- General. Savings accounts and other types of deposits have traditionally been important sources of the Bank's funds for use in lending and for other general business purposes. In addition to deposit accounts, the Bank derives funds from loan repayments, loan sales, and borrowings and operations. The availability of funds from loan sales is influenced by general interest rates and other market conditions. Loan repayments are a relatively stable source of funds while deposit inflows and outflows vary widely and are influenced by prevailing interest rates and money market conditions. Borrowings may be used on a short-term basis to compensate for reductions in deposits or deposit inflows at less than projected levels and may be used on a longer term basis to support expanded lending activities. Deposits. Horizon Bank offers several deposit accounts, including Regular Passbook and Statement Savings Accounts, Personal and Business Checking Accounts, Money Market with and without Check Access and Certificates of Deposit Accounts with maturities ranging from 30 days up to ten years. Certificates of deposit account requirements vary according to minimum principal balances, the time period the funds must remain on deposit and the interest rate determined for each term and minimum balance. 16 The following table sets forth certain information concerning the deposits at the Bank. Year Ended March 31, ----------------------------------------------------- 2008 2007 2006 ----------------- ----------------- ----------------- Weighted Weighted Weighted Average Average Average Average Average Average Type Balance Rate Balance Rate Balance Rate ------------------ ------- ---- ------- ---- ------- ---- (Dollars in thousands) Savings............... $19,241 0.92% $ 24,029 0.69% $35,275 0.54% Checking.............. 144,786 0.32 156,200 0.33 147,523 0.29 Money Market.......... 195,139 3.35 173,483 3.64 143,434 2.41 Time Deposits......... 633,501 4.89 551,671 4.60 458,017 3.50 -------- ----- -------- ----- -------- ------ Total...............$992,667 3.83% $905,383 3.56% $784,249 2.55% ======== ===== ======== ===== ======== ====== The following table indicates the Bank's time deposits by time remaining until maturity as of March 31, 2008 for amounts of $100,000 or more. Certificates Maturity Period of Deposit -------------------------- -------------- (In thousands) Three months or less........... $ 63,030 Over three through six months........................ 115,605 Over six through twelve months........................ 93,911 Over twelve months............. 14,735 ------------- Total......................... $287,281 ============= The Bank has a number of different programs designed to attract both short-term and long-term savings of the general public by providing a wide assortment of accounts and rates. These include traditional savings accounts, nonnegotiable time deposits with minimum deposits of $100,000 and terms of 30 days to five years called Jumbo Certificates of Deposit, nonnegotiable, nontransferable time deposits with minimum deposits of $500 and terms from 30 days to five years at fixed rates, 12-month to ten-year variable rate fixed term certificates, individual retirement accounts ("IRAs"), qualified retirement plans, transaction accounts such as regular checking, and money market deposit accounts ("MMDAs") with and without limited check access. The Bank's practice on early withdrawal penalties is applicable only to time deposits. Management believes that in periods of rising interest rates this practice will discourage depositors from making premature withdrawals for the purpose of reinvesting in higher rate time deposits. The minimum amount required to open a time deposit varies from $500 to $100 ,000, depending on the type of time deposit. Pricing of rates on time deposits with maturities from 30 days to ten years are determined periodically by the Bank, based upon local market rates, national money market rates, and yields on assets of the same maturity. The Bank's Personal MMDA currently has a $1,000 minimum deposit and has a tiered pricing program, with interest rates that vary by account dollar balance -- $1,000, $10,000, $25,000, $50,000 and higher. The Bank's Business MMDA has tiers of $1,000, $10,000, $50,000, $100,000 and higher, with a $1,000 minimum deposit. These accounts have no maturity requirements, no regulatory interest rate ceilings, and limited check writing privileges. The interest rates on these accounts are adjusted by the Bank periodically, based on money market conditions. The Bank currently has a $10,000 minimum deposit money market and has a tiered pricing program, with interest rates that vary by account dollar balance -- $10,000, $25,000, $50,000 and higher. The Bank also offers a $25,000 and a $50,000 minimum deposit money market, which have tiered pricing programs, with interest rates that vary by account dollar balance -- $25,000, $50,000, $100,000, $250,000 and higher. These accounts have no maturity requirements, no regulatory interest rate 17 ceiling, and no check writing privileges. The interest rates on the account are adjusted by the Bank periodically or as dictated by money market conditions. The large variety of deposit accounts offered by the Bank has increased its ability to retain deposits and has allowed it to be competitive in obtaining new funds, although the threat of disintermediation (the flow of funds away from the Bank into direct investment vehicles, such as common stocks and mutual funds) still exists. The Bank's ability to attract and retain deposits and its cost of funds have been, and will continue to be, significantly affected by capital and money market conditions. Horizon Bank attempts to control the flow of deposits by pricing its accounts to remain competitive with other financial institutions in its market area but does not necessarily seek to match the highest rates paid by competing institutions. The senior officers of the Bank meet periodically to determine the interest rates which the Bank will offer to the general public. These officers consider the amount of funds needed by the Bank on both a short-term and long-term basis, the rates being offered by the Bank's competitors, alternative sources of funds and the projected level of interest rates in the future. The Bank's deposits are obtained primarily from residents of Northwest Washington. Horizon Bank attracts deposits by offering a wide variety of services and convenient branch locations and service hours. For further information concerning the Bank's savings deposits, reference is made to Note 8 of the Notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K. Brokered Deposits. The Bank also utilizes brokered deposits as a supplemental source of funding, when appropriate. During fiscal 2008, the Bank increased its balances in brokered deposits from $79.4 million at March 31, 2007 to $121.0 million at March 31, 2008. The rates paid on these deposits are comparable to the rates on similar term from the Bank's alternative sources of funding (such as wholesale borrowings, discussed below). The Bank intends to continue utilizing brokered deposits to support its funding needs, when appropriate. Borrowings. In December 1998, the Bank joined the FHLB of Seattle which provides it with access to a variety of wholesale funding options. The Bank has a committed line of credit up to 25% of total assets, subject to the Bank pledging sufficient collateral and maintaining the required stock investment in the FHLB. Committed lines of credit agreements totaling approximately $272.7 million and $248.5 million were available to the Bank, of which, $192.0 million and $143.5 million were outstanding at March 31, 2008 and 2007, respectively. The following table sets forth information regarding FHLB of Seattle advances to the Bank at the end of and during the periods indicated. The table includes both long- and short-term borrowings. Year Ended March 31, ------------------------------ 2008 2007 2006 ---------- -------- -------- (Dollars in thousands) Maximum amount of borrowings outstanding at any month end........................ $ 212,500 $195,000 $149,000 Approximate average borrowings outstanding............................. 177,874 165,237 134,070 Approximate weighted average rate paid on borrowings 4.44% 4.74% 3.68% Balance outstanding at end of period...... $ 192,000 $143,500 $149,000 Weighted average rate paid on borrowings at end of period........................ 3.15% 5.03% 4.39% 18 The Bank has other borrowed funds in the form of retail repurchase agreements. These agreements are collateralized by securities held by a safekeeping agent not under control of the Bank. These advances are considered overnight borrowings and bear interest rates that fluctuate daily based on current market rates. The Bank had $21.9 million and $14.4 million outstanding as of March 31, 2008 and 2007, respectively. The Bank also had $850,000 and $1.0 million outstanding as of March 31, 2008 and 2007, respectively, in the form of a TT&L note option which is included in other borrowed funds. At March 31, 2008, the Bank had $214.8 million in borrowings from all sources, compared to $159.0 million at March 31, 2007. Access to these wholesale borrowing sources allows management to meet cyclical funding needs and assists in interest rate risk management efforts. For additional information on borrowings, see Note 9 of the Notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K. Competition ----------- The Bank faces strong competition in its market area in originating loans and attracting deposits. Competition in originating loans is primarily from other commercial banks, thrift institutions, mortgage companies, credit unions and consumer finance companies. The Bank competes for loan originations primarily through interest rates and loan fees it charges and through the efficiency and quality of services it provides borrowers. Competition is affected by, among other things, the general availability of lendable funds, general and local economic conditions and current interest rate levels. In attracting deposits, the Bank competes primarily with other commercial banks, thrift institutions, credit unions and brokerage firms. The Bank competes for customer deposits principally on the basis of convenience and quality of its banking services and the investment opportunities that satisfy the requirements of investors with respect to rate of return, liquidity, risk and other factors. The primary factors in competing for deposits are interest rates and the convenience of office locations. In light of the deregulation of interest rate controls on deposits, the Bank has faced increasing competition for deposits from commercial banks, other thrift institutions and non-regulated financial intermediaries. Personnel --------- At March 31, 2008, Horizon Bank employed 272 full-time and 43 part-time employees. Horizon Bank employees are not represented by any collective bargaining agreement. Management of Horizon Bank considers its relations with its employees to be good. Executive Officers of the Registrant The executive officers of the Corporation and the Bank are as follows: Age at Name March 31, 2008 Position ---------------- -------------- ------------------------------------- V. Lawrence Evans 61 Chairman of the Board of the Corporation and of the Bank Richard P. Jacobson 45 Chief Executive Officer, President, Chief Financial Officer and Director of the Corporation and Chief Executive Officer, Chief Financial Officer and Director of the Bank (table continued on following page) 19 Age at Name March 31, 2008 Position ---------------- -------------- ------------------------------------- Dennis C. Joines 58 Executive Vice President and Director of the Corporation and President, Chief Operating Officer and Director of the Bank William N. Gasperetti 61 Executive Vice President of the Bank Steve L. Hoekstra 57 Executive Vice President of the Bank Kelli J. Holz 39 Vice President of the Corporation and Senior Vice President of the Bank The following is a description of the principal occupation and employment of the executive officers of the Corporation and the Bank during at least the past five years: V. LAWRENCE EVANS is Chairman of the Board of Horizon and Horizon Bank, positions he has held since July 2001 and July 1997, respectively. Mr. Evans joined Horizon Bank in 1972 and served as its Executive Vice President from 1983 to 1990. Mr. Evans served as President of the Bank from May 1990 to April 2002 and as Chief Executive Officer of the Bank from March 1991 to December 31, 2007. He served as President and Chief Executive Officer of Horizon from October 13, 1995 to December 31, 2007. RICHARD P. JACOBSON is President, Chief Executive Officer and a Director of Horizon and Chief Executive Officer and a Director of Horizon Bank, positions he has held since January 1, 2008. Mr. Jacobson also serves as Chief Financial Officer of Horizon and Horizon Bank, a position he has held since March 2000. Mr. Jacobson joined Horizon Bank in 1987 and was appointed Vice President/Finance and Corporate Secretary in December 1994. In March 1998, he was appointed Senior Vice President of the Bank and in March 2000, he was appointed Executive Vice President of the Bank. DENNIS C. JOINES became Executive Vice President and a Director of Horizon and President, Chief Operating Officer and a Director of Horizon Bank on April 23, 2002. He joined the Bank following an extensive career in the Pacific Northwest banking industry for over 30 years. Most recently, Mr. Joines was Senior Vice President/National Small Business and SBA Manager for Washington Mutual Bank from 2001 to 2002. Prior to that time, he served in a variety of key roles at KeyBank from 1993 to 2001. WILLIAM N. GASPERETTI joined the Bank in December 2007 as Executive Vice President and Chief Credit Officer. Mr. Gasperetti has over 34 years of experience in the local and national banking markets, including eight years with the Resolution Trust Corporation. Prior to joining the Bank, he was Senior Vice President/Senior Commercial Real Estate Income Property Lender for Cascade Bank from 2004 to 2008. Prior to that, he was employed by Pacific NW Bank in a similar position from 1997 to 2004. STEVE L. HOEKSTRA joined the Bank in June, 2002 as Executive Vice President, Commercial Banking. Mr. Hoekstra has over 25 years of experience in the local commercial banking industry. Most recently, he led the Bellingham commercial and over retail team for Frontier Bank. Prior to that, Mr. Hoekstra was employed for 22 years by SeaFirst/Bank of America, where his titles included Commercial Credit Administrator, Sales Team Leader, Equipment Financing and Leasing Specialist and Dealer Banking. KELLI J. HOLZ, CPA, joined the Bank in 1988. From 1991 to 1998 she was the Manager of the Internal Audit Department. In March 1998, she was appointed Vice President. In March 2007, she was appointed Senior Vice President of the Bank and is currently the Vice President of Horizon and Senior Vice President and Controller of Horizon Bank. 20 Regulation and Supervision -------------------------- The Bank. General. As a state-chartered, federally insured commercial bank, Horizon Bank is subject to extensive regulation and must comply with various statutory and regulatory requirements, including prescribed minimum capital standards. Horizon Bank is regularly examined by the FDIC and its state regulators, and files quarterly and periodic reports concerning its activities and financial condition with its regulators. The Bank's relationship with depositors and borrowers also is regulated to a great extent by both federal and state law, especially in such matters as the ownership of deposit accounts and the form and content of loan documents. Federal and state banking laws and regulations govern all areas of the operation of the Bank, including reserves, loans, mortgages, capital, issuance of securities, payment of dividends and establishment of branches. Federal and state bank regulatory agencies also have the general authority to limit the dividends paid by insured banks and bank holding companies if such payments are deemed to constitute an unsafe and unsound practice. The respective primary federal regulators of the Corporation and the Bank have authority to impose penalties, initiate civil and administrative actions and take other steps intended to prevent banks from engaging in unsafe or unsound practices. State Regulation and Supervision. As a state-chartered commercial bank, the Bank is subject to applicable provisions of Washington law and regulations of the Washington State Department of Financial Institutions. State law and regulations govern the Bank's ability to take deposits and pay interest, 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. The Bank is subject to periodic examination and reporting requirements by and of the Washington State Department of Financial Institutions, Division of Banks. Federal Deposit Insurance Corporation. The Bank's deposits are insured up to applicable limits by the Deposit Insurance Fund of the FDIC. The Deposit Insurance Fund is the successor to the Bank Insurance Fund and the Savings Association Insurance Fund, which were merged effective March 31, 2006. 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 fund. The FDIC also has the authority to initiate enforcement actions against savings institutions, after giving the OTS 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. Under regulations effective January 1, 2007, the FDIC adopted a new risk-based premium system that provides for quarterly assessments based on an insured institution's ranking in one of four risk categories based upon supervisory and capital evaluations. Well-capitalized institutions (generally those with capital adequacy, asset quality, management, earnings and liquidity, or "CAMELS" composite ratings of 1 or 2) are grouped in Risk Category I and assessed for deposit insurance at an annual rate of between five and seven basis points. The assessment rate for an individual institution is determined according to a formula based on a weighted average of the institution's individual CAMEL component ratings plus either five financial ratios or, in the case of an institution with assets of $10.0 billion or more, the average ratings of its long-term debt. Institutions in Risk Categories II, III and IV are assessed at annual rates of 10, 28 and 43 basis points, respectively. The Corporation's expense related to this assessment for the year ended March 31, 2008 was $510,714. The net expense for the year ended March 31, 2008 was $0 as a result of the offset of the Bank's one-time assessment credit in fiscal 2008. Deposit Insurance Fund-insured institutions are required to pay a Financing Corporation assessment, in order to fund the interest on bonds issued to resolve thrift failures in the 1980s. For the semi-annual period ended December 31, 2007, the Financing Corporation assessment equaled 1.14 basis points for each $100 in domestic deposits. These assessments, which may be revised based upon the level of DIF deposits, will continue until the bonds mature in the years 2017 through 2019. For 2007, the Bank incurred $113,000 in FICO assessments. 21 The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is aware of no existing circumstances which would result in termination of the Bank's deposit insurance. 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 1 (core) capital to risk-weighted assets of less than 4%, or a ratio of Tier 1 (leverage) 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 core 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 undercapitalized. In most instances, 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 March 31, 2008, the Bank was categorized as "well capitalized" under the prompt corrective action regulations of the FDIC. 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 non-cumulative perpetual preferred stock, less most intangible assets. Tier 2 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 March 31, 2008, the Bank had a Tier 1 leverage capital ratio of 9.1%. Horizon Bank has not been notified by the FDIC of any higher capital requirements specifically applicable to it. 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 the 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 22 investment quality, the effectiveness of loan and investment policies, and management's ability to monitor and control financial operating risks. At March 31, 2008, the Bank determined that its total risk-based capital ratio was 11.0% and its Tier 1 risk-based capital ratio was 9.7%. The Washington State Department of Financial Institutions 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 March 31, 2008, Horizon Bank had a net worth of 9.2% of total assets. Horizon 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. For additional information concerning the Bank's capital, see Note 12 of the Notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K. Federal Deposit Insurance Improvement Act ("FDICIA"). In general, FDICIA requires the Bank to conduct an annual independent audit of its financial statements, appoint an independent audit committee of outside directors, report on and assess management's responsibilities for preparing financial statements, and establish an internal control structure. An independent accountant must attest to and report on the assertions in management's reports concerning these internal controls with the desired outcome of efficient and effective operations; the safeguarding of assets; reliable financial reporting and compliance with applicable laws and regulations. As the primary regulator of the Bank, the FDIC has outlined the requirements for compliance with FDICIA, but does not provide specific guidance on the internal control structure, documentation, or procedures to test the Bank's effectiveness. It is up to each bank to establish, document and design procedures to evaluate and test the internal control structure over financial reporting and compliance with designated laws and regulations that minimally include loans to insiders and dividend restrictions. In brief, to ensure compliance, the Bank has established and coordinated a management team that identifies and documents existing controls with consideration given to the Bank's control environment, risk assessment, control activities, information and communication systems, and monitoring activities. In addition, management establishes internal control procedures, develops and selects criteria for evaluation, tests the effectiveness of controls, and ensures that proper written documentation is in place. Under FDICIA, the Audit Committee has several responsibilities that include but are not limited to overseeing the internal audit function; conducting periodic meetings with management, the independent public accountant, and the internal auditors; review of significant accounting policies, and audit conclusions regarding significant accounting estimates; review of the assessments prepared by management and independent auditor on the adequacy of internal controls and the resolution of identified material weaknesses and reportable conditions in internal controls; and the review of compliance with laws and regulations. Federal Home Loan Bank System. The FHLB of Seattle serves as a reserve or central bank for the member institutions within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLBs. It makes loans (i.e., advances) to members in accordance with policies and procedures established by the Federal Housing Finance Board and the Board of Directors of the FHLB of Seattle. As a member, the Bank is required to purchase and hold stock in the FHLB of Seattle, based on formulas established by the FHLB. As of March 31, 2008, Horizon Bank held stock in the FHLB of Seattle in the amount of $8.9 million. See "Business -- Savings Activities and Other Sources of Funds -- Borrowings." Federal Reserve System. The Federal Reserve Board requires, under Regulation D, that all depository institutions maintain reserves on transaction accounts and nonpersonal 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 23 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 the reserve requirements, as are any non-personal time deposits at a savings bank. As of March 31, 2008, the Bank's deposit with the Federal Reserve Bank and vault cash exceeded its reserve requirements. 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. The Corporation. General. The Corporation, as the sole stockholder 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 (the "BHCA"), and the regulations of the Federal Reserve. As a bank holding company, the Corporation is required to file with the Federal Reserve annual, quarterly and periodic reports and such additional information as the Federal Reserve may require. The Federal Reserve may examine the Corporation and any of its subsidiaries, and charge the Corporation for the cost of the examination. 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 BHCA, the Corporation 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, Federal Reserve policy 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 Corporation and any subsidiaries, other than the Bank, that it may control are considered "affiliates" of Horizon Bank within the meaning of the Federal Reserve Act, and transactions between Horizon Bank and its affiliates are subject to numerous restrictions. With some exceptions, the Corporation and its subsidiaries are prohibited from tying the provision of various services, such as extensions of credit, to other services offered by the Corporation, or our affiliates. 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 the recent 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 24 generally applies to all companies 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"). The Sarbanes-Oxley Act includes very specific additional disclosure requirements and new corporate governance rules. 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. Acquisitions. The BHCA prohibits a bank holding company, with certain exceptions, from acquiring 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 in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. Under the BHCA, the Federal Reserve may 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. These activities include 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. Dividends. The Federal Reserve's policy statement on the payment of cash dividends by bank holding companies 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 policy statement indicates that it would be inappropriate for a company experiencing serious financial problems to borrow funds to pay dividends. Capital Requirements. The Federal Reserve has established capital adequacy guidelines for bank holding companies that generally parallel the capital requirements of the FDIC for banks. The Federal Reserve regulations provide that capital standards will be applied on a consolidated basis in the case of a bank holding company with $150 million or more in total consolidated assets. The Corporation'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. At March 31, 2008, the Corporation's capital position was in excess of these requirements with total risk based capital of 11.1% of risk-weighted assets and Tier 1 (core) capital of 9.8% of risk-weighted assets. 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. Taxation -------- Federal Taxation. General. The Corporation and the Bank report their consolidated 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 Corporation. Reference is made to Note 10 of the Notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K for additional information concerning the income taxes payable by the Bank. 25 Tax Bad Debt Reserves. Historically, savings institutions such as the Bank, which met certain definitional tests primarily related to their assets and the nature of their businesses, were permitted to establish a reserve for bad debts and to make annual additions to the reserve. These additions may, within specified formula limits, have been deducted in arriving at the Bank's taxable income. For purposes of computing the deductible addition to its bad debt reserve, the Bank's loans were separated into "qualifying real property loans" (i.e., generally those loans secured by interests in residential real property) and all other loans ("non-qualifying loans"). The following formulas were used to compute the bad debt deduction with respect to qualifying real property loans: (i) actual loss experience or (ii) a percentage equal to 8% of taxable income. The deduction with respect to non-qualifying loans was computed under the experience method. Reasonable additions to the reserve for losses on non-qualifying loans were based upon actual loss experience and would reduce the current year's addition to the reserve for losses on qualifying real property loans, unless that addition was also determined under the experience method. The sum of the additions to each reserve for each year was the Bank's annual bad debt deduction. The provisions repealing the current thrift bad debt rules were passed by Congress as part of "The Small Business Job Protection Act of 1996." The new rules eliminated the 8% of taxable income method for deducting additions to the tax bad debt reserves for all financial institutions for tax years beginning after December 31, 1995. These rules also 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 has previously recorded a deferred tax liability equal to the bad debt recapture and as such the new rules will have no effect on the net income or federal income tax expense. For taxable years beginning after December 31, 1995, 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 rules allowed an institution to suspend bad debt reserve recapture for the 1996 and 1997 tax years if the institution's lending activity for those years was equal to or greater than the institution's average mortgage lending activity for the six taxable years preceding 1996 adjusted for inflation. For this purpose, only home purchase or home improvement loans were included and the institution could have elected to have the tax years with the highest and lowest lending activity removed from the average calculation. If an institution was permitted to postpone the reserve recapture, it must have begun its six year recapture no later than the 1998 tax year. The unrecaptured base year reserves would 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 stockholders. Distributions. If a stock institution distributes amounts to stockholders and the distribution is treated as being from its accumulated bad debt reserves, the distribution will cause the institution to have additional taxable income. A distribution to stockholder is deemed to have been made from accumulated bad debt reserves to the extent that (i) the reserves exceed the amount that would have been accumulated on the basis of actual loss experience, and (ii) the distribution is a "non-dividend distribution." A distribution in respect of stock is a non-dividend distribution to the extent that, for federal income tax purposes, (i) it is redemption of shares, (ii) it is pursuant to a liquidation or partial liquidation of the institution, or (iii) in the case of current distribution, together with all other such distributions during the taxable year, it exceeds the institution's current and post-1951 accumulated earnings and profits. The amount of additional taxable income created by a non-dividend distribution is an amount that, when reduced by tax attributable to it, is equal to the amount of the distribution. Minimum Tax. In addition to regular corporate income tax, corporations are subject to an alternative minimum tax which generally is equal to 20% of alternative minimum taxable income (taxable income, increased by tax preference items and adjusted for certain regular tax items). The preference items which are generally applicable include an amount equal to 75% of the amount by which a financial institution's adjusted current earnings (generally alternative minimum taxable income computed without regard to this preference and prior to reduction for net operating losses) exceeds its alternative minimum taxable income without regard to this preference and the excess of the institution's bad debt deduction over the amount deductible under the experience method, as discussed below. Alternative minimum tax paid can be credited against regular tax due in later years. Audits. The Bank has not been audited by the Internal Revenue Service during the past five years. 26 Washington Taxation. The Bank is subject to a business and occupation tax which is imposed under Washington law at the rate of 1.50% of gross receipts; however, interest received on loans secured by mortgages or deeds of trust on residential properties is not subject to such tax. The Bank's business and occupation tax returns were audited in November 1995. Available Information ---------------------- The Corporation's Internet address is www.horizonbank.com. You may access, free of charge, copies of the following documents from the Corporation's website by using the "Investor Relations" button: 1. Annual Reports on Form 10-K; 2. Quarterly Reports on Form 10-Q; and 3. Current Reports on Form 8-K. The Corporation makes these reports and certain other information that it files available on its website as soon as reasonably practicable after filing or furnishing them electronically with the SEC. These and other SEC filings the Corporation are also available, free of charge, from the SEC on its website at www.sec.gov. The information contained on the Corporation's website is not incorporated by reference into this document and should not be considered a part of this Annual Report on Form 10-K. The Corporation's website address is included in this document as an inactive textual reference only. Item 1A. Risk Factors. ----------------------- An investment in our common stock is subject to risks inherent to our business. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones that affect us. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair our business operations. This report is qualified in its entirety by these risk factors. If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of our common stock could decline significantly, and you could lose all or part of your investment. The Maturity and Repricing Characteristics of Our Assets and Liabilities are Mismatched and Subject Us to Interest Rate Risk Which Could Adversely Affect Our Net Earnings and Economic Value. Our financial condition and operations are influenced significantly by general economic conditions, including the absolute level of interest rates as well as changes in interest rates and the slope of the yield curve. Our profitability is dependent to a large extent on our net interest income, which is the difference between the interest received from our interest-earning assets and the interest expense incurred on our interest-bearing liabilities. Our activities, like all financial institutions, inherently involve the assumption of interest rate risk. Interest rate risk is the risk that changes in market interest rates will have an adverse impact on our earnings and underlying economic value. Interest rate risk is determined by the maturity and repricing characteristics of our assets, liabilities and off-balance-sheet contracts. Interest rate risk is measured by the variability of financial performance and economic value resulting from changes in interest rates. Interest rate risk is the primary market risk affecting our financial performance. The greatest source of interest rate risk to us results from the mismatch of maturities or repricing intervals for rate sensitive assets, liabilities and off-balance-sheet contracts. Additional interest rate risk results from mismatched 27 repricing indices and formulae (basis risk and yield curve risk), and product caps and floors and early repayment or withdrawal provisions (option risk), which may be contractual or market driven, that are generally more favorable to customers than to us. Additionally, our portfolio is heavily concentrated in Prime rate based loans. At March 31, 2008, we had $722.7 million in Prime based loans, representing 59.7% of total loans. As such, the Corporation is adversely impacted during periods of rapidly declining rates, as has been evident in the second half of the fiscal year ended March 31, 2008. The Federal Reserve Open Market Committee ("FOMC") reduced its fed funds target by 300 basis points from September 2007 through March 2008, which had a significant adverse impact on the Corporation's net interest margin and earnings, with its Prime based loans adjusting instantly when Prime changes, while liability costs are impacted much more slowly and will take time to reprice in a lower rate environment. Also, no assurances can be made that liability rates will be able to be reduced by the same magnitude as Prime rate changes in a very competitive environment for attracting deposits. Our primary monitoring tool for assessing interest rate risk is asset/liability simulation modeling, which is designed to capture the dynamics of balance sheet, interest rate and spread movements and to quantify variations in net interest income resulting from those movements under different rate environments. The sensitivity of net interest income to changes in the modeled interest rate environments provides a measurement of interest rate risk. The net market value of equity is estimated by separately valuing our assets and liabilities under varying interest rate environments. The extent to which assets gain or lose value in relation to the gains or losses of liability values under the various interest rate assumptions determines the sensitivity of net equity value to changes in interest rates and provides an additional measure of interest rate risk. The interest rate sensitivity analysis we perform incorporates beginning-of-the-period rate, balance and maturity data, using various levels of aggregation of that data, as well as certain assumptions concerning the maturity, repricing, amortization and prepayment characteristics of loans and other interest-earning assets and the repricing and withdrawal of deposits and other interest-bearing liabilities into an asset/liability computer simulation model. We update and prepare simulation modeling at least quarterly for review by senior management and the directors. We believe the data and assumptions are realistic representations of our portfolio and possible outcomes under the various interest rate scenarios. Nonetheless, the interest rate sensitivity of our net interest income and net market value of equity could vary substantially if different assumptions were used or if actual experience differs from the assumptions used. Our Loan Portfolio Contains a Large Percentage of Construction and Land Development Loans, Commercial Real Estate Loans and Commercial Business Loans Which Involves a Higher Risk of Loss than Other Types of Lending. We have had a significant increase in our commercial real estate construction and land development lending and commercial business lending since March 31, 2003. Commercial and multi-family real estate, construction and land development and commercial business loans may expose a lender to greater risk of loss than loans secured by residential real estate and consumer loans because the type of collateral securing these loans and the large dollar value typically involved. These loans also have greater credit risk than residential real estate for the following reasons and the reasons discussed under "Item 1. Business-Lending Activities." * Commercial and Multi-family Mortgage Loans. These loans typically involve higher principal amounts than other types of loans, and repayment is dependent upon income being generated from the property securing the loan in amounts sufficient to cover operating expenses and debt service. * Construction and Land Development Loans. This type of lending contains the inherent difficulty in estimating both a property's value at completion of the project and the estimated cost (including interest) of the project. If the estimate of construction cost proves to be inaccurate, we 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, we may be confronted at, or prior to, the maturity of the loan with a project the value of which is insufficient to assure full repayment. In addition, speculative construction loans to a builder are often associated with homes 28 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. * Commercial Loans. Repayment is dependent upon the successful operation of the borrower's business. Joint Ventures in Real Estate Development May Expose Us to Additional Risk. As indicated in the Real Estate Development Subsidiary section of Part 1, Item 1 of this Form 10-K, the Bank's wholly owned subsidiary (Westward) is a land development company which periodically enters into joint ventures to develop residential real estate. While Westward has successfully partnered in various real estate developments since the 1970s, there can be no guarantee that success in this area will necessarily continue into the future. This activity may present additional risk to us, as we are exposed as an equity investor in the land being developed. Adverse movements in the value of the raw land or the values of the fully developed lots negatively affects our financial performance. Adverse changes in real estate development regulations (i.e. environmental regulations, project density requirements, and other related development regulatory matters) may also negatively impact our success in this regard. In addition, this development activity exposes us to potential reputation risk, as some members of our communities might not necessarily approve of our involvement as a real estate development partner. In addition, certain projects may be perceived negatively by residents of the area where the properties are being developed, instead of favoring to leave the land in an undeveloped state. For these and potentially other reasons related to real estate development, our joint ventures in real estate development may expose us to additional risk, and no assurances can be provided regarding continued success in this area. Our Profitability Depends Significantly on Economic Conditions in Our Primary Market Area. Our success depends primarily on the general economic conditions of the State of Washington and the specific local markets in which we operate. Unlike larger national or other regional banks that are more geographically diversified, we provide banking and financial services to customers located primarily in Whatcom, Skagit, Snohmish and Pierce Counties of Washington. The local economic conditions in our market areas have a significant impact on the demand for our products and services as well as the ability of our ustomers to repay loans, the value of the collateral securing loans and the stability of our deposit funding sources. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities markets or other factors could impact these local economic conditions and, in turn, have a material adverse effect on our financial condition and results of operations. Housing Market Slowdown and the Effects of the Sub-Prime Market. The potential impacts of sub-prime loans originated by others in Horizon Bank's markets in recent years could adversely impact Horizon Bank's performance. These sub-prime loans are cited as contributing to the slowdowns in the housing markets across the country. As homeowners face significant increases in their housing payments when these sub-prime loans reset, this will likely have an adverse affect on the economy with an increasing supply of housing units on the market. It is predicted that these adverse impacts will result in increased numbers of houses listed for sale (for those facing unaffordable increases in their monthly housing payments) and it will also likely increase the number of foreclosures on residential units. The housing market slowdown is adversely impacting the Bank's performance, and may continue into the future. Housing inventories are higher than the prior year period and housing sales activity for the quarter ended March 31, 2008 was lower than recent years in all of Horizon Bank's markets. In the quarter ended March 31, 2008, loans on non-accrual increased to 0.88% of assets, a significant increase over previous year levels. In addition, Horizon Bank's delinquency levels (loans 30 to 89 days past due) totaled $30.6 million at March 31, 2008, which are significantly higher than prior year levels. No reassurance can be provided that these levels will improve. Horizon Bank experienced loan charge-offs 29 of $875,000 during the fiscal year ended March 31, 2008, $777,000 of which occurred in the March quarter. While this level of losses is manageable, additional larger losses may occur in the future, especially if the current housing market slowdown continues. If Our Allowance for Loan Losses Is Not Sufficient to Cover Actual 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 our loans and the loss and delinquency experience, and evaluate economic conditions. If our assumptions are incorrect, the allowance for loan losses may not be sufficient to cover losses inherent in our loan portfolio, resulting in the need for additions to our allowance. Material additions to the allowance could materially decrease our net income. Our allowance for loan losses was 1.6% of net loans at March 31, 2008. 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. If External Funds Were Not Available, this Could Adversely Impact Our Growth and Prospects. We rely on deposits and advances from the FHLB-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 or market conditions were to change. 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. Strong Competition Within Our Market Area May Limit Our Growth and Profitability. Competition in the banking and financial services industry is intense. We compete in our market areas with commercial banks, savings institutions, mortgage brokerage firms, credit unions, finance companies, mutual funds, insurance companies, and brokerage and investment banking firms operating locally and elsewhere. Some of these competitors have substantially greater resources and lending limits than we do, have greater name recognition and market presence that benefit them in attracting business, and offer certain services that we do not or cannot provide. In addition, larger competitors may be able to price loans and deposits more aggressively than we do. Our profitability depends upon our continued ability to successfully compete in our market areas. The greater resources and deposit and loan products offered by some of our competitors may limit our ability to increase our interest-earning assets. For additional information see Item 1, "Business Competition." 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. 30 If Our Common Stock Was No Longer Included in the Russell 2000 or Russell 3000 Indices There Could be a Reduction in Liquidity and Prices for Our Stock. Our common stock is included in the Russell 2000 and Russell 3000 indices. Inclusion in these indices may have positively impacted the price, trading volume and liquidity of our common stock, in part, because index funds or other institutional investors often purchase securities that are in these indices. Conversely if our market capitalization falls below the minimum necessary to be included in either or both of these indices at any annual reconstitution date, the opposite could occur. Firms that attempt to predict which companies may no longer qualify to be included in the Russell 2000 Index identified Horizon as a likely deletion from the Index in 2008. No reassurance can be given that Horizon will or will not be included in the Russell 2000 and Russell 3000 indices, or similar indices, in the future. We Are Subject to Extensive Government Regulation and Supervision. We are subject to extensive federal and state regulation and supervision primarily through Horizon 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. See Item 1, "Business -- Regulation and Supervision." The Level Of Our Commercial Real Estate Loan Portfolio May Subject Us To Additional Regulatory Scrutiny. The FDIC, the Federal Reserve and the Office of the Comptroller of the Currency, have promulgated joint guidance on sound risk management practices for financial institutions with concentrations in commercial real estate lending. Under the guidance, a financial institution actively involved in commercial real estate lending should perform a risk assessment to identify concentrations. A financial institution may have a concentration in commercial real estate lending if, among other factors, (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 multifamily and non-farm residential properties, loans for construction, land development and other land and loans otherwise sensitive to the general commercial real estate market, including loans to commercial real estate related entities, represent 300% or more of total capital. Management should also 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. While we believe we have implemented policies and procedures with respect to our commercial real estate loan portfolio consistent with the guidance, bank regulators could require us to implement additional policies and procedures consistent with their interpretation of the guidance which could result in additional costs to us. Our Information Systems May Experience an Interruption or Breach in Security. 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 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 31 possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations. We Rely on Dividends From Our Subsidiaries For Most of Our Revenue. Horizon Financial 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 Horizon Bank and certain non-bank subsidiaries may pay to Horizon Financial. 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 Horizon Bank is unable to pay dividends to Horizon Financial, Horizon Financial may not be able to service debt, pay obligations or pay dividends on Horizon Financial's common stock. The inability to receive dividends from Horizon Bank could have a material adverse effect on our business, financial condition and results of operations. See Item 1, "Business -- Regulation and Supervision." 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 ("Act") 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 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 Company's 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. Item 1B. Unresolved Staff Comments ----------------------------------- None. 32 Item 2. Properties ------------------- The following table sets forth the location of the Bank's offices, as well as certain information relating to these offices. Net Book Year Value as of Square Leased/ Opened March 31, 2008 Feet Owned ------ -------------- ---- ----- (In thousands) Bellingham Main Office and Whatcom Mortgage Center..................... 1971 $2,619 19,179 Owned 1500 Cornwall Avenue Bellingham, WA 98225 Bellingham/Meridian................. 1987 705 4,650 Owned 4110 Meridian Street Bellingham, WA 98226 Ferndale Office..................... 1976 224 3,692 Owned Third and Main Ferndale, WA 98248 Lynden Office....................... 1981 548 3,702 Owned Third and Grover Streets Lynden, WA 98264 Blaine Office....................... 1976 534 3,610 Owned Fourth & "H" Streets Blaine, WA 98230 Mount Vernon Office................. 1976 182 3,275 Owned 1503 Riverside Dr. Mount Vernon, WA 98273 Anacortes Office.................... 1987 628 3,650 Owned 1218 Commercial Avenue Anacortes, WA 98221 Snohomish Office.................... 1987 147 1,388 Owned 620 2nd Street Snohomish, WA 98290 Puyallup Office, Pierce Mortgage Center (1).......................... 2007 724 3,402 Leased 413 29th Street NE Puyallup, WA 98372 Burlington Office, Skagit Commercial Center and Skagit Mortgage Center.......... 1994 1,033 3,980 Owned 1020 S. Burlington Blvd Burlington, WA 98232 (table continued on the following page) 33 Net Book Year Value as of Square Leased/ Opened March 31, 2008 Feet Owned ------ -------------- ---- ----- (In thousands) Edmonds Office...................... 1994 $1,881 15,265 Owned 130 Fifth Avenue South Edmonds, WA 98020 Murphy's Corner Office.............. 2000 1,532 3,720 Owned 12830 Bothell Everett Hwy. Everett, WA 98208 Barkley Office...................... 1999 2,735 14,691 Owned 2122 Barkley Blvd. Bellingham, WA 98228 Holly Street Office................. 1999 327 4,000 Owned 211 E. Holly Street Bellingham, WA 98227 Alabama Office...................... 1999 661 4,500 Owned 802 Alabama Street Bellingham, WA 98228 Marysville Office................... 2004 2,106 4,126 Owned 3617 88th St NE Marysville, WA 98270 Lynnwood Office..................... 2003 2,085 4,230 Owned 19405 44th Avenue W. Lynnwood, WA 98036 Lakewood Office, Pierce Commercial Center.............................. 2005 1,999 4,773 Owned 10318 Gravelly Lake Dr. SW Lakewood, WA 98499 Everett Office, Snohomish Commercial Center and Snohomish Mortgage Center.............................. 2006 6,441 16,000 Owned 9929 Evergreen Way Everett, WA 98204 Whatcom Commercial Center........... 2003 336 5,200 Leased 2211 Rimland Drive, Suite 230 Bellingham, WA 98226 ----------- (1) Opened in June 2007. At March 31, 2008, the aggregate book value of the Corporation's premises and equipment was $27.8 million. 34 Item 3. Legal Proceedings -------------------------- Neither the Corporation nor the Bank is engaged in any legal proceedings of a material nature at the present time. From time to time the Bank is a party to legal proceedings wherein it enforces its security interest in loans made by it. Item 4. Submission of Matters to a Vote of Security Holders ------------------------------------------------------------- Not applicable. PART II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters --------------------------------------------------------------------------- and Issuer Purchases of Equity Securities ----------------------------------------- Horizon Financial's common stock is traded on the NASDAQ Global Select Market under the symbol HRZB. The following table presents the high and low sales prices as reported by the NASDAQ and dividends paid for the last two fiscal years. All share prices shown below are adjusted for the 5-for-4 stock split, paid in the form of a stock dividend in October 2006. The Corporation has approximately 4,500 stockholders. 2008 Fiscal Year Quarter High Low Dividend ------------------ ------ ------ -------- Fourth $17.46 $11.68 $0.135 Third 22.00 15.12 0.135 Second 22.98 17.85 0.130 First 23.87 20.49 0.130 2007 Fiscal Year Quarter High Low Dividend ------------------ ------ ------ -------- Fourth $25.00 $20.47 $0.125 Third 25.90 22.24 0.125 Second 25.84 19.46 0.125 First 21.94 16.25 0.120 Dividend Policy --------------- Horizon Financial historically has paid cash dividends on its common stock. The Corporation must adhere to certain regulatory requirements governing the distribution of dividends, and there can be no assurance that the Corporation will continue to declare cash dividends in the future. See "Business -- Regulation and Supervision" in Item 1 of this Form 10-K for additional information regarding dividend restrictions. Stock Repurchases ----------------- The Corporation has conducted various stock buy-back programs since August 1996. In March 2006, the Board of Directors approved a stock repurchase program that continued through the 2007 fiscal year, allowing the Corporation to repurchase up to 5% of total shares outstanding, or approximately 625,000 shares, adjusted for the 5-for-4 stock split paid in the form of a 25% stock dividend in October 2006. This marked the Corporation's seventh stock repurchase program. During the year ended March 31, 2008, the Corporation repurchased 399,700 shares at an average price of $17.62. On March 27,2008, the Board of Directors authorized the repurchase of 300,000 shares, or approximately 2.5% of the Corporation's outstanding shares of common stock for a 12 month period. 35 The following table sets forth the Corporation's repurchases of its outstanding common stock during the fourth quarter of the year ended March 31, 2008. Issuer Purchases of Equity Securities --------------------------------------------------------- (d) Maximum (c) Number (or Total Number Approximate of Shares Dollar Value) (or Units) of Shares (or (a) Purchased as Units) that May Total (b) Part of Yet to Be Number of Average Publicly Purchased Shares (or Price Paid Announced Under the Units) per Share Plans or Plans or Period Purchased (or Unit) Programs Programs ------------------ ----------- ---------- ------------ -------------- January 1, 2008 - January 31, 2008.. 53,600 $13.749 334,000(1) 266,000 February 1, 2008 - February 29, 2008. 28,700 14.190 362,700(1) 237,300 March 1, 2008 - March 31, 2008.... 37,000 12.622 399,700(1) 200,300 ----------- ---------- ------------ -------------- Total............... 119,300 $13.506 399,700(1) 300,000(2) =========== ========== ============ ============== ----------- (1) Reflects purchases made under the repurchase plan authorized by the Board of Directors in March 2007. This program expired on March 31, 2008. (2) Reflects new repurchase plan authorized by the Board of Directors in March 2008. The fiscal 2007 repurchase plan authorized by the Board of Directors expired on March 31, 2008 with 200,300 shares remaining unpurchased. Equity Compensation Plan Information The equity compensation plan information presented under subparagraph (d) in Part III, Item 12 of this report is incorporated herein by reference. 36 Performance Graph. The following graph compares the cumulative total shareholder return on the Corporation's Common Stock with the cumulative total return on the NASDAQ Index and the SNL Western Bank Index which encompasses ten western states. Total return assumes reinvestment of all dividends. [GRAPH APPEARS HERE] Period Ending ---------------------------------------------------------- Index* 03/31/03 03/31/04 03/31/05 03/31/06 03/31/07 03/31/08 ------------------ -------- -------- -------- -------- -------- -------- Horizon Financial Corp. 100.00 126.85 132.79 185.66 204.85 131.53 NASDAQ - Composite 100.00 148.69 149.07 174.46 180.56 169.93 SNL Western Bank Index 100.00 136.89 149.88 169.24 180.14 148.66 *Source: SNL Financial LC, Charlottesville, VA Used with permission. All rights reserved. 37 Item 6. Selected Financial Data -------------------------------- The following table sets forth certain information concerning the financial position of the Corporation at and for the dates indicated. At March 31, ------------------------------------------------------ 2008 2007 2006 2005 2004 --------- ---------- ---------- -------- --------- (In thousands) Financial Condition Data: ------------------------ Total Assets........$1,392,178 $1,270,327 $1,116,728 $997,570 $858,876 Loans Receivable, net................ 1,191,478 1,054,870 918,510 804,981 658,226 Cash and Investment Securities........ 114,562 133,075 125,216 125,966 161,071 Deposits............ 1,038,792 975,295 834,299 746,849 670,259 Borrowings.......... 214,791 158,958 159,837 135,787 67,469 Stockholders' Equity............ 128,317 123,855 113,323 107,024 109,307 Year Ended March 31, ------------------------------------------------------ 2008 2007 2006 2005 2004 --------- ---------- ---------- -------- --------- (In thousands, except per share information) Operating Data: -------------- Interest Income..... $100,243 $92,600 $69,388 $52,182 $48,979 Interest Expense.... (46,645) (40,133) (24,896) (16,144) (15,509) Net Interest Income. 53,598 52,467 44,492 36,038 33,470 Provision for Loan Losses............ (4,100) (1,850) (2,575) (1,700) (1,915) Noninterest Income.. 7,044 5,838 5,411 5,713 7,415 Noninterest Expense. (29,180) (27,861) (24,770) (21,619) (19,772) Income before Provision for Income Taxes...... 27,362 28,594 22,558 18,432 19,198 Provision for Income Taxes...... (8,949) (9,566) (6,903) (5,369) (6,332) Net Income.......... $18,413 $19,028 $15,655 $13,063 $12,866 Per Common Share:(1) Fully-diluted earnings........ $1.51 $1.53 $1.25 $1.01 $0.96 Dividends......... 0.530 0.495 0.456 0.424 0.392 Book Value........ 10.79 10.11 9.16 8.53 8.40 Weighted average shares out- standing........12,196,783 12,409,092 12,542,845 12,952,542 13,357,556 ---------- (1) Restated for the 5-for-4 stock split paid in the form of a 25% stock dividend distributed on October 23, 2006. 38 Key Operating Ratios: -------------------- The table below sets forth certain performance ratios of the Corporation for the periods indicated. These ratios are calculated based on month end balances. At and for the Year Ended March 31, ----------------------- 2008 2007 2006 ---- ---- ---- Return on average assets (net income divided by average total assets)....................... 1.37% 1.57% 1.48% Return on average equity (net income divided by average equity)............................. 14.53 16.11 14.32 Dividend payout ratio (dividends declared per share divided by fully-diluted earnings per share)............................ 35.10 32.35 36.54 Equity to assets ratio (average equity divided by average total assets)............... 9.22 9.74 10.35 Interest rate spread (difference between average yield on interest-earning assets and average cost of interest bearing liabilities).. 4.24 4.60 4.54 Net yield on earning assets (net interest income as a percentage of average interest earning assets)................................ 4.37 4.73 4.66 Efficiency ratio (noninterest expense divided by the sum of net interest income and noninterest income)............................ 48.12 47.79 49.64 Non-performing loans ratio (non-performing loans divided by net loans).................... 0.97% 0.02% 0.13% Non-performing asset ratio (non-performing assets divided by total assets)................ 0.88% 0.07% 0.10% Item 7. Management's Discussion and Analysis of Financial Condition and ------------------------------------------------------------------------ Results of Operations --------------------- The following discussion is intended to assist in understanding the financial condition and results of operations of the Corporation and the Bank. The information contained in this section should be read in conjunction with the Consolidated Financial Statements and the accompanying Notes contained in Item 8 of this Form 10-K. Forward Looking Statements -------------------------- Management's Discussion and Analysis of Financial Condition and Results of Operations and this Form 10-K contain certain forward-looking statements which are based on assumptions and describe future plans, strategies and expectations of the Corporation. Management desires to take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and is including this statement for the express purpose of availing the Corporation of the protections of the safe harbor with respect to all forward-looking statements in this Form 10-K. These forward-looking statements are generally identified by use of the words "believe," expect," "intend," "anticipate," "estimate," "project," or similar words. The Corporation's ability to predict results of the actual effect of future plans or strategies is uncertain. Factors which could have a material adverse effect on the Corporation's operations include, but are not limited to, changes in interest rates, general economic conditions, legislative/regulatory changes, monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the loan or investment portfolios, increase in the housing supply in our market area, demand for loan products, deposit flows, competition, demand for financial services in the Corporation's market areas and 39 accounting principles and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and you should not rely too much on these statements. General ------- The Corporation's results of operations depend primarily on revenue generated as a result of its net interest income and non-interest income. Net interest income is the difference between the interest income the Corporation earns on its interest-earning assets (consisting primarily of loans and investment securities) and the interest the Corporation pays on its interest-bearing liabilities (consisting primarily of customer savings and money market accounts, time deposits and borrowings). Non-interest income consists primarily of service charges on deposit and loan accounts, gains on the sale of loans and investments, and loan servicing fees. The Corporation's results of operations are also affected by the provisions for loan losses and other expenses. Other expenses consist primarily of noninterest expense, including compensation and benefits, occupancy, equipment, data processing, marketing, automated teller machine costs and, when applicable, deposit insurance premiums. The Corporation's results of operations may also be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities, as well as other factors identified under the caption "Forward Looking Statements" above. Business Strategy ----------------- The Bank's business strategy is to operate as a well-capitalized, profitable and independent community bank, dedicated to commercial lending, home mortgage lending, consumer lending, small business lending and providing quality financial services to local personal and business customers. The Bank has sought to implement this strategy by: (i) focusing on commercial banking opportunities; (ii) continued efforts towards the origination of residential mortgage loans, including one-to-four family residential construction and land development loans; (iii) providing high quality, personalized financial services to individuals and business customers and communities served by its branch network; (iv) selling many of its fixed rate mortgages to the secondary market; (v) focusing on asset quality; (vi) containing operating expenses; and (vii) maintaining capital in excess of regulatory requirements combined with prudent growth. Operating Strategy ------------------ The Corporation serves as a holding company for the Bank and other subsidiaries whereby it provides strategic oversight, management, access to capital and other resources and activities typically performed by bank holding companies. The operating strategy of the Corporation has been to expand and diversify its consolidated operations across a variety of companies and/or operating units that are engaged in complementary, but different, businesses and/or operating strategies. This diversification strategy is expected to continue as opportunities arise, although there are no specific acquisitions or new business formations planned at this time. The Bank currently has two offices in Pierce County (south of King County), with the remaining offices all located north of King County. Management has further indicated that the market areas just outside King County (including, but not necessarily limited to Snohomish, Pierce, Kitsap and Thurston counties) are logical areas for potential future expansion, as these markets have characteristics most similar to those in which the Bank has experienced previous success. The primary business of the Bank is to acquire funds in the form of deposits and wholesale funds, and to use the funds to make commercial, consumer, and real estate loans in its primary market area. In addition, and to a lesser extent, the Bank invests in a variety of investment grade securities including, but not necessarily limited to U.S. Government and federal agency obligations, mortgage-backed securities, corporate debt, equity securities, and municipal securities. The Bank intends to continue to fund its assets primarily with retail and commercial deposits, although, FHLB advances, brokered deposits, and other wholesale borrowings, will also likely be used as a supplemental source of funds. The Corporation's profitability depends primarily on its net interest income, which is the difference between the income it receives on the Bank's loan and investment portfolio and the Bank's cost of funds, which consists of interest paid on deposits and borrowings. The Bank reviews its opportunities with respect to both assets and liabilities. In the past two fiscal years, for example, the Bank chose to concentrate its commercial lending efforts on growing its Prime 40 based loan portfolio, at a time when many lenders were offering fixed rate real estate loans at sub-Prime rates. In this regard, the Bank's loan portfolio growth is heavily concentrated in the active real estate development and construction markets in the Puget Sound region. Through its relationships with established real estate developers and builders, the Bank's experienced loan officers were successful at growing this portion of the Bank's portfolio, which is primarily Prime based business. This was beneficial in previous years, with the FOMC's (Federal Reserve's Open Market Committee) efforts to increase short terms interest rates, which have in turn increased the Prime lending rate. With the FOMC's 50 basis point reduction on September 18, 2007, 25 basis point reduction on October 31, 2007, 25 basis point reduction on December 11, 2007, 125 basis point reduction in January 2008 and 75 basis point reduction in March 2008, the Corporation is experiencing a decline in its net interest margin. This rapid pace of easing monetary policy by the FOMC will contribute to further declines in the Corporation's net interest margin. The results of this strategy are discussed in more detail in the section entitled "Comparison of Operating Results for the Years Ended March 31, 2008 and March 31, 2007 - Net Interest Income." On the liability side of the balance sheet, these changing rates also impact the Bank's earnings. Management acknowledges that there is a lag effect in this regard, in both increasing and decreasing rate environments as the rates on the Bank's certificate of deposit liabilities do not adjust instantly, rather the impact occurs more gradually as the certificates of deposit mature and reprice in a changing interest rate environment. Net interest income is also affected by the relative amounts of interest-earning assets and interest-bearing liabilities. When interest-earning assets equal or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. The Corporation's profitability is also affected by the level of the Bank's other income and expenses. Other noninterest income includes income associated with the origination and sale of mortgage loans, loan servicing fees, deposit account related fees, and net gains and losses on sales of interest-earning assets. This portion of the Bank's income is heavily dependent on the Bank's success at originating and selling one-to-four family mortgage loans into the secondary market. In addition, the Bank's ability to generate fee income on its deposit accounts impacts this portion of the Bank's income stream. In fiscal 2006, the Bank introduced an Overdraft Protection service, which increased the deposit related fee income and is discussed in more detail in the section entitled "Comparison of Operating Results for the Years Ended March 31, 2007 and March 31, 2006." Other noninterest expenses include compensation and benefits, occupancy and equipment expenses, deposit insurance premiums, data servicing expenses and other operating costs. In fiscal 2006, the Bank began a Bank-wide efficiency initiative, soliciting input from all employees and implementing many of the suggestions it received. This is an ongoing process, as management continues to look for ways to improve efficiency. To encourage employees to participate in this initiative, the Bank includes a profitability component to the incentive portion of the employee's pay, and efficiency accounts for one-third of this profitability component. Also during fiscal 2006, the Bank formed a Core Data Processor task team, to analyze ways to best utilize its new data processing system. At the time of conversion in November 2004, the focus was appropriately placed on converting the data from the previous system. Subsequently, the focus shifted to ensuring that the Bank was taking advantage of the benefits offered by the new system, and this is a process that will continue in future years along with the efficiency initiative discussed above. Finally, the Corporation's results of operations are also significantly affected by general economic and competitive conditions, particularly changes in market interest rates, government legislation, regulation, and monetary and fiscal policies. Critical Accounting Estimates ----------------------------- Management recognizes that loan losses occur over the life of a loan, and that the allowance for loan losses must be maintained at a level sufficient to absorb probable losses inherent in the loan portfolio. Management's determination of the allowance is based on a number of factors, including the level of non-performing loans, loan loss experience, credit concentrations, reviews of the quality of the loan portfolio, collateral values, historical industry loss experience, and uncertainties in economic conditions. The allowance is increased by the provision for loan losses, which is charged against current period operating results and decreased by the amount of actual loan charge-offs, net of recoveries. Management believes that the accounting estimate related to the allowance for loan losses is a "critical accounting estimate" because: (i) it is highly susceptible to change from period to period because it requires management 41 to make assumptions about future losses on loans; and (ii) the impact of a sudden large loss could deplete the allowance and potentially require increased provisions to replenish the allowance, which would negatively affect earnings. The Corporation has an active ongoing credit review function. The allowance for loan losses is maintained at a level sufficient to provide for estimated, probable loan losses based on evaluating known and inherent risks in the loan portfolio. These factors include changes in the size and composition of the loan portfolio, actual loan loss experience, historical industry loss experience, current and anticipated economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. The reserve is based upon factors and trends identified by management at the time financial statements are prepared, but the ultimate recovery of loans is susceptible to future market factors beyond the Bank's control, which may result in losses or recoveries differing significantly from those provided for in the financial statements. Management believes the Bank maintains an allowance for credit losses sufficient to absorb losses inherent in the loan portfolio. The Bank has established a systematic methodology to assist management in evaluating the adequacy of the allowance, and continues to work on enhancing its methodologies in this regard. As required by SFAS No. 114, Accounting by Creditors for Impairment of a Loan, each individual loan, previously classified by management, or newly classified during the quarterly review, is evaluated for loss potential, and a specific amount or percentage deemed to be at risk is added to the overall required reserve amount. For the remaining portion of the portfolio the Bank applies SFAS No. 5, Accounting for Contingencies. Reserve factors are applied to homogeneous loan pools which are consistent with the Bank's experience in that loan pool type or with industry guidelines if management believes such guidelines are more appropriate. The applied percentage is also influenced by other economic factors in the Bank's market area, the state's economy, and national economic factors that could influence the quality of the loan portfolio in general. The calculated amount is compared to the actual amount recorded in the allowance at the end of each quarter and a determination is made as to whether the allowance is adequate. Management increases the amount of the allowance for loan losses by charges to income and decreases the amount by loans charged off (net of recoveries). The Corporation's senior management reviews and analyzes the loan portfolio, charge-offs, and allowance on a quarterly basis. Management then discusses the development and calculation of this critical accounting estimate with the executive committee of the Board of Directors. Horizon's audit committee also reviews the Corporation's disclosures including this critical accounting estimate. Management reviewed and evaluated the loan portfolio and the adequacy of the allowance at March 31, 2008 and believes that the allowance at 1.60% of net loans, or $19.1 million is adequate for the risk inherent in the loan portfolio and the current economic environment. The allowance was 1.51% of net loans or $15.9 million at March 31, 2007. In fiscal 2008, the loan portfolio grew 12.9% to $1.2 billion at March 31, 2008 from $1.1 billion at March 31, 2007. The loan portfolio has experienced substantial growth especially in construction and land development loans. At March 31, 2008, construction and land development loans totaled $486.5 million, an increase of $81.2 million or 20% from $405.3 million at March 31, 2007. The increase in the allowance is primarily attributable to the substantial growth in this higher risk portion of the loan portfolio. The Bank's Allowance for Loan and Lease Losses ("ALLL") analysis also considered the potential impacts of sub-prime loans originated by others in the Bank's markets in recent years. These loans are cited as contributing to the slowdowns in the housing markets across the country. As homeowner's face significant increases in their housing payments when these sub-prime loans reset, this will have potential adverse affects on the economy with an increasing supply of housing units on the market. It is predicted that these adverse impacts will result in increased numbers of houses listed for sale (for those facing unaffordable increases in their monthly housing payments), a decline in prices and it will also likely increase the number of foreclosures on residential units. Economic data from the Federal Reserve showed a slowdown in overall economic activity in recent quarters. Economic conditions in the region remain do remain stronger than reported national trends, however we continue to see increasing signs of a slowing housing market, including increasing inventories and overall slower sales activity. We are seeing a slowdown in our land acquisition and development progress and are closely watching a number of relationships. 42 The Bank's loan portfolio showed increasing signs of strain at March 31, 2008. During the fiscal year ended March 31, 2008, it was necessary to recognize $875,000 in writeoffs relating primarily to two of the Bank's builder/developer relationships. In addition, the loans relating to these writeoffs were placed on non-accrual status, bringing our total non-accruing loans to $11.6 million at March 31, 2008 compared to $226,000 at March 31, 2007. This brings the Bank's total non-performing assets/total assets ratio to 0.88% at March 31, 2008 compared to 0.07% at March 31, 2007. In addition, the Bank's delinquency levels (loans 30 to 89 days past due) totaled $30.6 million at March 31, 2008 compared to $3.0 million at March 31, 2007. The factors discussed above led management to increase the allowance to its current levels. The Bank recorded net charge-offs of $875,000 and $145,000, during the years ended March 31, 2008 and 2007. The provision for loan losses has fluctuated depending on the growth and mix of the loan portfolio and the level of charge-offs. The provision for loan losses was $4.1 million, $1.9 million and $2.6 million for the fiscal years ended 2008, 2007 and 2006, respectively. Critical Accounting Policies ---------------------------- The Corporation's significant accounting principles are described in Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K and are essential to understanding Management's Discussion and Analysis of Financial Condition and Results of Operations. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions which affect the reported amounts and disclosures. Actual results may differ from these estimates under different assumptions or conditions. The following policies involve a higher degree of judgment than do our other significant accounting policies detailed in Note 1 of the Notes to Consolidated Financial Statements. Allowance for Loan Losses. The Corporation reviews historical origination and charge-off relationships, charge-off experience factors, collection data, delinquency reports, estimates of the value of the underlying collateral, economic conditions and trends and other information in order to make the necessary judgments as to the appropriateness of the provision for loan losses and the allowance for loan losses. Loans are charged-off to the allowance for loan losses when the Corporation repossesses and disposes of the collateral or the account is otherwise deemed uncollectible. The Corporation believes that the allowance for loan losses is adequate yet not excessive to cover probable losses inherent in its loan portfolio; however, because the allowance for loan losses is based on estimates, there can be no assurance that the ultimate charge-off amount will not exceed such estimates. Investments. The Corporation classifies its investments as either available-for-sale or held-to-maturity. Available for sale securities are reported at their fair value, which is determined by obtaining quoted market prices. Unrealized gains and losses on available for sale securities are included in other comprehensive income and excluded from earnings. Realized gains and losses and declines in fair value determined to be other than temporary are included in earnings. The fair value of investments is discussed in more detail in Notes 3 and 4 of the Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K. Long-Lived Assets and Intangibles. The Corporation periodically assesses the impairment of its long-lived assets and intangibles using judgment as to the effects of external factors, including market conditions. If actual external conditions and future operating results differ from the Corporation's judgments, impairment charges may be necessary to reduce the carrying value of these assets to the appropriate market value. Accrued Taxes. The Corporation estimates tax expense based on the amount it expects to owe various tax authorities. Taxes are discussed in more detail in Note 10 of the Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K. Accrued taxes represent the net estimated amount due or to be received from taxing authorities. In estimating accrued taxes, management assesses the relative merits and risks of the appropriate tax 43 treatment of transactions taking into account statutory, judicial and regulatory guidance in the context of the Corporation's tax position. Comparison of Financial Condition at March 31, 2008 and March 31, 2007 ---------------------------------------------------------------------- Total consolidated assets for the Corporation as of March 31, 2008, were $1.4 billion, a 9.6% increase from the March 31, 2007 level of $1.3 billion. This increase in assets was primarily attributable to the growth in loans receivable to $1.2 billion at March 31, 2008 from $1.1 billion at March 31, 2007. The growth in loans receivable was primarily attributable to a $81.2 million, or 20.0%, increase in construction and land development loans since March 31, 2007. The Bank continued its focus on expanding its relationships with established residential real estate developers and one-to-four family residential builders, which resulted in the continued growth in this component of loans receivable during the period. Also contributing to this increase is a slowing pace of loan paydowns in this category, as the sales activity has slowed compared to previous periods. This has resulted in loan balances remaining on the Corporation's balance sheet longer than in more active periods for real estate sales. Also increasing during the period was the commercial loan category, as the Bank continues to focus on increasing its commercial lines of credit balances to diversify its loan portfolio and expand its relationships with businesses in its markets. Commercial real estate loans, primarily consisting of loans with initial fixed rate periods of three to five years, moderated during the period as the Bank continued its trend away from the lower returns available in this segment in favor of the returns available in the construction and land development category. One-to-four family mortgage loans, net increased 18.6% to $146.9 million at March 31, 2008 from $123.9 million at March 31, 2007. A portion of the growth, approximately $16.2 million, is related to loans secured by one- to-four family homes where builders were allowed to convert unsold speculative construction inventory into rental homes to assist with cash flow needs. The Bank continues its practice of selling most of its single-family long term fixed rate loan production into the secondary market. The Bank sold $79.9 million of real estate loans during fiscal year ended March 31, 2008, compared to $83.0 million during the fiscal year ended March 31, 2007. The following is an analysis of the loan portfolio by major type of loan at March 31, 2008 and 2007. At March 31, ----------------------------------- 2008 2007 --------- --------- (Dollars in thousands) First mortgage loans: One-to-four family ................... $165,824 13.7% $149,885 14.0% One-to-four family construction....... 35,303 2.9 28,576 2.7 Less participations sold.............. (54,269) (4.5) (54,592) (5.1) --------- ----- --------- ----- Subtotal......................... 146,858 12.1 123,869 11.6 Commercial land development........... 178,726 14.8 173,270 16.1 Commercial construction............... 307,809 25.4 232,078 21.7 Multi-family residential.............. 45,049 3.7 52,727 4.9 Nonresidential commercial real estate.............................. 300,109 24.8 292,212 27.3 Commercial loans...................... 177,685 14.7 146,265 13.7 Home equity secured................... 47,351 3.9 45,307 4.2 Other consumer loans.................. 7,005 0.6 5,031 0.5 --------- ----- --------- ----- Subtotal......................... 1,063,734 87.9 946,890 88.4 --------- ----- --------- ----- Total loans receivable........... 1,210,592 100.0% 1,070,759 100.0% --------- ----- --------- ----- (table continued on following page) 44 At March 31, ----------------------------------- 2008 2007 --------- --------- Less: Allowance for loan losses............ (19,114) (15,889) ---------- ---------- Total loans receivable, net.... $1,191,478 $1,054,870 ========== ========== Net residential loans.................. $ 145,565 12.2% $ 122,839 11.7% Net commercial loans................... 174,263 14.6 143,604 13.6 Net commercial real estate loans (1)... 818,215 68.7 738,861 70.0 Net consumer loans (2)................. 53,435 4.5 49,566 4.7 ---------- ----- ---------- ----- $1,191,478 100.0% $1,054,870 100.0% ========== ===== ========== ===== ------- (1) Includes construction and development, multi-family and commercial real estate loans. (2) Includes home equity and other consumer loans. As reflected in the table above, approximately 70% of our total loan portfolio consists of commercial real estate and construction and land development loans. These types of lending afford the Bank an opportunity to receive interest at rates higher than those generally available from one-to-four family residential lending. These loans, however, also typically are greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater degree of risk than single family residential mortgage loans. Because payments on loans secured by commercial real estate often depend upon 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 limiting the maximum loan-to-value ratio to between 75 and 85% and carefully reviewing the financial condition of the borrower, the quality of the collateral and the management of the property securing the loan. Construction and land development lending generally involves a higher degree of risk than permanent financing for a finished residence or commercial building, because of the inherent difficulty in estimating both the estimated cost of the project and the property's value at completion. If the estimated cost of construction proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to complete the project. To address this risk, and because of the level of construction loans in the Bank's portfolio, the Bank has personnel dedicated specifically to monitoring the progress of its construction projects, and making on-site inspections of the properties. In addition, in an effort to monitor the available inventory in its markets, the Bank also regularly reviews the overall building and development activity in its markets. Also, to mitigate the risks related to construction lending, the Bank primarily deals with experienced builders, with acceptable credit histories, sound financial statements, and a proven track record in the industry. In addition, the Bank utilizes the services of experienced inspectors to monitor the progress and draw process in the more complex construction projects. The Bank also has an experienced appraisal staff, and members of senior management with related appraisal education and experience, who regularly review the appraisals utilized by the Bank in analyzing prospective construction projects. Finally, members of the Bank's senior management and loan committees also have a significant amount of experience in the areas of construction lending, appraisals, and loan underwriting, further mitigating the Bank's risk in this area. However, even with strong underwriting, changing economic conditions can have an adverse impact on the Bank's borrowers and on the Bank's loan portfolio. See the Asset Quality section below for details on the Bank's non-performing assets and comments regarding identified potential weaknesses in its loan portfolio. The Bank actively originates construction loans through its Mortgage Loan Division and its Commercial Loan Division. The Bank's Mortgage Loan Division generally oversees the single family custom construction loans, and to a lesser extent, speculative construction loans (i.e., loans for homes that do not have a contract with a buyer for the purchase of the home upon completion of the construction) to smaller contractors building a limited number of speculative homes per year. These construction loans are further broken down in the first two lines of the table below (speculative construction one-to-four family and custom construction one-to-four family). The Bank's Commercial Lending Division is responsible for the speculative construction projects for the Bank's larger builders (including large 45 one-to-four family developments), in addition to the Bank's multi-family construction loans, non-residential commercial construction loans, and the Bank's land development loans. The following table is provided to show additional details on the Corporation's construction and land development loan portfolio: At March 31, 2008 At March 31, 2007 ------------------- -------------------- Amount Percent Amount Percent ------ ------- ------ ------- (Dollars in thousands) Speculative construction one-to-four family........... $27,206 5.2% $16,597 3.8% Custom construction one- four-family.................. 8,097 1.6 11,979 2.8 -------- ----- -------- ----- Total one-to-four family... 35,303 6.8 28,576 6.6 Commercial speculative construction one-to-four family....................... 236,536 45.3 177,602 40.9 Commercial construction multi-family................. 11,732 2.2 6,986 1.6 Commercial construction non-residential.............. 59,541 11.4 47,490 11.0 Land development............... 178,726 34.3 173,270 39.9 -------- ----- -------- ----- Total construction and land development......... 486,535 93.2 405,348 93.4 -------- ----- -------- ----- Total construction loans... $521,838 100.0% $433,924 100.0% ======== ===== ======== ===== The tables below display the characteristics of the available for sale and held to maturity portfolios at March 31, 2008: At March 31, 2008 --------------------------------------- Unrealized Amortized Gain/ Estimated Cost (Loss) Fair Value --------- ---------- ---------- (In thousands) Available For Sale Securities State and political subdivisions and U.S. government agency securities ...................... $33,107 $ 572 $33,679 Marketable equity securities...... 569 2,194 2,763 Mutual funds...................... 5,000 (201) 4,799 Mortgage-backed securities and CMOs......................... 38,646 454 39,100 ------- ------ ------- Total available-for-sale securities.................. 77,322 3,019 80,341 Held To Maturity Securities State and political subdivisions and U.S. government agency securities....................... -- -- -- Mortgage-backed securities and CMOs......................... 30 5 35 ------- ------ ------- Total held to maturity securities.................. 30 5 35 ------- ------ ------- Total securities.............. $77,352 $3,024 $80,376 ======= ====== ======= 46 Maturity Schedule of Securities at March 31, 2008 ---------------------------------------------- Available For Sale Held To Maturity --------------------- --------------------- Amortized Estimated Amortized Estimated Cost Fair Value Cost Fair Value ---- ---------- ---- ---------- (In thousands) Maturities: Less than one year.......... $ 6,726 $ 6,760 $ 7 $ 7 Over one year to five years..................... 12,745 13,159 12 12 Over five to ten years...... 21,531 21,828 3 6 Over ten years.............. 30,751 31,032 8 10 ------- ------- --- --- 71,753 72,779 30 35 Mutual funds and marketable equity securities........... 5,569 7,562 -- -- ------- ------- --- --- Total investment securities............... $77,322 $80,341 $30 $35 ======= ======= === === Total liabilities also increased 10.2% to $1.3 billion at March 31, 2008, from $1.1 billion at March 31, 2007. This increase in liabilities was primarily the result of growth in other borrowed funds, which increased 38.7% to $192.3 million at March 31, 2008 from $138.7 million at March 31, 2007. During the fiscal year ended March 31, 2008 the Bank borrowed an additional $48.5 million from the FHLB to support asset growth and help manage interest rate risk. Also contributing to the growth in liabilities during the fiscal year ended March 31, 2008 was the growth in the balance of deposits, which increased 6.5% to $1.04 billion at March 31, 2008 from $975.3 million at March 31, 2007. The following is an analysis of the deposit portfolio by major type of deposit at March 31, 2008 and 2007: At March 31, ----------------------- 2008 2007 ---------- ---------- (In thousands) Demand Deposits Savings............................ $ 17,933 $ 21,628 Checking........................... 72,434 78,294 Checking (noninterest-bearing)..... 70,438 91,703 Money Market....................... 183,063 187,912 ---------- ---------- 343,868 379,537 ---------- ---------- Time certificates of deposit Less than $100,000................. 286,657 273,022 Greater than or equal to $100,000 . 287,281 243,346 Brokered certificates of deposit... 120,986 79,390 ---------- ---------- Total certificates of deposit........ 694,924 595,758 ---------- ---------- Total deposits..................... $1,038,792 $ 975,295 ========== ========== Also included in the March 31, 2008 balance sheet is an investment in real estate for a joint venture and the corresponding borrowing. During the year ended March 31, 2005, the Bank's subsidiary (Westward Financial Services), as a 50% partner in the Greenbriar NW LLP ("GBNW"), purchased an 85 acre parcel of land in Bellingham, Washington for future residential development. GBNW intends to develop the property in future years, into a neighborhood community to be known as Fairhaven Highlands. The $17.6 million shown on the Corporation's balance sheet as an asset at March 31, 2008 represents the current level of the investment in real estate joint ventures, including the Fairhaven Highlands joint venture. This amount also includes the remaining net investment in other residential development joint ventures. The $22.4 million shown in the liability section of the balance sheet represents the corresponding wholesale borrowing used to fund the investment in the Fairhaven Highlands joint venture, which includes costs that have been 47 incurred and capitalized since the acquisition of the property. At this time, the partnership is in the process of meeting with the appropriate public and private entities, in its preliminary planning efforts relating to the future development of the property, including an Environmental Impact Statement which is currently in the process of being completed. Stockholders' equity at March 31, 2008 increased 3.6% to $128.3 million from $123.9 million at March 31, 2007. This increase was primarily attributable to net income of $18.4 million for the year ended March 31, 2008 partially offset by the effects of $6.4 million in dividends paid to stockholders and the Corporation's share repurchase program. The Corporation repurchased shares totaling $7.1 million during the year ended March 31, 2008 compared to $2.9 million for the year ended March 31, 2007. The Corporation remains strong in terms of its capital position, with a stockholder equity- to-assets ratio of 9.2% at March 31, 2008, compared to 9.8% at March 31, 2007. Comparison of Operating Results for the Years Ended March 31, 2008 and March ---------------------------------------------------------------------------- 31, 2007 -------- Net Interest Income. Net interest income in fiscal 2008 was $53.6 million, a 2.2% increase from $52.5 million in fiscal 2007. Total interest income increased 8.3% in fiscal 2008 to $100.2 million from $92.6 million in fiscal 2007. Interest income on loans in fiscal 2008 was $96.3 million, an 8.7% increase from $88.6 million in fiscal 2007. The increase in fiscal 2008 was primarily a result of the growth in loans receivable, as the Bank experienced significant loan growth during the year, increasing the loan portfolio to $1.2 billion at March 31, 2008, compared to $1.1 billion at March 31, 2007. Also included in interest income for the year ended March 31, 2008 and 2007 were approximately $5.1 million and $4.8 million, respectively, of deferred fee income recognition. Most of these fees were related to the Bank's commercial loan portfolio for the years ended March 31, 2008 and 2007, which resulted in large part from the success in increasing the real estate development loan portfolio. These development loans typically are shorter term in nature, so the deferred fee recognition during the life of the loan is greater than what would be recognized for a comparable loan fee on a longer amortizing loan. The table below presents an analysis of deferred fee recognition for the past two fiscal years: Year Ended March 31, -------------------- 2008 2007 ------- ------- (In thousands) Commercial loan deferred fees........... $ 4,240 $ 4,076 One-to-four real estate mortgage loan deferred fees.................... 854 684 ------- ------- Total............................... $ 5,094 $ 4,760 ======= ======= Interest and dividends on investments and mortgage-backed securities remained relatively unchanged at $3.9 million in fiscal 2008, compared to $4.0 million in fiscal 2007. Total interest expense in fiscal 2008 increased 16.2% to $46.6 million from $40.1 million in fiscal 2007. Interest on deposits increased significantly to $38.1 million in fiscal 2008 from $32.3 million in fiscal 2007, as a result of increased growth in average deposits outstanding to $992.9 million compared to $906.0 million at March 31, 2007. Also contributing to the increase was the higher level of interest rates paid during much of the year ended March 31, 2008 compared to the previous period. At March 31, 2008, approximately 67% of the Bank's deposits were in the form of certificates of deposit, including $121.0 million in brokered certificates of deposit. While management continues its efforts to increase core deposits as a funding source, the competitive marketplace for core deposit dollars has resulted in limited success in this regard. Interest on borrowings increased to $8.6 million in fiscal 2008 from $7.9 million in fiscal 2007. The increase was a result of a higher level of average borrowings outstanding during the year ended March 31, 2008 of $193.3 million 48 compared to $166.3 million during the year ended March 31, 2007. The Bank continues to utilize wholesale borrowings in order to further leverage its balance sheet and better manage its interest rate risk profile. Provision for Loan Losses. Provisions for loan losses are charges to earnings to bring the total allowance for loan losses to a level considered by management as adequate to provide for known and inherent risks in the loan portfolio, based on management's continuing analysis of factors underlying the quality of the loan portfolio at the time the financial statements are prepared. These factors include changes in portfolio size and composition, actual loss experience, current economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. The ultimate recovery of loans is susceptible to future market factors beyond the Corporation's control, which may result in losses or recoveries differing significantly from those provided for in the financial statements. The following table summarizes the allowance for loan losses, charge-offs, and loan recoveries: Year Ended March 31, -------------------- 2008 2007 ------- ------- (Dollars in thousands) Allowance at beginning of period...... $15,889 $ 14,184 Provision for loan losses............. 4,100 1,850 Charge offs, net of recoveries........ (875) (145) ------- -------- Allowance at end of period............ $19,114 $ 15,889 ======= ======== Allowance for loan losses as a percentage of net loans receivable at the end of the period............ 1.60% 1.51% Net charge-offs as a percentage of average loans outstanding during the period................... 0.08% 0.01% Allowance for loan losses as a percentage of nonperforming assets at the end of period................ 155.87% 1,670.06% The allowance for loan losses is established as losses are estimated to have occurred through the provision for loan losses charged to earnings. Loan losses are charges against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. The provision for loan losses was $4.1 million for the year ended March 31, 2008 compared to $1.9 million for the year ended March 31, 2007. These provisions reflect management's ongoing analysis of changes in loan portfolio composition by collateral categories, balances outstanding, overall credit quality of the portfolio, peer group analysis, historical industry loss experience, and current economic conditions. The allowance for loan losses was $19.1 million, or 1.60% of net loans receivable at March 31, 2008 compared to $15.9 million, or 1.51% of net loans receivable at March 31, 2007. The increased allowance level resulted from continued loan portfolio growth in the higher-risk lending categories of construction and land development, commercial real estate and commercial business loans during the period, which amounted to $992.5 million, or 83.3% of total loans receivable at March 31, 2008, versus $896.6 million, or 83.7% at March 31, 2007. Non-Performing Assets. As of March 31, 2008, there were no loans in the loan portfolio over 90 days delinquent and accruing and 13 loans on nonaccrual status. At March 31, 2008, total non-performing loans were $11.6 million. Non-performing assets grew significantly in the final quarter of our fiscal year. Two lending relationships contributed to the majority of the increase in our non-accrual figures, including a residential developer in Snohomish County with inventory consisting of 17 homes (four of which are in escrow with sales pending), eight residential building lots and one commercial development project for a 7.4 acre site in Monroe, Washington. The Bank had one property 49 in the real estate owned category totaling $655,000 at March 31, 2008. Total non-performing assets represented $12.3 million, or 0.88% of total assets at March 31, 2008 compared to $951,000 or 0.07% of total assets at March 31, 2007. The following table summarizes the Corporation's non-performing assets: At March 31, ------------------- 2008 2007 ---- ---- (Dollars in thousands) Non-Performing Assets Accruing loans 90 days past due.......... $ -- $ -- Non-accrual loans.......................... 11,608 226 Restructured loans......................... -- -- -------- -------- Total non-performing loans................ 11,608 226 Total non-performing loans/net loans...... 0.97% 0.02% Real estate owned.......................... 655 725 -------- -------- Total non-performing assets............... 12,263 951 -------- -------- Total non-performing assets/total assets . 0.88% 0.07% The majority of the Corporation's loan portfolio consists of commercial loans and single-family residential loans secured by real estate in the Whatcom, Skagit, Snohomish, and Pierce County areas of Washington. Economic conditions in the region remain relatively healthy (compared to national trends), however we are seeing increasing signs of a slowing housing market, including increasing inventories and overall slower sales activity. Construction and land development, commercial real estate and multi-family real estate loans have larger individual loan amounts, which have a greater single impact on the total portfolio quality in the event of delinquency or default. The Bank is closely watching the construction and land development loan portfolio, and believe there is a potential for significant additions to non-performing loans or real estate owned in the near future. The Corporation considers the allowance level to be appropriate, as a result of the changing portfolio mix and the current economic environment. While the Bank believes it has established its existing allowance for loan losses in accordance with accounting principles generally accepted in the United States, there can be no assurance that regulators, in reviewing the Bank's loan portfolio, will not request the Bank to significantly increase or decrease 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 elsewhere in this document. Any material increase in the allowance for loan losses may adversely affect the Bank's financial condition and results of operations. Noninterest Income. Noninterest income in fiscal 2008 increased to $7.0 million, from $5.8 million in fiscal 2007. Service fee income increased 10.0% to $3.6 million in fiscal 2008 from $3.3 million in fiscal 2007. The net gain on the sale of loans servicing released increased 2.5% to 848,000 in fiscal 2008, compared to $827,000 in fiscal 2007. Mortgage loan originations were strong in fiscal 2008, and the Bank continued its practice of selling most of its single-family long term fixed rate loan production into the secondary market. There was a net gain on sales of investment securities of $480,000 in fiscal 2008 compared to a net loss of $(10,000) in fiscal 2007. The gains in fiscal 2008 were primarily attributable to management's decision to sell selected equity securities from the Bank's investment portfolio. The losses in fiscal 2007 were a result of management's decisions to replace certain investment securities during the year in its efforts to improve future returns. Other noninterest income increased 12.5% to $1.9 million for the year ended March 31, 2008 from $1.7 million for the year ended March 31, 2007. The primary reason for the increase from the prior period was additional income related to the purchase of approximately $5.0 million of bank owned life insurance. 50 Noninterest Expense. Noninterest expense in fiscal 2008 increased to $29.2 million, a 4.7% increase from $27.9 million in fiscal 2007. Compensation and employee benefits increased slightly in fiscal 2008 to $16.6 million from $16.3 million in fiscal 2007. Building occupancy expense was $4.7 million in fiscal 2008, a 9.8% increase from $4.3 million in fiscal 2007. Increases in compensation and employee benefits and building and occupancy expenses resulted from the opening of a full service retail facility and mortgage loan center in Puyallup, Washington in June 2007. Other noninterest expenses increased 8.5% to $6.1 million in fiscal 2008 from $5.6 million in fiscal 2007 as a result of increased operating expenses related to the opening of the Bank's Puyallup retail office and loan center, consulting expenses, increased State of Washington Business & Occupation tax as a result of the growth in the loan portfolio of taxable commercial loans, as well as a valuation write-down of the Bank's other real estate owned of $70,000. Comparison of Operating Results for the Years Ended March 31, 2007 and March ---------------------------------------------------------------------------- 31, 2006 -------- Net Interest Income. Net interest income in fiscal 2007 was $52.5 million, a 17.9% increase from $44.5 million in fiscal 2006. Total interest income increased 33.5% in fiscal 2007 to $92.6 million from $69.4 million in fiscal 2006. Interest income on loans in fiscal 2007 was $88.6 million, a 34.5% increase from $65.9 million in fiscal 2006. The increase in fiscal 2007 was as a result of a combination of factors, including: 1) the growth in loans receivable, as the Bank experienced significant loan growth during the year, increasing to $1.1 billion at March 31, 2007, compared to $918.5 million at March 31, 2006; and 2) an increasing Prime lending rate throughout the fiscal year. With a portfolio of Prime based loans in excess of $450 million throughout the year ($605.5 million at March 31, 2007) each quarter point increase in the Prime lending rate equated to an annualized increase in interest income on those types of loans of over $1.0 million. The Prime lending rate increased to 8.25% in June 2006, where it remained at March 31, 2007, compared to 7.75% at March 31, 2006. Also included in interest income for the year ended March 31, 2007 and 2006 were approximately $4.8 million and $3.5 million, respectively, of deferred fee income recognition. In fiscal 2007 and 2006, most of these fees were related to the Bank's commercial loan portfolio, that resulted in large part from the success in increasing the real estate development loan portfolio. These development loans typically are shorter term in nature, so the deferred fee recognition during the life of the loan is greater than what would be recognized for a comparable loan fee on a longer amortizing loan. The table below presents an analysis of deferred fee recognition for the past two fiscal years: Year Ended March 31, --------------------- 2007 2006 ------- ------- (In thousands) Commercial loan deferred fees.............. $ 4,076 $ 2,960 One-to-four real estate mortgage loan deferred fees....................... 684 519 ------- ------- Total.................................. $ 4,760 $ 3,479 ======= ======= Interest and dividends on investments and mortgage-backed securities was $4.0 million in fiscal 2007, a 13.6% increase from $3.5 million in fiscal 2006. Contributing to this increase was the restructuring of approximately $13.0 million of the investment securities portfolio during the quarter ended March 31, 2006. The proceeds from those lower-yielding securities were reinvested in highly rated, higher-yielding investments. Also contributing to the change in fiscal 2007 was a reduction in dividend income on the Bank's FHLB stock. At March 31, 2007, Horizon Bank held $7.2 million in FHLB of Seattle stock and received dividends in the amounts of $14,500 in fiscal 2007 compared to $29,500 in fiscal 2006. The FHLB of Seattle has been operating under a regulatory directive since May 2005. In December 2006, the FHLB of Seattle announced that quarterly cash dividends would resume with payment of a cash dividend in December 2006. On January 29, 2007, the FHLB of Seattle declared a similar dividend ($0.10 per share), payable in February 2007. Subsequently, on May 2, 2007, the FHLB announced a cash dividend of $0.15 per share, payable May 18, 2007. The Bank's stock ownership in the FHLB of Seattle is expected to remain stable, increasing only 51 if necessary to support its borrowing needs. The FHLB of Seattle also revised its requirements related to borrowings outstanding and stock levels required to support borrowings, and, therefore, the Bank's existing level of FHLB stock will support a higher level of wholesale borrowings, decreasing the likelihood that the Bank will need to purchase additional stock to support its borrowing activities. Total interest expense in fiscal 2007 increased 61.2% to $40.1 million from $24.9 million in fiscal 2006. Interest on deposits increased significantly to $32.3 million in fiscal 2007 from $20.0 million in fiscal 2006. Also contributing to the increase was the increasing level of interest rates during the year which resulted in an increase in interest expense, including interest paid on the Bank's deposits. At March 31, 2007, approximately 61% of the Bank's deposits were in the form of certificates of deposit, including $79.4 million in brokered certificates of deposit. As such, an increasing interest rate environment affects the Bank's deposit interest expense more dramatically than if a larger portion of the Bank's funding were in the form of lower cost checking and liquid savings accounts. While management continues its efforts to decrease its reliance on certificates of deposit as a funding source, the competitive marketplace for core deposit dollars has resulted in only moderate success in this regard. During fiscal 2007, the Bank's increase in deposit interest expense lagged the increase in its interest income on loans (in dollar terms). This was the result, in large part, to the immediate impact to interest income from the Bank's Prime based loan portfolio (with each increase in the Prime lending rate), and the lagged effect of increased interest expense on certificates of deposit, since these certificate of deposit rate increases do not occur instantaneously, instead lagging until the maturity of the certificate of deposit. In addition, even if current market interest rates were not increasing, the Bank's interest on deposits would continue to increase, since the current prevailing market rates to attract deposits are higher than the rates being paid on its renewing deposits. Interest on borrowings increased to $7.9 million in fiscal 2007 from $4.9 million in fiscal 2006. The increase was a result of a higher level of average borrowings outstanding during the year ended March 31, 2007 of $166.3 million compared to $127.3 million during the year ended March 31, 2006 along with the increasing interest rate environment in fiscal 2007. The significant increase in fiscal 2007 was related to funding the Bank's loan growth during the year. The vast majority of this borrowing growth was in short term borrowings, consistent with the shorter term, Prime based loan growth the Bank experienced during the year. The Bank continues to utilize wholesale borrowings in order to further leverage its balance sheet and better manage its interest rate risk profile. Provision for Loan Losses. Provisions for loan losses are charges to earnings to bring the total allowance for loan losses to a level considered by management as adequate to provide for known and inherent risks in the loan portfolio, based on management's continuing analysis of factors underlying the quality of the loan portfolio. These factors include changes in portfolio size and composition, actual historical industry loss experience, current economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. Year Ended March 31, --------------------- 2007 2006 -------- -------- (Dollars in thousands) Allowance at beginning of period ....... $ 14,184 $ 11,767 Provision for loan losses............... 1,850 2,575 Charge offs, net of recoveries.......... (145) (158) -------- -------- Allowance at end of period.............. $ 15,889 $ 14,184 ======== ======== Allowance for loan losses as a percentage of net loans receivable at the end of the period.............. 1.51% 1.54% Net charge-offs as a percentage of average loans outstanding during the period............................ 0.01% 0.02% Allowance for loan losses as a percentage of nonperforming assets at the end of period.................. 1,670.06% 1,221.35% 52 The provision for loan losses was $1.9 million for the year ended March 31, 2007 compared to $2.6 million for the year ended March 31, 2006. This change resulted from management's ongoing analysis of changes in loan portfolio composition by collateral categories, overall credit quality of the portfolio, peer group analysis, and current economic conditions. The allowance for loan losses was $15.9 million, or 1.51% of net loans receivable at March 31, 2007 compared to $14.2 million, or 1.54% of net loans receivable at March 31, 2006. The increased allowance level resulted from continued loan portfolio growth in the higher-risk lending categories of construction and land development, commercial real estate and commercial business loans during the period, which comprised $896.6 million, or 83.7% of total loans receivable at March 31, 2007, versus $770.2 million, or 82.6% at March 31, 2006. As of March 31, 2007, there were no loans in the loan portfolio over 90 days delinquent and five loans on non- accrual status. The Bank had one real estate owned at March 31, 2007. Total non-performing assets were $951,000, or 0.07% of total assets at March 31, 2007 compared to $1.2 million, or 0.10% of total assets at March 31, 2006. At March 31, --------------------- 2007 2006 ---- ---- (Dollars in thousands) Non-Performing Assets Accruing loans 90 days past due............ $ -- $ -- Non-accrual loans.......................... 226 1,161 Restructured loans......................... -- -- ------ ------- Total non-performing loans............... 226 1,161 Total non-performing loans/net loans..... 0.02% 0.13% Real estate owned.......................... 725 -- ------ ------- Total non-performing assets.............. 951 1,161 ------ ------- Total non-performing assets/total assets................................. 0.07% 0.10% Noninterest Income. Noninterest income in fiscal 2007 increased to $5.8 million, from $5.4 million in fiscal 2006. Service fees increased 12.7% to $3.3 million in fiscal 2007 from $2.9 million in fiscal 2006. The primary reason for this increase was the implementation of our overdraft protection service during fiscal 2006, which, together with the increase in deposits, resulted in increased fee income. There was a net loss on sales of investment securities of $(10,000) in fiscal 2007 compared to a net loss of $(476,000) in fiscal 2006. The losses in fiscal 2007 were a result of management's decisions to replace certain investment securities during the year in its efforts to improve future returns. The losses in fiscal 2006 were a result of the restructuring of approximately $13.0 million of lower-yielding securities during the fourth quarter of fiscal 2006. The proceeds from these sales have since been reinvested in highly rated, higher-yielding investments. The securities sold were yielding approximately 170 basis points lower than the securities purchased, therefore the effect of this restructuring was to increase interest income from these securities by over $220,000 in fiscal 2007. Other noninterest income decreased slightly to $1.7 million for the year ended March 31, 2007 from $1.9 million for the year ending March 31, 2006. Noninterest Expense. Noninterest expense in fiscal 2007 increased to $27.9 million, a 12.5% increase from $24.8 million in fiscal 2006. Compensation and employee benefits increased 11.7% in fiscal 2007 to $16.3 million from $14.6 million in fiscal 2006. Building occupancy expense was $4.3 million in fiscal 2007, a 19.7% increase from $3.6 million in fiscal 2006. Increases in compensation and employee benefits and building and occupancy expenses resulted primarily from the opening of a full service retail office in Lakewood, Washington in fiscal 2006 and a full service regional facility in Everett, Washington in June 2006. Other noninterest expenses increased 13.4% to $5.6 million in fiscal 2007 from $5.0 million in fiscal 2006. The increase in fiscal 2007 was primarily attributable to additional transfer agent and investor relations expenses, and increased business & occupation tax as a result of the shifting loan portfolio from non-taxable mortgage loans to taxable commercial loans. 53 Average Balances, Interest and Average Yields/Costs --------------------------------------------------- The following table presents at the date and for the periods indicated, the average balances of assets and liabilities and the total dollar amount of interest income and interest expense, as well as the resulting yields earned and rates paid. Year Ended March 31, At March 31, ---------------------------------------------------------------------------- 2008 2008 2007 2006 --------------- ------------------------ ------------------------ ------------------------ Average Average Average Average Yield/ Average Yield/ Average Yield/ Average Yield/ Balance Cost Balance Interest Cost Balance Interest Cost Balance Interest Cost ------- ------ ------- -------- ------ ------- -------- ------ ------- -------- ------ (Dollars in thousands) Interest-earning assets: Loans re- ceiv- able(1)....$1,191,478 8.47% $1,137,051 $ 96,320 8.47% $1,017,460 $88,589 8.71% $862,893 $65,857 7.63% Investment securi- ties(2).... 53,020 4.00 56,470 2,259 4.00 64,805 2,678 4.13 70,621 2,556 3.62 Mortgage-backed securities. 39,130 5.06 32,854 1,664 5.06 27,150 1,333 4.91 21,573 975 4.52 ---------- ---- ---------- -------- ---- ---------- ------- ---- --------- ------- ---- Total interest- earning assets.... 1,283,628 8.17 1,226,375 100,243 8.17 1,109,415 92,600 8.35 955,087 69,388 7.27 Interest-bearing liabilities: Deposits.... 1,038,792 3.83 992,667 38,072 3.83 905,383 32,251 3.56 784,249 19,988 2.55 Borrowings.. 214,791 4.44 193,272 8,573 4.44 166,276 7,882 4.74 127,284 4,908 2.68 ---------- ---- ---------- -------- ---- ---------- ------- ---- --------- ------- ---- Total interest- bearing lia- bilities.. 1,253,583 3.93 1,185,939 46,645 3.93 1,071,659 40,133 3.74 911,533 24,896 2.70 -------- ------- ------- Net interest income...... $ 53,598 $52,467 $44,492 ======== ======= ======= Interest rate spread...... 4.24% 4.60% 4.54% ==== ==== ==== Net interest margin...... 4.37% 4.73% 4.66% ==== ==== ==== Ratio of average interest-earning assets to average interest- bearing liabilities. 103.39% 103.46% 104.38% ====== ====== ====== ---------- (1) Average balances include nonaccrual loans, if any. Interest income on nonaccrual loans has been included. (2) The yield on investment securities is calculated using historical cost basis.
54 Rate/Volume Analysis -------------------- The table below sets forth certain information regarding changes in interest income and interest expense for the Corporation for the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to (1) changes in volume (change in volume multiplied by old rate); (2) changes in rates (change in rate multiplied by old volume); (3) changes to rate-volume (changes in rate multiplied by the change in volume); and (4) the total changes (the sum of the prior columns). Year Ended March 31, ---------------------------------------------------------------------- 2008 vs. 2007 2007 vs. 2006 --------------------------------- ---------------------------------- Increase (Decrease) Increase (Decrease) Due to Due to --------------------------------- ---------------------------------- Rate/ Rate/ Volume Rate Volume Total Volume Rate Volume Total ------- ------- ----- ------ ------- ------ ------ ------- (In thousands) Interest income: Interest and fees on loans..... $10,413 $(2,399) $(283) $7,731 $11,797 $9,274 $1,661 $22,732 Investment securities and other interest-bearing securities.... (115) 27 -- (88) (9) 490 (1) 480 ------- ------- ----- ------ ------- ------ ------ ------- Total interest income............ $10,298 $(2,372) $(283) $7,643 $11,788 $9,764 $1,660 $23,212 ======= ======= ===== ====== ======= ====== ====== ======= Interest expense: Deposit accounts................. $ 3,090 $ 2,493 $ 239 $5,822 $ 3,002 $8,051 $1,209 $12,262 Borrowings....................... 1,280 (508) (82) 690 1,209 1,417 349 2,975 ------- ------- ----- ------ ------- ------ ------ ------- Total interest expense........... $ 4,370 $ 1,985 $ 157 $6,512 $ 4,211 $9,468 $1,558 $15,237 ======= ======= ===== ====== ======= ====== ====== =======
Liquidity and Capital Resources ------------------------------- The Bank maintains liquid assets in the form of cash and short-term investments to provide a source to fund loans, savings withdrawals, and other short-term cash requirements. At March 31, 2008, the Bank had liquid assets (cash and marketable securities with maturities of one year or less) with a book value of $37.4 million. As of March 31, 2008, the total book value of investments and mortgage-backed securities was $77.4 million compared to a market value of $80.4 million with an unrealized gain of $3.0 million. As of March 31, 2007, the total book value of investments and mortgage-backed securities was $74.4 million compared to a market value of $79.6 million with an unrealized gain of $5.2 million. The Corporation foresees no factors that would impair its ability to hold debt securities to maturity. As indicated on the Corporation's Consolidated Statement of Cash Flows contained in Item 8 of this Form 10-K, the Corporation's primary sources of funds are cash flow from operations, which consist primarily of mortgage loan repayments, deposit increases, loan sales, borrowings and cash received from the maturity or sale of investment securities. The Corporation's liquidity fluctuates with the supply of funds and management believes that the current level of liquidity is adequate at this time. If additional liquidity is needed, the Corporation's options include, but are not necessarily limited to: (i) selling additional loans in the secondary market; (ii) entering into reverse repurchase agreements; (iii) borrowing from the FHLB of Seattle; (iv) accepting additional jumbo, brokered, and/or public funds deposits; or (v) accessing the discount window of the Federal Reserve Bank of San Francisco. Stockholders' equity as of March 31, 2008 was $128.3 million, or 9.2% of assets, compared to $123.9 million, or 9.7% of assets at March 31, 2007. The Bank continues to exceed the 5.0% minimum tier one capital required by the FDIC in order to be considered well-capitalized. The Bank's total risk-adjusted capital ratio as of March 31, 2008 was 55 11.0%, compared to 12.0% as of March 31, 2007. These figures remain well above the well-capitalized minimum of 10% set by the FDIC. The Corporation has conducted various buy-back programs since August 1996. In March 2008, the Board of Directors approved a new stock repurchase plan that runs concurrent with the 2009 fiscal year, allowing the Corporation to repurchase up to 2.5% of total shares outstanding, or approximately 300,000 shares. This marked the Corporation's tenth stock repurchase plan. In fiscal 2008, under the previous plan, the Corporation repurchased 399,700 shares at an average price of $17.62. For additional information concerning the Corporation's repurchase activities during the fourth quarter of fiscal 2008, see Item 5 of this Form 10-K. Management intends to continue its stock buy-back programs from time to time as long as repurchasing the stock is perceived to contribute to the overall growth of stockholder value. The number of shares of stock to be repurchased and the price to be paid is the result of many factors, several of which are outside of the control of the Corporation. The primary factors, however, are market and economic factors such as the price at which the stock is trading in the market, the number of shares available in the market; the attractiveness of other investment alternatives in terms of the rate of return and risk involved in the investment; the ability to increase the value and/or earnings per share of the remaining outstanding shares, the corporation's liquidity and capital needs, and regulatory requirements. Presently, it is management's belief that purchases made under the current Board approved plan will not materially affect the Corporation's capital or liquidity position. Quantitative and Qualitative Disclosures About Market Risk ---------------------------------------------------------- The Corporation continues to be exposed to interest rate risk. Currently, the Corporation's assets and liabilities are not materially exposed to foreign currency or commodity price risk. At March 31, 2008, the Corporation had no off-balance sheet derivative financial instruments, nor did it have a trading portfolio of investments. In fiscal 2008 and fiscal 2007, the Corporation continued to outsource its interest rate risk modeling to a third party provider that utilizes an IPS Sendero model. This model analyzes the Corporation's major balance sheet components, and attempts to estimate the changes to the Corporation's income statement and economic value of equity, under a variety of interest rate change scenarios. The figures contained in the table presented under Item 7A of this Form 10-K below, in the Quantitative Disclosures About Market Risk section, were derived from this model. While numerous assumptions go into this modeling, and undue reliance should not be placed on the specific results, management believes that this improved modeling will enhance its interest rate risk management efforts. Similar to the analysis performed one year ago, the current interest rate risk modeling continues to show the Bank's balance sheet as moderately asset sensitive over a 12-month time period. The Bank's continued focus on shorter term, variable rate assets has contributed to the Bank's performance in this regard. This strategy has allowed the Bank to utilize wholesale borrowing and brokered deposits as a supplemental source of funds to its retail and commercial deposit gathering efforts, without significantly impacting the Bank's interest rate risk profile. In addition, the Bank has been successful at increasing its demand deposit base in recent years, further enhancing the Bank's interest rate risk profile. Accordingly, the interest rate risk modeling performed each quarter during fiscal 2008 shows that the Bank continues to operate within the interest rate risk tolerance limits set by its Board of Directors. With the current level of interest rates at March 31, 2008 and the associated prepayment assumptions in the low-rate environment, interest rate risk modeling predicts moderate improvement in the Bank's performance in a moderately higher rate environment over a 12-month time period. However, as interest rates increase, prepayment assumptions can change significantly, therefore it would be inappropriate to assume that significantly higher rates would have a sustained positive effect on the Bank's and the Corporation's performance. Further, an increase in rates, without a corresponding increase in certain indices (such as Prime), would adversely affect the Corporation's performance. For example, if it becomes necessary for the Corporation to increase the rates it pays to attract funds in a rising rate environment (as is the case currently), an absence of a corresponding increase in the Prime lending rate would, of course, negatively affect performance. In addition, depending on timing differences, the magnitude of various rates 56 change in future periods, and the composition of the Corporation's balance sheet, future modeling efforts may show the Corporation's returning to a liability sensitive position. Management continues to monitor these areas, in its ongoing effort to manage the Corporation's interest rate risk. Contractual Obligations ----------------------- In the normal course of business, the Corporation enters into contractual obligations that meet various business needs. These contractual obligations include time deposits to customers, borrowings from the FHLB of Seattle and lease obligations for facilities. See Notes 8, 9 and 14 of the Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K for additional information. The following table summarizes the Corporation's long-term contractual obligations at March 31, 2008: Less than One to Three to One Three Five Year Years Years Total -------- -------- ------- -------- (In thousands) Time deposits................ $558,566 $122,208 $14,150 $694,924 Long-term borrowings......... 100,291 114,500 -- 214,791 Operating lease obligations.. 419 869 763 2,051 -------- -------- ------- -------- Total..................... $659,276 $237,577 $14,913 $911,766 ======== ======== ======= ======== Off-Balance Sheet Arrangements ------------------------------ In the normal course of business, the Corporation makes off-balance sheet arrangements, including credit commitments to its customers to meet their financial needs. These arrangements involve, to varying degrees, elements of credit and interest rate risk not recognized in the consolidated statement of financial condition. The Bank makes personal, commercial, and real estate lines of credit available to customers as well as stand by letters of credit or financial guarantees. Commitments to extend credit to customers are subject to the Bank's normal credit policies and are essentially the same as those involved in extending loans to customers. See Note 17 of the Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K for additional information. Impact of Inflation ------------------- 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. These principles generally require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time as a result of inflation. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. The primary impact of inflation is reflected in the increased cost of our operations. 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. In a period of rapidly rising interest rates, the liquidity and maturities structures of our assets and liabilities are critical to the maintenance of acceptable performance levels. The principal effect of inflation on earnings, as distinct from levels of interest rates, is in the area of noninterest expense. Expense items such as employee compensation, employee benefits and occupancy and equipment costs may be subject to increases as a result of inflation. An additional effect of inflation is the possible increase in dollar value 57 of the collateral securing loans that we have made. Our management is unable to determine the extent, if any, to which properties securing loans have appreciated in dollar value as a result of inflation. Recent Accounting Pronouncements -------------------------------- For a discussion of new accounting pronouncements and their impact on the Corporation, see Note 1of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K. Item 7A. Quantitative and Qualitative Disclosures About Market Risk ------------------------------------------------------------------- Quantitative Disclosures About Market Risk. The table below represents the balances of the Bank's financial instruments at March 31, 2008. The expected maturity categories take into consideration projected prepayment rates as well as actual amortization of principal. In preparation of the table, numerous assumptions were made regarding prepayment rates and deposit account interest sensitivity. Over 1 Over 2 Over 3 Carrying Fair Average Within Year to Years Years Beyond Value Value Yield 1 Year 2 Years to 3 Years to 5 Years 5 Years Total Total ----- -------- ---------- ---------- ---------- ---------- ---------- ---------- (Dollars in thousands) Interest-Sensitive Assets: Loans receivable.. 8.47% $922,707 $ 103,390 $ 104,176 $ 40,748 $ 20,457 $1,191,478 $1,190,418 Mortgage-backed securities...... 5.06% 8,837 5,138 3,729 6,289 15,137 39,130 39,135 Investments and other interest- earning assets.. 4.00% 30,332 2,535 3,241 6,403 10,509 53,020 53,020 Total Interest Sensitive Assets. 8.35% 961,876 111,063 111,146 53,440 46,103 1,283,628 1,282,573 Cumulative Totals. -- 961,876 1,072,939 1,184,085 1,237,525 1,283,628 -- -- Interest-Sensitive Liabilities: Checking accounts. 0.57% 7,244 24,753 24,753 24,606 61,516 142,872 169,997 Money market ultimate accounts........ 3.35% 128,144 13,730 13,730 7,846 19,614 183,064 187,912 Savings accounts.. 0.92% 3,587 1,793 1,793 3,074 7,686 17,933 21,628 Certificates of deposit......... 4.89% 566,655 56,137 62,235 9,754 143 694,924 677,364 Other borrowings(1)... 4.44% 130,291 68,000 16,500 -- -- 214,791 215,452 Total Interest Sensitive Liabilities..... 3.74% 835,921 164,413 119,011 45,280 88,959 1,253,584 1,272,353 Cumulative Totals. -- 835,921 1,000,334 1,119,345 1,164,625 1,253,584 -- -- Off-Balance Sheet Items: Commitments to extend credit... 6.08% 208,882 -- -- -- -- 208,882 208,882 Unused lines of credit.......... 6.74% 152,882 -- -- -- -- 152,882 152,882 Credit card arrangements.... 8.40% 10,510 -- -- -- -- 10,510 10,510 Stand by letters of credit....... -- 2,047 -- -- -- -- 2,047 2,047 -------- ---------- ---------- ---------- ---------- ---------- ---------- Total Off-Balance Sheet Items..... $374,321 $ -- $ -- $ -- $ -- $ 374,321 $ 374,321 ======== ========== ========== ========== ========== ========== ========== ------- (1) Includes borrowing related to investment in real estate for a joint venture.
58 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, they may react in different degrees to changes in market interest rates. In addition, in the event of changes in interest rates, expected rates of prepayments on loans and withdrawals from savings accounts might deviate significantly from those assumed in presenting the table. Therefore, the data presented in the table should not be relied upon as necessarily indicative of actual future results. Item 8. Financial Statements and Supplementary Data ---------------------------------------------------- (a) (1) Financial Statements. Page -------------------- ---- Management's Annual Report on Internal Control Over Financial Reporting 60 Report of Independent Registered Public Accounting Firm 61 Consolidated Statement of Financial Position as of March 31, 2008 and 2007 63 Consolidated Statement of Income for the Years Ended March 31, 2008, 2007 and 2006 64 Consolidated Statement of Stockholders' Equity and Comprehensive Income for the Years Ended March 31, 2008, 2007 and 2006 65 Consolidated Statement of Cash Flows for the Years Ended March 31, 2008, 2007 and 2006 66 Notes to Consolidated Financial Statements 67 59 Management's Annual Report on Internal Control Over Financial Reporting: ----------------------------------------------------------------------- MANAGEMENT'S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Management of Horizon Financial Corp. and its subsidiaries ("the Company") is responsible for establishing and maintaining adequate internal control over financial reporting, and for performing an assessment of the effectiveness of internal control over financial reporting as of March 31, 2008. The Company's internal control over financial reporting is a process designed under the supervision of the Company's management, including the Chief Executive Officer and Chief Financial Officer, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. The Company's system of internal control over financial reporting includes policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States, 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. Management recognizes that there are inherent limitations in the effectiveness of any system of internal control, and accordingly, even effective internal control can provide only reasonable assurance with respect to financial statements preparation and fair presentation. Further, because of changes in condition, the effectiveness of internal control may vary over time. Under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, the Company performed an assessment of the effectiveness of the Company's internal control over financial reporting as of March 31, 2008 based upon criteria in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). Based on this assessment, Management determined that the Company's internal control over financial reporting was effective as of March 31, 2008. Dated June 11, 2008 60 Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders Horizon Financial Corp. & Subsidiary We have audited the accompanying consolidated statement of financial position of Horizon Financial Corp. & Subsidiary (the "Company") as of March 31, 2008 and 2007, and the related consolidated statements of income, stockholders' equity and comprehensive income, and cash flows for each of the years in the three-year period ended March 31, 2008. We also have audited the Company's internal control over financial reporting as of March 31, 2008, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management Report on Internal Controls over Financial Reporting. Our responsibility is to express an opinion on these financial statements, an opinion on the effectiveness of the Company's internal control over financial reporting based on our audits. We conducted our audits in accordance with auditing 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 and whether effective internal control over financial reporting was maintained in all material respects. Our audits of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also include, performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. The 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. The 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 authorization 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. 61 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. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Horizon Financial Corp. & Subsidiary as of March 31, 2008 and 2007, and the results of their operations and cash flows for each of the years in the three-year period ended March 31, 2008, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, Horizon Financial Corp. & Subsidiary maintained, in all material respects, effective internal control over financial reporting as of March 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. /s/Moss Adams LLP Bellingham, Washington June 11, 2008 62 HORIZON FINANCIAL CORP. CONSOLIDATED STATEMENT OF FINANCIAL POSITION MARCH 31, 2008 AND 2007 ------------------------------------------------------------------------------ Assets Dollars in Thousands ------------------------ 2008 2007 ---------- ---------- Cash and cash equivalents $ 22,412 $ 40,833 Interest-bearing deposits 2,912 5,379 Investment securities Available-for-sale (amortized cost 2008: $38,676; 2007: $47,675) 41,241 52,865 Held-to-maturity (estimated fair value 2008: $0; 2007: $372) - 370 Mortgage-backed securities Available-for-sale (amortized cost 2008: $38,646; 2007: $26,220) 39,100 26,233 Held-to-maturity (estimated fair value 2008: $35; 2007: $157) 30 148 Federal Home Loan Bank ("FHLB") Stock 8,867 7,247 Loans held for sale 2,644 4,493 Loans receivable, net of allowance for loan losses of $19,114 in 2008 and $15,889 in 2007 1,191,478 1,054,870 Investment in real estate joint venture 17,567 17,169 Accrued interest and dividends receivable 7,916 6,626 Premises and equipment, net 27,778 27,631 Net deferred income tax assets 6,253 3,733 Real estate owned 655 725 Other assets 23,325 22,005 ---------- ---------- TOTAL ASSETS $1,392,178 $1,270,327 ========== ========== Liabilities and Stockholders' Equity Deposits $1,038,792 $ 975,295 Accrued interest payable and other liabilities 5,746 9,508 Other borrowed funds 192,343 138,715 Borrowing related to investment in real estate joint venture 22,448 20,243 Advances by borrowers for taxes and insurance 414 454 Income tax currently payable 2,174 237 Deferred compensation 1,944 2,020 ---------- ---------- Total liabilities 1,263,861 1,146,472 ---------- ---------- COMMITMENTS AND CONTINGENCIES (Notes 14 & 17) STOCKHOLDERS' EQUITY Serial preferred stock, $1 par value, 10,000,000 shares authorized; none issued or outstanding Common stock, $1 par value, 30,000,000 shares authorized; 11,892,208 and 12,254,476 issued and outstanding, respectively 11,892 12,254 Additional paid-in capital 50,597 51,489 Retained earnings 63,906 56,770 Accumulated other comprehensive income 1,922 3,342 ---------- ---------- Total stockholders' equity 128,317 123,855 ---------- ---------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $1,392,178 $1,270,327 ========== ========== See accompanying notes to these consolidated financial statements. 63 HORIZON FINANCIAL CORP. CONSOLIDATED STATEMENT OF INCOME YEARS ENDED MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ Dollars in Thousands (except for number of per share amounts) -------------------------------------- 2008 2007 2006 -------- -------- -------- INTEREST INCOME Interest and fees on loans $ 96,320 $88,589 $65,857 Investments and mortgage-backed securities Taxable interest 3,279 3,492 3,136 Nontaxable interest income 479 293 196 Dividends 165 226 199 -------- ------- ------- Total interest income 100,243 92,600 69,388 -------- ------- ------- INTEREST EXPENSE Interest on deposits 38,073 32,251 19,988 Interest on other borrowings 8,572 7,882 4,908 -------- ------- ------- Total interest expense 46,645 40,133 24,896 -------- ------- ------- Net interest income 53,598 52,467 44,492 PROVISION FOR LOAN LOSSES 4,100 1,850 2,575 -------- ------- ------- Net interest income after provision for loan losses 49,498 50,617 41,917 -------- ------- ------- NONINTEREST INCOME Service fees 3,601 3,274 2,905 Net gain on sales of loans - servicing retained 176 23 55 Net gain on sales of loans - servicing released 848 827 1,040 Net gain (loss) on sale of investment securities 480 (10) (476) Other 1,939 1,724 1,887 -------- ------- ------- Total noninterest income 7,044 5,838 5,411 -------- ------- ------- NONINTEREST EXPENSE Compensation and employee benefits 16,595 16,328 14,614 Building occupancy 4,698 4,280 3,575 Data processing 957 862 887 Advertising 812 751 720 Other expenses 6,118 5,640 4,974 -------- ------- ------- Total noninterest expense 29,180 27,861 24,770 -------- ------- ------- INCOME BEFORE PROVISION FOR INCOME TAX 27,362 28,594 22,558 PROVISION FOR INCOME TAX Current 10,704 11,058 6,903 Deferred (1,755) (1,492) - -------- ------- ------- Total provision for income tax 8,949 9,566 6,903 -------- ------- ------- NET INCOME $ 18,413 $19,028 $15,655 ======== ======= ======= BASIC EARNINGS PER SHARE $ 1.52 $ 1.55 $ 1.26* ======== ======= ======= DILUTED EARNINGS PER SHARE $ 1.51 $ 1.53 $ 1.25* ======== ======= ======= *restated for the 5 for 4 stock split in the form of a 25% stock dividend distributed on October 23, 2006. See accompanying notes to these consolidated financial statements. 64 HORIZON FINANCIAL CORP. CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME YEARS ENDED MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------------------------------------ (In thousands, except number of shares) --------------------------------------------------------------------- Common Stock Accumulated --------------------- Additional Unearned Other Number of At Par Paid-In Retained ESOP Comprehensive Shares Value Capital Earnings Shares Income(Loss) --------- -------- --------- -------- -------- ----------- Balance, March 31, 2005 10,038 $10,038 $54,737 $38,939 $(72) $3,382 Comprehensive income Net income - - - 15,655 - - Other comprehensive income Change in unrealized gains on available-for-sale securities, net tax benefit of $34 - - - - - (64) Total other comprehensive income Comprehensive income Recognition of ESOP shares released - - - - 72 - Cash dividends on common stock at $.57 per share - - - (5,651) - - Stock options exercised 73 73 391 - - - Stock award plan - - 22 - - - Tax benefit associated with stock options - - 179 - - - Treasury stock purchased - - - - - - Retirement of treasury stock (213) (213) (1,213) (2,952) - - ------ ------- ------- ------- ----- ------- Balance, March 31, 2006 9,898 9,898 54,116 45,991 - 3,318 ------ ------- ------- ------- ----- ------- Comprehensive income Net income - - - 19,028 - - Other comprehensive income Change in unrealized gains on available-for-sale securities, net tax of $13 - - - - - 24 Total other comprehensive income Comprehensive income Cash dividends on common stock at $.495 per share - - - (6,074) - - 5 for 4 stock split in the form of a 25% stock dividend 2,453 2,453 (2,453) - - - Cash paid in lieu of fractional shares - - - (10) - - Stock options exercised 22 22 137 - - - Stock award plan 3 3 289 - - - Tax benefit associated with stock options - - 55 - - - Treasury stock purchased - - - - - - Retirement of treasury stock (122) (122) (655) (2,165) - - ------ ------- ------- ------- ----- ------- Balance, March 31, 2007 12,254 12,254 51,489 56,770 - 3,342 ------ ------- ------- ------- ----- ------- Comprehensive income Net income - - - 18,413 - - Other comprehensive income Change in unrealized gains on available-for-sale securities, net tax benefit of $764 - - - - - (1,420) Total other comprehensive income Comprehensive income Cash dividends on common stock at $.53 per share - - - (6,385) - - Stock options exercised 28 28 166 - - - Stock award plan 9 9 669 - - - Tax benefit associated with stock options - - 44 - - - Treasury stock purchased - - - - - - Retirement of treasury stock (399) (399) (1,771) (4,892) - - ------ ------- ------- ------- ----- ------- Balance, March 31, 2008 11,892 $11,892 $50,597 $63,906 $ - $ 1,922 ====== ======= ======= ======= ===== =======
Treasury Total Stock Stockholders' Comprehensive at Cost Equity Income -------- ------------ ------------- Balance, March 31, 2005 $ - $107,024 Comprehensive income Net income - 15,655 $15,655 Other comprehensive income Change in unrealized gains on available-for-sale securities, net tax benefit of $34 - (64) (64) ------- Total other comprehensive income (64) ------- Comprehensive income $15,591 ======= Recognition of ESOP shares released - 72 Cash dividends on common stock at $.57 per share - (5,651) Stock options exercised - 464 Stock award plan - 22 Tax benefit associated with stock options - 179 Treasury stock purchased (4,378) (4,378) Retirement of treasury stock 4,378 - ------- -------- Balance, March 31, 2006 - 113,323 ------- -------- Comprehensive income Net income - 19,028 $19,028 Other comprehensive income Change in unrealized gains on available-for-sale securities, net tax of $13 - 24 24 ------- Total other comprehensive income 24 ------- Comprehensive income $19,052 ======= Cash dividends on common stock at $.495 per share - (6,074) 5 for 4 stock split in the form of a 25% stock dividend - - Cash paid in lieu of fractional shares - (10) Stock options exercised - 159 Stock award plan - 292 Tax benefit associated with stock options - 55 Treasury stock purchased (2,942) (2,942) Retirement of treasury stock 2,942 - ------- -------- Balance, March 31, 2007 - 123,855 ------- -------- Comprehensive income Net income - 18,413 $18,413 Other comprehensive income Change in unrealized gains on available-for-sale securities, net tax benefit of $764 - (1,420) (1,420) ------- Total other comprehensive income (1,420) ------- Comprehensive income $16,993 ======= Cash dividends on common stock at $.53 per share - (6,385) Stock options exercised - 194 Stock award plan - 678 Tax benefit associated with stock options - 44 Treasury stock purchased (7,062) (7,062) Retirement of treasury stock 7,062 - ------- -------- Balance, March 31, 2008 $ - $128,317 ======= ========
See accompanying notes to these consolidated financial statements. 65 HORIZON FINANCIAL CORP. CONSOLIDATED STATEMENT OF CASH FLOWS YEARS ENDED MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ Increase (Decrease) in Cash and Cash Equivalents Dollars in Thousands --------------------------------- 2008 2007 2006 --------- --------- --------- Cash Flows From Operating Activities Net income $ 18,413 $ 19,028 $ 15,655 Adjustments to reconcile net income to net cash provided by operating activities Depreciation 2,102 1,878 1,608 Amortization and deferrals, net 597 212 (482) Stock dividends - FHLB stock - - (29) Provision for loan losses 4,100 1,850 2,575 Provision for loss - Real estate owned 70 110 - Net gain on sale of mortgage loans held- for-sale (848) (827) (1,040) Proceeds from sales of mortgage loans held- for-sale 76,976 75,649 94,683 Origination of mortgage loans held-for-sale (74,279) (74,063) (94,824) Net gain/loss on sale of investment securities (480) 10 476 Stock award plan compensation 678 292 22 Excess tax benefits from the exercise of stock options (44) (55) (179) Provision for deferred income tax (1,755) (1,492) - Changes in assets and liabilities Interest and dividends receivable (1,290) (1,441) (686) Interest payable (1,885) 1,448 1,116 Federal income tax payable 1,937 1,045 (477) Other assets (795) (5,701) (1,296) Other liabilities (2,067) 1,168 341 --------- --------- --------- Net cash flows from operating activities 21,430 19,111 17,463 --------- --------- --------- Cash Flows From Investing Activities Investment in interest-bearing deposits, net 2,467 4,060 (5,532) Purchases of investment securities - available-for-sale (16,065) (3,395) (23,555) Proceeds from sales and maturities of investment securities - available-for-sale 25,064 10,482 35,590 Purchases of mortgage-backed securities - available-for-sale (20,177) (18,319) (12,174) Proceeds from sales and maturities of mortgage-backed securities - available- for-sale 7,751 15,658 6,969 Proceeds from maturities of mortgage-backed securities - held-to-maturity 488 334 403 Purchase of FHLB stock (1,620) - - Net change in loans (141,305) (139,257) (115,550) Purchases of bank premises and equipment (2,249) (3,192) (5,143) Net change in investment in joint venture (398) (241) 276 --------- --------- --------- Net cash flows from investing activities (146,044) (133,870) (118,716) --------- --------- --------- Cash Flows From Financing Activities Net change in deposits 63,497 140,996 87,450 Advances of other borrowed funds 738,628 369,654 229,995 Repayments of other borrowed funds (685,000) (372,500) (207,500) Borrowing related to inv. in real estate joint venture 2,205 1,967 1,555 Common stock issued, net 194 149 464 Tax benefit associated with stock options 44 55 179 Cash dividends paid (6,313) (5,977) (5,572) Treasury stock purchased (7,062) (2,942) (4,378) --------- --------- --------- Net cash flows from financing activities 106,193 131,402 102,193 --------- --------- --------- Net Change In Cash And Cash Equivalents (18,421) 16,643 940 Cash and Cash Equivalents, beginning of year 40,833 24,190 23,250 --------- --------- --------- Cash And Cash Equivalents, end of year $ 22,412 $ 40,833 $ 24,190 ========= ========= ========= Supplemental Disclosures Of Cash Flow Information Cash paid during the year for interest $ 48,529 $ 38,684 $ 23,780 ========= ========= ========= Cash paid during the year for income tax $ 8,717 $ 9,949 $ 7,201 ========= ========= ========= Noncash Investing And Financing Transactions Property taken in settlement of loans $ - $ 835 $ - ========= ========= ========= See accompanying notes to these consolidated financial statements. 66 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 1 - NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations - Horizon Financial Corp. (the "Corporation" or "Company"), through its wholly-owned subsidiary, Horizon Bank (the "Bank"), provides a full range of commercial, mortgage and consumer lending services to borrowers and a full range of customer services to depositors through 19 full-service offices, four commercial loan centers, and four real estate loan centers located in Whatcom, Skagit, Snohomish, and Pierce Counties of Washington State. The Bank is a state-chartered commercial bank, the deposits of which are insured by the Federal Deposit Insurance Corporation ("FDIC"). Financial Statement Presentation and Use of Estimates - The financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and reporting practices applicable to the banking industry. All per share data included in the financial statements have been restated to reflect all stock splits and dividends. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of revenues and expenses for the period and assets and liabilities as of the balance sheet date. Actual results could differ from estimated amounts. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for losses on loans, the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans and deferred tax assets. In connection with the determination of the estimated losses on loans and foreclosed assets held for sale, management obtains independent appraisals for significant properties. Principles of Consolidation - As of March 31, 2008, 2007 and 2006, and for the years then ended, the consolidated financial statements include the accounts of the Company, and its wholly-owned subsidiary, the Bank. Westward Financial Services, Inc. ("Westward"), a land development Company, is a wholly-owned subsidiary of the Bank, and its accounts are also included in the consolidation. All material inter-Company balances and transactions have been eliminated. In October 2004, the Bank's wholly-owned subsidiary, Westward, entered into a real estate development joint venture in Greenbriar Northwest LLC ("GBNW"), an established residential land development company headquartered in Bellingham, Washington. The Company believes that GBNW is a variable interest entity. Under the Financial Accounting Standards Board ("FASB") Interpretation No. ("FIN") 46, GBNW is consolidated in the accompanying financial statements. The Company accounts for the unowned portion of the joint venture's real estate as a minority interest. The minority interest is recognized within other liabilities. The assets of the real estate joint venture have a carrying value of approximately $17.6 million, with a related borrowing of approximately $22.4 million. Cash and Cash Equivalents - For purposes of reporting cash flows, cash and cash equivalents include cash on hand and noninterest-bearing amounts due from banks with maturities of three months or less. Included in cash and cash equivalents are legally reserved amounts which are required to be maintained on an average basis in the form of cash and balances due from the Federal Reserve Bank and other banks. Reserve requirements were $500,000 for the years ended March 31, 2008 and 2007. The Company maintains cash balances at several banks. Accounts at each institution are insured by the FDIC up to $100,000. Investments in Interest-Bearing Deposits - Investments in interest-bearing deposits consist principally of funds on deposit with the FHLB and short-term certificates of deposit with western Washington financial institutions. They mature within one year and are carried at cost. Amounts, at times, may exceed FDIC insured limits. Investments and Mortgage-Backed Securities - The Company classifies its securities into one of three categories: (1) held-to-maturity, (2) available-for-sale, or (3) trading. The Company had no trading securities at March 31, 2008 and 2007. Investment securities are categorized as held-to-maturity when the Bank has the positive intent and ability to hold those securities to maturity. Securities which are held-to-maturity are stated at cost, adjusted for amortization of premiums, and accretion of discounts which are recognized as adjustments to interest income. 67 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 and 2006 ------------------------------------------------------------------------------ NOTE 1 - NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Investment securities categorized as available-for-sale are generally held for investment purposes (to maturity), although unanticipated future events may result in the sale of some securities. Available-for-sale securities are recorded at fair value, with the net unrealized gain or loss included as other comprehensive income within the statement of stockholders' equity, net of the related tax effect. Realized gains or losses on dispositions are based on the net proceeds and the adjusted carrying amount of securities sold, using the specific identification method. Declines in the fair value of individual held-to-maturity and available-for-sale securities below their cost that are other than temporary are recognized by write-downs of the individual securities to their fair value. Such write-downs would be included in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (1) he length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method. Premiums and discounts are recognized in interest income using the interest method over the period to maturity. Federal Home Loan Bank Stock - The Bank's investment in FHLB stock is a restricted investment carried at par value ($100 per share), which reasonably approximates its fair value. As a member of the FHLB system, the Bank is required to maintain a minimum level of investment in FHLB stock based on specific percentages of its outstanding FHLB advances. The Bank may request redemption at par value of any stock in excess of the amount the Bank is required to hold. Stock redemptions are at the discretion of the FHLB. Loans Held for Sale - Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income. Mortgage loans held for sale can be sold with the mortgage servicing rights retained by the Company. The carrying value of mortgage loans sold is reduced by the cost allocated to the associated mortgage servicing rights. Gains or losses on sales of mortgage loans are recognized based on the difference between the selling price and the carrying value of the related mortgage loans sold. Loans Receivable - Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal adjusted for any charge-offs, the allowance for loan losses, and any net deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. Interest income is accrued on the daily unpaid principal balance using the simple-interest method. Loan origination fees, net of certain direct loan origination costs, are deferred and recognized as an adjustment of the yield on the related loans, using the interest method. Impaired Loans and Revenue Recognition - A loan is considered impaired when management determines that it is probable that all contractual amounts of principal and interest will not be paid as scheduled in the loan agreement. These loans include nonaccruing loans past due 90 days or more and other loans that management considers to be impaired. When a loan is placed on nonaccrual status, all interest previously accrued, but not collected, is reversed and charged against interest income. Income on nonaccrual loans is then recognized only when the loan is brought current, or when, in the opinion of management, the borrower has demonstrated the ability to resume payments of principal and interest. Interest income on restructured loans is recognized pursuant to the terms of new loan agreements. Interest income on impaired loans is monitored and is recognized based upon the terms of the underlying loan agreement. However, the recorded net investment in impaired loans, including accrued interest, is limited to the present value of the expected cash flows of the impaired loan, the observable fair market value of the loan, or the fair value of the loan's collateral. 68 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 1 - NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Provision for Loan Losses - Management estimates the provision for loan losses by evaluating known and inherent risks in the loan portfolio. These factors include changes in the size and composition of the loan portfolio, actual loan loss experience, current and anticipated economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. The allowance for loan losses is based upon factors and trends identified by market factors beyond the Company's control, which may result in losses or recoveries differing significantly from those provided in the financial statements. The majority of the Company's loan portfolio consists of commercial loans and single-family residential loans secured by real estate in the Whatcom, Skagit, Snohomish, and Pierce County areas of Washington. Real estate prices in these markets are stable at this time. However, the ultimate collectibility of a substantial portion of the Company's loan portfolio may be susceptible to changes in local market conditions in the future. The allowance for loan losses is established as losses are estimated to have occurred through the provision for loan losses charged to earnings. Loan losses are charges against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. While management uses available information to recognize losses on loans, further reductions in the carrying amounts of loans may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process periodically review the estimated losses on loans. Such agencies may require the Company to recognize additional losses based on their judgment about information available to them at the time of their examination. Mortgage Servicing Rights - Servicing assets are recognized as separate assets when rights are acquired through sale of financial assets. Generally, for sales of mortgage loans, a portion of the cost of originating the loan is allocated to the servicing right based on relative fair value. Fair value is based on market prices for comparable mortgage servicing contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds, and default rates and losses. Capitalized servicing rights are reported in other assets and are amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights into tranches based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual tranche, to the extent that fair value is less than the capitalized amount for the tranche. If the Company later determines that all or a portion of the impairment no longer exists for a particular tranche, a reduction of the allowance may be recorded as an increase to income. Servicing fee income is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal or a fixed amount per loan and are recorded as income when earned. The amortization of mortgage servicing rights is netted against loan servicing fee income. Premises and Equipment - Premises and equipment are stated at cost less accumulated depreciation. Major renewals or betterments are capitalized and depreciated over their estimated useful lives. Depreciation is computed by the straight-line method over the estimated useful lives of thirty-five years for buildings and three to ten years for equipment. Bank Owned Life Insurance - The carrying amount of bank owned life insurance approximates its fair value. Fair value of bank owned life insurance is estimated using the cash surrender value net of surrender charges. The Bank owns approximately $20.3 million and $19.4 million in bank owned life insurance as of March 31, 2008 and 2007, respectively, which is included in other assets. 69 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 1 - NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Goodwill - Goodwill was recognized in connection with the purchase of branch assets and related liabilities. The Company performs periodic evaluations for impairment. During the years ended March 31, 2008 and 2007, impairment testing was performed and goodwill was found not to be impaired. At March 31, 2008 and 2007, goodwill in the amount of $545,000 was included in other assets. Real Estate Owned - Other real estate owned includes properties acquired through foreclosure. These properties are recorded at the lower of cost or estimated fair value. Losses arising from the acquisition of property, in full or partial satisfaction of loans, are charged to the allowance for loan losses. Subsequent to their transfer to other real estate owned, these assets continue to be recorded at the lower of cost or fair value (less estimated cost to sell), based on periodic evaluations. Generally, legal and professional fees associated with foreclosures are expensed as incurred. Costs incurred to improve property prior to sale are capitalized; however, in no event are recorded costs allowed to exceed fair value. Subsequent gains, losses, or expenses recognized on the sale of these properties are included in noninterest income or expense. Income Taxes - The Company reports income and expenses using the accrual method of accounting and files a consolidated tax return which includes its subsidiary. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled using the asset liability method. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Deferred taxes result from temporary differences in the recognition of certain income and expense amounts between the Company's financial statements and its tax returns. Earnings Per Share - Basic earnings per share amounts are computed based on the weighted average number of shares outstanding during the period after giving retroactive effect to stock dividends and stock splits. Diluted earnings per share amounts are computed by determining the potential number of additional shares that may be outstanding from stock options and grants using the treasury stock method. Financial Instruments - All financial instruments held or issued by the Company are held or issued for purposes other than trading. In the ordinary course of business, the Bank enters into off-balance-sheet financial instruments consisting of commitments to extend credit. These commitments are recorded in the financial statements when they are funded. Advertising Costs - The Company expenses advertising costs as they are incurred. Share Based Payment - The Company adopted Statement of Financial Accounting Standard No. 123R, Share-Based Payment, (SFAS 123R) on April 1, 2006 using the "modified prospective" method. Under this method, awards that are granted, modified, or settled after March 31, 2006 are measured and accounted for in accordance with Statement 123R. Also under this method, expense is recognized for unvested awards that were granted prior to April 1, 2006 based upon the fair value determined at the grant date under Statement 123, Accounting for Stock-based Compensation. For the years ended March 31, 2008 and 2007, the Company recognized $678,000 and $292,000, respectively, in stock option and restricted stock award compensation expense as a component of salaries and benefits. As of March 31, 2008, there was approximately $577,000 of total unrecognized compensation cost related to nonvested options and restricted stock awards which are scheduled to amortize over the next four years. Prior to the adoption of SFAS 123R, the Company recognized the financial effects of stock options under the intrinsic value method as permitted by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and as such, recognized no compensation cost for employee stock options. 70 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 1 - NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING P0LICIES (Continued) The following table provides pro forma disclosures for the year ended March 31, 2006 had the Company accounted for stock-based compensation using SFAS 123R for the year presented: Net income as reported $15,655 Additional compensation for fair value of stock options, net of tax (31) ------- Pro forma net income $15,624 ======= Earnings per share Basic As reported $ 1.26 ======= Pro forma $ 1.26 ======= Diluted As reported $ 1.25 ======= Pro forma $ 1.25 ======= Prior to the adoption of SFAS 123R, the Company presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the Consolidated Statement of Cash Flows. Statement 123R requires the cash flows resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. The $44,000, $55,000, and $179,000 excess tax benefit for the years ended March 31, 2008, 2007 and 2006, respectively, classified as a financing cash inflow would have been classified as an operating cash inflow if the Company had not adopted SFAS 123R. 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. Comprehensive Income - Accounting principles generally require that recognized revenue, expenses, gains, and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. The components of other comprehensive income and related tax effects are as follows for the years ended March 31: 2008 2007 2006 ------ ------ ------ (Dollars in Thousands) ------------------------- Unrealized holding gains (losses) on available- for-sale securities $(1,705) $ 27 $(574) Reclassification adjustment for losses (gains) realized in income (480) 10 476 ------- ---- ----- Net unrealized gains (2,185) 37 (98) Tax effect 765 (13) 34 ------- ---- ----- Net-of-tax amount $(1,420) $ 24 $ (64) ======= ==== ===== Recent Accounting Pronouncements - In July 2006, the FASB issued FIN No. 48, Accounting for Uncertainty in Income Taxes (an interpretation of SFAS No. 109). Under FIN No. 48, a tax position shall initially be recognized in the financial statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions shall initially and subsequently be measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the tax authority, assuming full knowledge of the position and all relevant facts. The adoption of FIN No. 48 on April 1, 2007, did not have a material impact on the Company's consolidated financial statements, results of operations, or liquidity. 71 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 1 - NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. This Statement applies to other accounting pronouncements that require or permit fair value measurements. Accordingly, this Statement does not require any new 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. Implementation of this Statement beginning April 1, 2008, is not expected to have a material impact on the Company s' consolidated financial statements. In February 2007, the Financial Accounting Standards Board released Statement No. 159, Fair Value Option for Financial Assets and Financial Liabilities. This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those years. Implementation of this Statement beginning April 1, 2008, is not expected to have a material impact on the Company s' consolidated financial statements. In March 2008, the Financial Accounting Standards Board ("FASB") issued Statement No. 161, Disclosures about Derivative Instruments and Hedging Activities, an Amendment of FASB Statement No. 133 ("FAS 161"). FAS 161 amends FAS 133, Accounting for Derivative Instruments and Hedging Activities ("FAS 133"), to amend and expand the disclosure requirements of FAS 133 to provide greater transparency about (i) how and why an entity uses derivative instruments, (ii) how derivative instruments and related hedge items are accounted for under FAS 133 and its related interpretations, and (iii) how derivative instruments and related hedged items affect an entity's financial position, results of operations and cash flows. To meet those objectives, FAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments and disclosures about credit-risk related contingent features in derivative agreements. FAS 161 is effective on April 1, 2009, and is not expected to have a material impact on our consolidated financial statements as we currently do not have any derivative instruments. Reclassifications - Certain reclassifications have been made to prior years' financial statements to conform to the current year presentation. These reclassifications have no significant effect on the Company's previously reported financial position or results of operations. NOTE 2 - INTEREST-BEARING DEPOSITS Interest bearing deposits consisted of the following at March 31: 2008 2007 ------- ------- (Dollars in Thousands) -------------------- FHLB interest-bearing demand deposits $2,712 $5,079 Certificates of deposit 200 300 ------ ------ $2,912 $5,379 ====== ====== The Company has funds on deposit with the FHLB in a demand account. This account acts like a savings account and earns interest based on the daily federal funds rate. These funds are uninsured deposits held at the Federal Home Loan Bank of Seattle. The FHLB of Seattle, a federally chartered corporation, is one of 12 district FHLB institutions, which operate under the supervision of the Federal Housing Finance Board. The Finance Board is an independent agency of the executive branch within the U.S. Government which ensures that the FHLB operates in a safe and sound manner, remains adequately capitalized, and raises funds in the capital markets. NOTE 3 - INVESTMENT SECURITIES The Company's investment policy requires that the Company purchase only high-grade investment securities. Purchases of debt instruments are generally restricted to those rated A or better by a nationally recognized statistical rating organization. 72 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 3 - INVESTMENT SECURITIES (Continued) The amortized cost and estimated fair values of investments, together with unrealized gains and losses, are as follows as of March 31, 2008 and 2007, respectively: 2008 ----------------------------------------------------- (Dollars in Thousands) ----------------------------------------------------- Gross Gross Unrealized Unrealized Gross Losses Losses Estimated Amortized Unrealized 12 Months Greater Than Fair Costs Gains or Less 12 Months Value --------- ---------- --------- ----------- --------- Available-For-Sale Securities State and political subdivisions and U.S. government agency securities $33,107 $ 703 $ (3) $(128) $33,679 Marketable equity securities 569 2,209 (15) - 2,763 Mutual funds 5,000 - (201) - 4,799 ------- ------ ----- ----- ------- Total available- for- sale securities 38,676 2,912 (219) (128) 41,241 ------- ------ ----- ----- ------- Total investment securities $38,676 $2,912 $(219) $(128) $41,241 ======= ====== ===== ===== ======= Certain investment securities shown above currently have fair values less than amortized cost and therefore contain unrealized losses. At March 31, 2008, the Company has evaluated these securities and has determined that the decline in value is temporary and is related to the change in market interest rates since purchase. The decline in value is not related to any company or industry specific event. At March 31, 2008, there are six investment securities with unrealized losses. The Company anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of more favorable market interest rates. 2007 ----------------------------------------------------- (Dollars in Thousands) ----------------------------------------------------- Gross Gross Unrealized Unrealized Gross Losses Losses Estimated Amortized Unrealized 12 Months Greater Than Fair Costs Gains or Less 12 Months Value --------- ---------- --------- ----------- --------- Available-For-Sale Securities State and political subdivisions and U.S. government agency securities $41,350 $ 60 $(124) $(178) $41,108 Marketable equity securities 323 5,559 - - 5,882 Mutual funds 5,000 - (126) - 4,874 Corporate debt securities 1,002 - (1) - 1,001 ------- ------ ----- ----- ------- Total available-for- sale securities 47,675 5,619 (251) (178) 52,865 ------- ------ ----- ----- ------- Held-To-Maturity Securities State and political subdivisions and U.S. government agency securities 370 2 - - 372 ------- ------ ----- ----- ------- Total held-to-maturity securities 370 2 - - 372 ------- ------ ----- ----- ------- Total investment securities $48,045 $5,621 $(251) $(178) $53,237 ======= ====== ===== ===== ======= 73 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 3 - INVESTMENT SECURITIES (Continued) The amortized cost and estimated fair value of investment securities at March 31, 2008, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. (Dollars in Thousands) -------------------------------------------- Available-For-Sale Held-To-Maturity -------------------- --------------------- Amortized Estimated Amortized Estimated Cost Fair Value Cost Fair Value --------- ---------- --------- ---------- State and political subdivisions and U.S. government agencies One year or less $ 6,726 $ 6,760 $ - $ - More than one to five years 12,212 12,613 - - More than five to ten years 10,171 10,379 - - Over ten years 3,998 3,927 - - ------- ------- ----- ----- 33,107 33,679 - - Mutual funds and marketable/ equity securities 5,569 7,562 - - ------- ------- ----- ----- Total investment securities $38,676 $41,241 $ - $ - ======= ======= ===== ===== Proceeds from sales of investment securities and gross realized gains and losses on investment sales were as follows for the years ended March 31: 2008 2007 2006 ---- ---- ---- (Dollars in Thousands) --------------------------- Proceeds from sales of investments $454 $3,748 $15,857 ==== ====== ======= Gross gains realized on sales of investments $450 $ 287 $ - ==== ====== ======= Gross losses realized on sales of investments $ - $ (316) $ (565) ==== ====== ======= Information about concentrations of investments in particular industries for marketable equity securities and corporate debt securities at March 31 consists of the following: 2008 2007 --------------- -------------- Market Market Cost Value Cost Value ---- ------ ---- ------ (Dollars in Thousands) ---------------------------------- Marketable equity securities Banking $560 $2,122 $ 309 $1,933 Government agency stocks 9 641 14 3,949 ---- ------ ------ ------ Total $569 $2,763 $ 323 $5,882 ==== ====== ====== ====== Corporate debt securities Private utilities $ - $ - $1,002 $1,001 ---- ------ ------ ------ Total $ - $ - $1,002 $1,001 ==== ====== ====== ====== At March 31, 2008 and 2007, U.S. government agency and corporate debt securities of $5.6 million were pledged as collateral for deposits of state and local government agencies and deposits for trust accounts in excess of $100,000, as required by Washington State Law. 74 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 4 - MORTGAGE-BACKED SECURITIES Mortgage-backed securities at March 31 consist of the following: 2008 ----------------------------------------------------- (Dollars in Thousands) ----------------------------------------------------- Gross Gross Unrealized Unrealized Gross Losses Losses Estimated Amortized Unrealized 12 Months Greater Than Fair Costs Gains or Less 12 Months Value --------- ---------- --------- ----------- --------- Available-for-sale securities $38,646 $603 $ - $(149) $39,100 Held-to-maturity securities 30 5 - - 35 ------- ---- ------ ----- ------- Total mortgage- backed securities $38,676 $608 $ - $(149) $39,135 ======= ==== ====== ===== ======= Certain investment securities shown above currently have fair values less than amortized cost and therefore contain unrealized losses. At March 31, 2008, the Company has evaluated these securities and has determined that the decline in value is temporary and is related to the change in market interest rates since purchase. The decline in value is not related to any company or industry specific event. At March 31, 2008, there were 22 mortgage-backed securities with unrealized losses. The Company anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of a more favorable market interest rate environment. 2007 ----------------------------------------------------- (Dollars in Thousands) ----------------------------------------------------- Gross Gross Unrealized Unrealized Gross Losses Losses Estimated Amortized Unrealized 12 Months Greater Than Fair Costs Gains or Less 12 Months Value --------- ---------- --------- ----------- --------- Available-for-sale securities $26,220 $178 $(37) $(128) $26,233 Held-to-maturity securities 148 9 - - 157 ------- ---- ---- ----- ------- Total mortgage- backed securities $26,368 $187 $(37) $(128) $26,390 ======= ==== ==== ===== ======= The amortized cost and estimated fair value of mortgage-backed securities at March 31, 2008, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to prepay obligations with or without prepayment penalties. (Dollars in Thousands) -------------------------------------------- Available-For-Sale Held-To-Maturity -------------------- --------------------- Amortized Estimated Amortized Estimated Cost Fair Value Cost Fair Value --------- ---------- --------- ---------- Mortgage-backed securities One year or less $ - $ - $ 7 $ 7 More than one to five years 533 546 12 12 More than five to ten years 11,360 11,449 3 6 After ten years 26,753 27,105 8 10 ------- ------- ---- ---- Total $38,646 $39,100 $ 30 $ 35 ======= ======= ==== ==== All of the above mortgage-backed securities are rated AAA by a nationally recognized statistical rating organization. 75 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 4 - MORTGAGE-BACKED SECURITIES (Continued) Proceeds from sales of mortgage-backed securities and gross realized gains and losses on mortgage-backed security sales were as follows for the year ended March 31: 2008 2007 2006 ------ ------ ------ (Dollars in Thousands) ------------------------ Proceeds from sales of mortgage-backed securities $2,080 $8,748 $1,054 ====== ====== ====== Gross gains realized on sales of mortgage-backed securities $ 19 $ 28 $ 65 ====== ====== ====== Gross losses realized on sales of mortgage-backed securities $ - $ (9) $ - ====== ====== ====== NOTE 5 - LOANS RECEIVABLE Loans receivable (collateralized principally by properties in the Whatcom, Skagit, Snohomish, and Pierce Counties of Washington State) at March 31 consist of the following: (Dollars in Thousands) ----------------------- 2008 2007 ---------- ---------- First mortgage loans 1-4 family $ 165,824 $ 149,885 1-4 family construction 35,303 28,576 Less participations (54,269) (54,592) ---------- ---------- Net first mortgage loans 146,858 123,869 Commercial construction 307,809 232,078 Commercial land development 178,726 173,270 Multi family residential 45,049 52,727 Commercial real estate 300,109 292,212 Commercial loans 177,685 146,265 Home equity secured loans 47,351 45,307 Other consumer loans 7,005 5,031 ---------- ---------- 1,210,592 1,070,759 Less: Allowance for loan losses (19,114) (15,889) ---------- ---------- $1,191,478 $1,054,870 ========== ========== The Company originates both adjustable and fixed interest rate loans. At March 31, 2008, the Company had adjustable and fixed rate loans as follows: Fixed Rate Adjustable Rate -------------------------------- -------------------------------- (Dollars in (Dollars in Thousands) Thousands) Term to Maturity Book Value Term to Maturity Book Value ---------------- ---------- ---------------- ---------- Less than one year $187,347 Less than one year $697,841 One to three years 70,622 One to three years 85,562 Three to five years 21,648 Three to five years 36,556 Five to fifteen years 71,932 Five to fifteen years 1,916 Over fifteen years 37,168 Over fifteen years - -------- -------- $388,717 $821,875 ======== ======== 76 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 5 - LOANS RECEIVABLE (Continued) Loans serviced for others were approximately $108.9 and $126.0 million, respectively, as of March 31, 2008 and 2007, respectively. The Bank generally receives a monthly fee of 0.25% to 0.375% per annum of the unpaid balance of each loan that is serviced for others. Loans sold are without right of recourse to the Bank by the buyer of the loan interests in the event of default by the borrower. At March 31, 2008, the balance and activity in the servicing asset is immaterial. The allowance for loan losses at March 31, and changes during the year are as follows: 2008 2007 2006 ------- ------- ------- (Dollars in Thousands) --------------------------- Balance, beginning of year $15,889 $14,184 $11,767 Provision for loan losses 4,100 1,850 2,575 Loan chargeoffs (898) (195) (165) Loan recoveries 23 50 7 ------- ------- ------- Balance, end of year $19,114 $15,889 $14,184 ======= ======= ======= The following is a summary of information pertaining to impaired and non-accrual loans: March 31, ------------------- 2008 2007 ------- ------- (Dollars in Thousands) ------------------- Impaired loans without a valuation allowance $ - $ - Impaired loans with a valuation allowance 12,147 1,434 ------- ------- Total impaired loans $12,147 $ 1,434 ======= ======= Valuation allowance related to impaired loans $ 1,972 $ 577 Total non-accrual loans $11,608 $ 226 Total loans past-due 90 days or more and still accruing $ - $ - Years Ended March 31, ---------------------------- 2008 2007 2006 ------ ------ ------ (Dollars in Thousands) ---------------------------- Average investment in impaired loans $1,899 $2,324 $2,261 ====== ====== ====== Interest income recognized on impaired loans $ 228 $ 276 $ - ====== ====== ====== No additional funds are committed to be advanced in connection with impaired loans. Subsequent to March 31, 2008, the Bank accepted a deed in lieu for one property included in the above impairment analysis. Approximately $1.8 million in principal balances were moved to real estate owned and $200,000 was charged against the allowance for loan losses based on the present value calculation of expected cash flows at the time of repossession. 77 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 6 - ACCRUED INTEREST AND DIVIDENDS RECEIVABLE Accrued interest and dividends receivable at March 31 are summarized as follows: 2008 2007 ------- ------- (Dollars in Thousands) ------------------- Investment securities $ 435 $ 528 Mortgage-backed securities 160 111 Loans receivable 7,318 5,980 Dividends on marketable equity securities 3 7 ------ ------ $7,916 $6,626 ====== ====== NOTE 7 - PREMISES AND EQUIPMENT Premises and equipment at March 31 consisted of: 2008 2007 ------- ------- (Dollars in Thousands) ------------------- Buildings $ 19,960 $ 19,988 Equipment 14,544 12,576 -------- -------- 34,504 32,564 Accumulated depreciation (13,719) (11,925) -------- -------- 20,785 20,639 Land 6,993 6,992 -------- -------- Balance, end of year $ 27,778 $ 27,631 ======== ======== NOTE 8 - DEPOSITS A comparative summary of deposits at March 31 follows: 2008 2007 ------- ------- (Dollars in Thousands) ------------------- Demand deposits Savings $ 17,933 $ 21,628 Checking 72,434 78,294 Checking (noninterest-bearing) 70,438 91,703 Money Market 183,063 187,912 ---------- -------- 343,868 379,537 Time certificates of deposit Less than $100,000 286,657 273,022 Greater than or equal to $100,000 287,281 243,346 Brokered CD's 120,986 79,390 ---------- -------- 694,924 595,758 ---------- -------- Total deposits $1,038,792 $975,295 ========== ======== 78 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 8 - DEPOSITS (Continued) Time certificate of deposit accounts, classified by variable and fixed rates, and their maturities at March 31 were as follows: 2008 -------------------------------- Variable Fixed Rate Rate Total 2007 ------- -------- -------- -------- (Dollars in Thousands) -------------------------------------------- Within one year $ 6,321 $552,245 $558,566 $512,062 One to two years 7,617 51,040 58,657 42,020 Two to three years 1,324 62,227 63,551 14,525 Three to four years 489 4,107 4,596 9,426 Four to five years 413 5,647 6,060 13,903 Over five years 3,351 143 3,494 3,822 ------- -------- -------- -------- $19,515 $675,409 $694,924 $595,758 ======= ======== ======== ======== The terms of variable rate certificates of deposit allow customers to make additional deposits to existing certificates of deposit at any time. The weighted average nominal interest rate on all deposits at March 31, 2008 and 2007, was 3.83% and 3.56%, respectively. Interest expense on all deposit accounts for the years ended March 31 is summarized as follows: (Dollars in Thousands) ----------------------------- 2008 2007 2006 ------- ------- ------- Money market $ 6,534 $ 6,316 $ 3,456 Checking 466 510 426 Savings 176 167 189 Certificates of deposit 30,897 25,258 15,917 ------- ------- ------- Balance, end of year $38,073 $32,251 $19,988 ======= ======= ======= NOTE 9 - OTHER BORROWED FUNDS The Bank is a member of the FHLB of Seattle. As a member, the Bank has a committed line of credit up to 25% of total assets, subject to the Bank pledging sufficient collateral and maintaining the required stock investment in the FHLB. Committed lines of credit agreements totaling approximately $272.7 million and $248.5 million were available to the Bank, of which, $192.0 million and $143.5 million were outstanding at March 31, 2008 and 2007, respectively. Included in these amounts is the borrowing related to the investment in real estate in a joint venture of $22.4 million and $20.2 illion as of March 31, 2008 and 2007, respectively. These advances bear interest rates ranging from 2.36% to 5.09% and 2.75% to 5.69% per annum in 2008 and 2007, respectively. Maturities for the advances are $77.5 million in fiscal 2009, $101.0 million in fiscal 2010, and $13.5 million in fiscal 2011. The maximum outstanding, average outstanding balances and average interest rates on advances from the FHLB were as follows for the year ended March 31: 2008 2007 2006 ------- ------- ------- (Dollars in Thousands) ----------------------------- Maximum outstanding at any month end $212,500 $195,000 $149,000 Average outstanding 177,874 165,237 134,070 Weighted average interest rates: Annual 4.44% 4.74% 3.68% ==== ==== ==== End of year 3.15% 5.03% 4.39% ==== ==== ==== 79 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 9 - OTHER BORROWED FUNDS (Continued) The Bank has other borrowed funds in the form of retail repurchase agreements. These agreements are collateralized by securities held by a safekeeping agent not under control of the Bank. These advances are considered overnight borrowings and bear interest rates that fluctuate daily based on current market rates. The Bank had $21.9 million and $14.4 million outstanding as of March 31, 2008 and 2007, respectively. The Bank also had $850,000 and $1.0 million outstanding as of March 31, 2008 and 2007, respectively, in the form of a TT&L note option which is included in other borrowed funds. At March 31, 2008 and 2007, U.S. government agency and corporate debt securities of $35.8 million and $16.3 million, respectively, were pledged as collateral for retail repurchase agreements. NOTE 10 - INCOME TAX A reconciliation of the Company's income tax provision to the statutory federal income tax rate for the years ended March 31 is as follows: 2008 2007 2006 ------ ------ ------ (Dollars in Thousands) ----------------------------- Provision for income tax at the statutory rate of 35 percent $9,577 $10,008 $7,895 Increase (decrease) in tax resulting from: Nontaxable income (572) (469) (539) Nondeductible expense 46 29 15 Dividends received deduction (52) (52) (48) Other, net (50) 50 (420) ------ ------ ------ Income tax provision $8,949 $9,566 $6,903 ====== ====== ====== The nature and components of the Company's net deferred tax assets (liabilities), established at an estimated tax rate of 35% are as follows at March 31: 2008 2007 -------- --------- (Dollars in Thousands) -------------------- Deferred Tax Assets Deferred compensation agreements $ 681 $ 707 Financial reporting loan loss reserve not recognized for tax purposes 6,344 5,215 Financial reporting accrued expenses not recognized for tax purposes 329 403 Other deferred tax assets 2,173 1,404 ------- ------- Total deferred assets 9,527 7,729 ------- ------- Deferred Tax Liabilities Deferred loan fees for tax purposes in excess of amounts deferred for financial reporting (255) (264) Tax effect of unrealized gains on available-for- sale securities (1,098) (1,862) FLHB stock dividends (793) (793) Other deferred tax liabilities (1,128) (1,077) ------- ------- Total deferred liabilities (3,274) (3,996) ------- ------- Net deferred tax assets $ 6,253 $ 3,733 ======= ======= The Company believes, based upon the available evidence, that all deferred tax assets will be realized in the normal course of operations. Accordingly, these assets have not been reduced by a valuation allowance. 80 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 10 - INCOME TAX (Continued) The Company adopted the provisions of FASB Interpretation No. 48. Accounting for Uncertainty in Income Taxes, on April 1, 2007. The Company had no unrecognized tax benefits which would require an adjustment to the April 1, 2007 beginning balance of retained earnings. The Company had no unrecognized tax benefits at April 1, 2007 and at March 31, 2008. The Company recognizes interest accrued and penalties related to unrecognized tax benefits in tax expense. During the years ended March 31, 2008 and 2007, the Company recognized no interest and penalties. The Company files federal and various state and local tax returns. With few exceptions, the Company is no longer subject to U.S. Federal or state/local tax examinations by tax authorities for years before 2005. NOTE 11 - BENEFIT PLANS Deferred Compensation Plan - The Company has entered into deferred compensation agreements with certain of its officers. The agreements provide for additional retirement benefits payable over a 12 to 20 year period following retirement. In connection with these agreements, the Company has acquired life insurance policies on the individual officers covered by the deferred compensation agreements. At March 31, 2008 and 2007, the cash surrender values of these policies included in other assets aggregated $2.1 million and $1.9 million, respectively. The Company performs a present value calculation using an appropriate discount rate on an annual basis to ensure that deferred compensation plan obligations are adequately estimated in the accompanying financial statements. The discount rate was 3.30%, 2.67%, and 2.72% in 2008, 2007 and 2006, respectively. Deferred compensation expense amounted to $213,000, and $137,500 for the years ended March 31, 2007 and 2006, respectively. No deferred compensation expense was recognized in 2008. Employee Incentive Plan - The Company has an incentive plan with employees meeting certain performance requirements. Payments made to employees pursuant to the plan are based upon earnings, growth in deposits, and loans and attainment of certain corporate objectives. Costs of the plan were $1.0 million, $2.3 million, and $2.1 million for the years ended March 31, 2008, 2007 and 2006, respectively. Employee Stock Ownership Plan - The Company has a noncontributory employee stock ownership plan ("ESOP") for those employees who have completed a minimum of two years of service. The Company's contribution is determined annually by the Board of Directors. Participants receive distributions from the ESOP only in the event of retirement, disability or termination of employment. The primary purpose of the ESOP is to acquire shares of the Company's common stock on behalf of ESOP participants. In April 1996, the Company issued a loan to the ESOP in the amount of $500,000, to purchase 40,000 shares of the Company's common stock in the open market. The loan was to be repaid over a period of ten years, with annual ayments including interest due on March 31 of each year. The ESOP shares initially were pledged as collateral for this debt. As the obligation was reduced, shares were released from collateral and allocated to the participants' accounts at a rate of 10% a year. In May 1997, the Company issued a 15% stock dividend which added an additional 5,400 shares to the unallocated ESOP shares. In May 1999, the Company made an additional loan to the ESOP in the amount of $154,725, to purchase 12,500 shares of common stock in the open market. The loan was to be repaid over seven years with annual payments including interest due March 31. In April 2001, the Company issued a 15% stock dividend which added an additional 4,789 shares to the unallocated ESOP shares. In July 2002, the Company issued a 25% stock split which added an additional 7,342 shares to the unallocated ESOP shares. In October 2006, the Company issued a 5-for-4 stock split paid in the form of a 25% stock dividend which added an additional 21,023 shares to the allocated ESOP shares. As of March 31, 2006, all loans secured by ESOP shares were paid off, and the remaining shares released. Shares released for allocation were 9,175 for the year ended March 31, 2006. Shares outstanding for the years ended March 31, 2008, 2007 and 2006 were 266,565, 263,262 and 229,411, respectively. Dividends paid on shares of stock are reinvested and the new shares purchased are allocated to the participants. Compensation expense for the ESOP plan was $15,000, $10,000, and $105,000 for the years ended March 31, 2008, 2007 and 2006, respectively. 81 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 11 - BENEFIT PLANS (Continued) 401(k) Plan - Effective January 1, 1993, the Company adopted a defined contribution 401(k) retirement and savings plan (the "Plan") covering substantially all employees. The Company contributes three percent of participating employees' eligible salary to the Plan and a discretionary amount determined annually by the Board of Directors. Total Company contributions to the Plan which were recorded as employee benefits expense amounted to $525,000, $490,000, and $500,000 for the years ended March 31, 2008, 2007 and 2006, respectively. Stock Option and Restricted Stock Award Plans - In 2005, Shareholders approved an Incentive Stock Plan (the "Plan") to promote the best interest of the Company, our subsidiaries and our shareholders, by providing an incentive to those key employees who contribute to our success. The Plan allows for incentive stock options and restricted stock grants to be awarded. The maximum number of shares that may be issued under the Plan is 937,500 common shares. At March 31, 2008, 795,903 common shares were available for grant. Shares issued and outstanding are adjusted to reflect common stock dividends and splits. Options and awards are granted at fair market value and may or may not vest immediately upon issuance based on the terms established by the Board of Directors. Options and awards are generally exercisable within one to five years from date of grant and expire after ten years. Dividends are paid on restricted stock grants and are not paid on incentive stock options. Certain options provide for accelerated vesting if there is a change in control. The Company measures the fair value of each stock option grant at the date of grant, using the Black Scholes option pricing model. The expected term of the options is developed by considering the historical share option exercise experience, historical share retention practices of employees and assumptions about their propensity for early exercise in the future. Expected volatility is estimated using daily historical volatility. We believe that historical volatility is currently the best estimate of expected volatility. The dividend yield is the annualized yield on our common stock on the date of grant. The risk free interest rate is the yield on the grant date of U.S. Treasury zero coupon issues with a maturity comparable to the expected term of the option. The weighted average fair value of options granted during the twelve months ended March 31, 2008, 2007 and 2006 was $4.75, $4.18, and $3.81 per share, as adjusted, respectively. The following assumptions were used in arriving at the fair value of options granted during the twelve months ended March 31: 2008 2007 2006 ------ ------ ------ Risk-free interest rate 4.213% 5.27% 4.17% Dividend yield rate 2.702% 2.417% 2.613% Price volatility 31.06% 24.77% 25.27% Weighted average expected life of options 4.45 yr. 3.78 yr 5.50 yr. The following tables summarize option activity under the Plan as of March 31, 2008 and 2007 and changes during the year then ended: Weighted Weighted Average Average Aggregate Number Exercise Remaining Intrinsic Outstanding Price per Contractual Value (in Stock Options Under Plan Share Total 2007 ----------------------------- ----------- --------- ----------- --------- Balance, March 31, 2007 184,475 10.05 4.84 2,184 Granted 39,362 19.95 Exercised (28,531) 6.81 Forfeited, expired or cancelled (2,085) 19.26 ------- ------ ---- ------ Balance, March 31, 2008 193,221 $12.45 5.40 $ 761 ======= ====== ==== ====== Exercisable, March 31, 2008 128,256 $ 8.91 3.66 $ 761 ======= ====== ==== ====== 82 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 11 - BENEFIT PLANS (Continued) The weighted average grant date fair value of options granted during the twelve months ended March 31, 2008, 2007 and 2006 was $4.75, $4.18, and $3.81 per share, as adjusted, respectively. The total intrinsic value, the amount by which the fair value of the underlying stock exceeds the exercise price of an option on the exercise date, of options exercised for the years ended March 31, 2008, 2007 and 2006 was $215,000, $364,000, and $1.4 million, respectively. Options Outstanding Options Exercisable ------------------------------------------------- ---------------------- Weighted Average Weighted Range of Remaining Average Average Exercise Number Contractual Exercise Number Exercise Prices Outstanding Life Price Exercisable Price --------- ----------- ------------ -------- ----------- -------- $5 to $10 97,727 2.67 years $ 6.78 97,727 $ 6.78 $10 to $15 8,126 5.07 years $11.87 7,813 $11.77 $15 to $20 63,400 8.21 years $17.65 22,716 $17.09 $20 to $25 23,968 9.24 years $21.97 - $ - The following table summarizes restricted stock award activity under the Plan as of March 31, 2008 and 2007 and changes during the years then ended: Weighted Weighted Average Aggregate Grant Remaining Outstanding Price per Contractual Restricted Stock Awards Under Plan Share Term (in Years) ----------------------------------- ----------- --------- -------------- Balance, March 31, 2007 31,682 $18.91 1.86 Granted 30,500 21.88 Vested (8,751) 18.73 Forfeited, expired or cancelled (1,670) 20.01 ------ ------ ---- Balance, March 31, 2008 51,761 $20.66 0.91 ====== ====== ==== The total intrinsic value of restricted stock vested for the years ended March 31, 2008 and 2007 was $173,000 and $76,000, respectively. No restricted stock vested for the year ended March 31, 2006. NOTE 12 - STOCKHOLDERS' EQUITY Capital Requirements - The Company and 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 and the Bank's financial statements. Under capital adequacy guidelines within the regulatory framework for prompt corrective action, the Bank must meet specific capital adequacy guidelines that involve quantitative measures of each entity's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures are established by regulation to ensure capital adequacy, require maintenance of minimum amounts and ratios of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets, and of Tier 1 capital to average assets as illustrated in the following table. Management believes, as of March 31, 2008, that each entity meets all capital adequacy requirements to which they are subject. Additionally, as of March 31, 2008, the Bank was categorized as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank's category. 83 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 12 - STOCKHOLDERS' EQUITY (Continued) To Be Well Capitalized Under Prompt For Capital Corrective Adequacy Action Actual Purposes Provisions -------------- -------------- -------------- Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- As of March 31, 2008 (in thousands) Total Capital (to Risk Weighted Assets) Consolidated $142,881 11.08% $103,198 >8.00% N/A Horizon Bank $142,118 11.02% $103,157 >8.00% $128,947 >10.00% Tier I Capital (to Risk Weighted Assets) Consolidated $125,815 9.75% $ 51,599 >4.00% N/A Horizon Bank $125,058 9.70% $ 51,579 >4.00% $ 77,368 > 6.00% Tier I Capital (to Average Assets) Consolidated $125,815 9.10% $ 55,300 >4.00% N/A Horizon Bank $125,058 9.05% $ 55,300 >4.00% $ 69,125 > 5.00% To Be Well Capitalized Under Prompt For Capital Corrective Adequacy Action Actual Purposes Provisions -------------- -------------- -------------- Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- As of March 31, 2007 (in thousands) Total Capital (to Risk Weighted Assets) Consolidated $136,606 12.03% $ 90,870 >8.00% N/A Horizon Bank $136,337 12.00% $ 90,862 >8.00% $113,578 >10.00% Tier I Capital (to Risk Weighted Assets) Consolidated $119,942 10.56% $ 45,435 >4.00% N/A Horizon Bank $119,674 10.54% $ 45,431 >4.00% $ 68,147 > 6.00% Tier I Capital (to Average Assets) Consolidated $119,942 9.64% $ 49,751 >4.00% N/A Horizon Bank $119,674 9.63% $ 49,728 >4.00% $ 62,160 > 5.00% Holding Company Loans - Under federal regulations, the Bank is limited, unless previously approved, as to the amount it may loan to the holding company and any one affiliate, to 10% of its capital stock and surplus, and the total of loans to the holding company and affiliates must not exceed 20% of capital and surplus. Further, all such loans must be fully collateralized. In addition, dividends paid by the Bank to the Company would be prohibited if the effect thereof would cause the Bank's capital to be reduced below applicable minimum capital requirements. Dividend Reinvestment Plan - As a service to its stockholders of record, the Bank offers a Dividend Reinvestment and Stock Purchase Plan ("Reinvestment Plan"). Under the terms of the Reinvestment Plan, dividends and optional cash payments may be reinvested toward the purchase of additional shares of stock. No brokerage commission or fees are charged to acquire shares through the Reinvestment Plan. Stock Repurchase Plans - The Company has conducted various stock buy-back programs since August 1996. In March 2005, the Company announced a plan to repurchase up to 1,250,000 shares, or approximately 10% of the Company's outstanding common stock. During fiscal 2006, 266,065 shares were repurchased and subsequently retired at a cost of $4.4 million. In March 2006, the Company announced a plan to repurchase up to 625,000 shares, or approximately 5% of the Company's outstanding common stock. During fiscal 2007, 144,580 shares were repurchased and subsequently retired at a cost of $2.9 million. In March 2007, the Company announced a plan to repurchase up to 600,000 shares, or approximately 5% of the Company's outstanding common stock. During fiscal 2008, 399,700 shares were repurchased and subsequently retired at a cost of $7.1 million. Share information related to stock repurchases has been restated to reflect stock splits and dividends. 84 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ Stock Split - The Company's Board of Directors, at its September 26, 2006 Board meeting, announced a 5 for 4 stock split paid in the form of a 25% stock dividend to be issued October 23, 2006 for shareholders of record October 6, 2006. NOTE 13 - EARNINGS PER SHARE The numerators and denominators, adjusted for stock splits and dividends, of basic and diluted earnings per share are as follows: (Dollars in Thousands) ------------------------------------- 2008 2007 2006 ----------- ----------- ----------- Net income (numerator) $ 18,413 $ 19,028 $ 15,655 Shares used in the calculation (denominators) Basic earnings per weighted average share outstanding 12,097,615 12,287,805 12,422,000 Effect of dilutive stock options 99,168 121,287 120,845 ----------- ----------- ----------- Diluted shares 12,196,783 12,409,092 12,542,845 =========== =========== =========== Basic earnings per share $ 1.52 $ 1.55 $ 1.26 =========== =========== =========== Diluted earnings per share $ 1.51 $ 1.53 $ 1.25 =========== =========== =========== Anti-dilutive shares outstanding related to options to acquire the Company's common stock 40,593 - - =========== =========== =========== NOTE 14 - COMMITMENTS AND CONTINGENCIES Employment Agreement - The Company has entered into employment agreements with members of senior management that provide for potential payments upon change in control, disability, termination without cause, or death. The arrangements generally provide severance payments at 2.99 times the then current compensation levels and continuation of certain benefits. Long-Term Lease Commitments - The Company has entered into lease agreements for certain parcels of land and branch offices. Future noncancelable lease payments under these agreements are as follows for the years ending March 31: (Dollars in Thousands) ---------- 2009 $ 419 2010 429 2011 440 2012 443 2013 240 Thereafter 80 ------ $2,051 ====== Rent expense charged to operations was $410,000, $293,000, and $294,000 for the years ended March 31, 2008, 2007 and 2006, respectively. NOTE 15 - RELATED PARTY TRANSACTIONS Certain directors, executive officers, and principal stockholders are Bank customers and have had banking transactions with the Bank. All loans and commitments to loan included in such transactions were made in compliance with applicable laws on substantially the same terms (including interest rates and collateral) as those prevailing at the time for comparable transactions with other persons and do not involve more than the normal risk of collectibility or present any other unfavorable features. 85 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 15 - RELATED PARTY TRANSACTIONS (Continued) The aggregate balances and activity during the years ended March 31, 2008 and 2007, are as follows and were within regulatory limitations: (Dollars in Thousands) ------------------- 2008 2007 ------- ------- Balance, beginning of year $13,505 $15,528 New loans or advances 8,355 5,155 Repayments (8,135) (7,178) ------- ------- Balance, end of year $13,725 $13,505 ======= ======= Interest earned on loans $ 948 $ 1,130 ======= ======= Deposits from related parties totaled approximately $3.9 million and $3.8 million at March 31, 2008 and 2007, respectively. The Company leases office space from a limited partnership in which one of the Company's directors is a part owner. Lease expense for this office space was $156,000, $151,000 and $123,000 for the fiscal years ended March 31, 2008, 2007 and 2006, respectively. The future commitments related to this lease are included in the totals disclosed in Note 14 regarding Long-Term Lease Commitments. NOTE 16 - SIGNIFICANT GROUP CONCENTRATIONS OF CREDIT RISK Most of the Bank's business activity is with customers located within Whatcom, Skagit, Snohomish, and Pierce Counties. Investments in state and municipal securities involve governmental entities within the state of Washington. The Bank originates commercial, real estate, and consumer loans. Generally, loans are secured by deposit accounts, personal property, or real estate. Rights to collateral vary and are legally documented to the extent practicable. Although the Bank has a diversified loan portfolio, local economic conditions may affect borrowers' ability to meet the stated repayment terms. NOTE 17 - FINANCIAL INSTRUMENTS The Bank is a party to financial instruments with off-balance-sheet risk (loan commitments) in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. Loan commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract amounts of those commitments reflect the extent of the Bank's exposure to credit loss from these commitments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. 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. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties. Unfunded commitments under commercial lines-of-credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines-of-credit are uncollateralized and usually do not contain a specified maturity date and may be drawn upon to the total extent to which the Company is committed. 86 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 17 - FINANCIAL INSTRUMENTS (Continued) Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. Except for certain long-term guarantees, the majority of guarantees expire in one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral supporting those commitments, for which collateral is deemed necessary, generally amounts to 100% of the commitment amount at March 31, 2008. The Bank has not been required to perform on any financial guarantees and has not incurred any losses on its commitments for the years ended March 31, 2008, 2007 and 2006. The following is a summary of the off-balance-sheet financial instruments or contracts outstanding at March 31: (Dollars in Thousands) -------------------- 2008 2007 ------- -------- Commitments to extend credit $361,763 $379,549 Credit card arrangements 10,510 10,105 Standby letters of credit 2,047 3,056 NOTE 18 - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of the following classes of financial instruments: Cash Equivalents and Interest-Bearing Deposits - Due to the relatively short period of time between the origination of these instruments and their expected realization, the carrying amount is estimated to approximate fair value. Investment and Mortgage-Backed Securities - Fair values are based on quoted market prices or dealer quotes, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Federal Home Loan Bank Stock - FHLB Stock is carried at $100 par value. This investment is considered restricted, as a minimum, the investment must be maintained in order to obtain borrowing commitments from FHLB. The Company may redeem its investment only at par value, which is used as the estimated market value. Loan Receivables and Investment in Real Estate in a Joint Venture - For certain homogeneous categories of loans, such as those written to FHLMC standards, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Loans Held for Sale - The fair value of loans held for sale is based on the estimated value at which the loans could be sold in the secondary market. Accrued Interest Income and Expense Accounts - Due to the short-term nature of these amounts, recorded book value is believed to approximate fair value. Deposit Liabilities, Repurchase Agreements, Other Borrowed Funds, and Borrowing Related to Investment in Real Estate in a Joint Venture - The fair value of demand deposits, savings accounts, certain money market deposits, and federal funds purchased, is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit, repurchase agreements and other borrowed funds are estimated by discounting the estimated future cash flows using the rates currently offered for these instruments with similar remaining maturities. Off-Balance-Sheet Instruments - The Company's off-balance-sheet instruments include unfunded commitments to extend credit and borrowing facilities available to the Company. The fair value of these instruments is not considered practicable to estimate because of the lack of quoted market price and the inability to estimate fair value without incurring excessive costs. 87 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 18 - DISCLOSURES ABOUT FAIN VALUE OF FINANCIAL INSTRUMENTS (Continued) The carrying amounts and estimated fair values of the Bank's financial instruments at March 31, are as follows: (Dollars in Thousands) -------------------------------------------- 2008 2007 --------------------- --------------------- Carrying Carrying Amount Fair Value Amount Fair Value -------- ---------- -------- ---------- Financial Assets Cash and cash equivalents $ 22,412 $ 22,412 $ 40,833 $ 40,833 Interest-bearing deposits 2,912 2,912 5,379 5,379 Investment securities 41,241 41,241 53,235 53,237 Mortgage-backed securities 39,130 39,135 26,381 26,390 Federal Home Loan Bank stock 8,867 8,867 7,247 7,247 Loans held-for-sale 2,644 2,644 4,493 4,493 Loans receivable 1,191,478 1,190,418 1,054,870 1,049,670 Investment in real estate in a joint venture 17,567 17,567 17,169 17,169 Accrued interest and dividends receivable 7,916 7,916 6,626 6,626 Financial Liabilities Demand and savings deposits 343,868 343,868 379,537 379,537 Time deposits 694,924 677,364 595,758 590,370 Accrued interest payable 1,566 1,566 3,450 3,450 Other borrowed funds 192,343 193,003 138,715 138,009 Borrowing related to investment in real estate in a joint venture 22,448 22,448 20,243 20,243 NOTE 19 - PARENT COMPANY (ONLY) FINANCIAL INFORMATION Condensed balance sheet at March 31: (Dollars in Thousands) -------------------- 2008 2007 -------- -------- Cash $ 216 $ 138 Investment in Bank 127,560 123,586 Investment Securities - available for sale 235 - Other assets 1,912 1,663 -------- -------- $129,923 $125,387 ======== ======== Other liabilities $ 1,606 $ 1,532 Stockholders' equity 128,317 123,855 -------- -------- $129,923 $125,387 ======== ======== 88 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 19 - PARENT COMPANY (ONLY) FINANCIAL INFORMATION (Continued) Condensed statement of income for the years ended March 31, 2008, 2007 and 2006: (Dollars in Thousands) --------------------------- 2008 2007 2006 ------- ------- ------- Income Cash dividends from Bank subsidiary $13,961 $ 9,149 $ 9,981 Interest - - 2 ------- ------- ------- Total income 13,961 9,149 9,983 ------- ------- ------- Expenses Compensation 851 426 164 Other 221 372 346 ------- ------- ------- Total expenses 1,072 798 510 ------- ------- ------- Income before undistributed income of subsidiary and benefit equivalent to income taxes 12,889 8,351 9,473 Benefit equivalent to income taxes 141 279 178 ------- ------- ------- Income before undistributed income of subsidiary 13,030 8,630 9,651 Undistributed income of subsidiary 5,383 10,398 6,004 ------- ------- ------- Net income $18,413 $19,028 $15,655 ======= ======= ======= (Dollars in Thousands) --------------------------- 2008 2007 2006 ------- ------- ------- Cash flows from operating activities Net income $ 18,413 $ 19,028 $15,655 Adjustments to reconcile net income to net cash flows from operating activities Equity in undistributed income of subsidiary (5,383) (10,398) (6,004) Other operating activities 478 127 (66) -------- -------- ------- Net cash flows from operating activities 13,508 8,757 9,585 -------- -------- ------- Cash flows from investing activities Other investing activities (250) - 22 -------- -------- ------- Net cash flows from investing activities (250) - 22 -------- -------- ------- Cash flows from financing activities Sale of common stock 194 149 464 Dividends paid (6,312) (5,977) (5,572) Treasury stock purchased (7,062) (2,942) (4,378) -------- -------- ------- Net cash flows from financing activities (13,180) (8,770) (9,486) -------- -------- ------- Net change in cash 78 (13) 121 Cash, beginning of year 138 151 30 -------- -------- ------- Cash, end of year $ 216 $ 138 $ 151 ======== ======== ======= 89 HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2008, 2007 AND 2006 ------------------------------------------------------------------------------ NOTE 20 - SELECTED QUARTERLY FINANCIAL DATA (IN THOUSANDS) (UNAUDITED) (Dollars in Thousands) -------------------------------------------------- Year Ended March 31, 2008 -------------------------------------------------- 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter ----------- ----------- ----------- ----------- Interest income $24,899 $25,892 $25,909 $23,543 Interest expense 11,458 11,949 12,109 11,129 Net interest income 13,441 13,943 13,800 12,414 Provision for loan losses 400 800 900 2,000 Noninterest income 1,703 1,612 1,516 2,213 Noninterest expense 7,255 7,452 7,422 7,051 ------- ------- ------- ------- Income before provision for income tax 7,489 7,303 6,994 5,576 Provision for income tax 2,473 2,390 2,282 1,804 ------- ------- ------- ------- Net income $ 5,016 $ 4,913 $ 4,712 $ 3,772 ======= ======= ======= ======= Basic earnings per share (adjusted for stock splits and dividends) $ 0.41 $ 0.40 $ 0.39 $ 0.32 ======= ======= ======= ======= Diluted earnings per share (adjusted for stock splits and dividends) $ 0.41 $ 0.40 $ 0.39 $ 0.31 ======= ======= ======= ======= (Dollars in Thousands) -------------------------------------------------- Year Ended March 31, 2007 -------------------------------------------------- 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter ----------- ----------- ----------- ----------- Interest income $21,183 $22,993 $24,299 $24,125 Interest expense 8,501 9,860 10,877 10,895 Net interest income 12,682 13,133 13,422 13,230 Provision for loan losses 700 700 450 - Noninterest income 1,474 1,437 1,419 1,508 Noninterest expense 6,550 6,876 7,054 7,381 ------- ------- ------- ------- Income before provision for income tax 6,906 6,994 7,337 7,357 Provision for income tax 2,324 2,344 2,454 2,444 ------- ------- ------- ------- Net income $ 4,582 $ 4,650 $ 4,883 $ 4,913 ======= ======= ======= ======= Basic earnings per share (adjusted for stock splits and dividends) $ 0.37 $ 0.38 $ 0.40 $ 0.40 ======= ======= ======= ======= Diluted earnings per share (adjusted for stock splits and dividends) $ 0.37 $ 0.37 $ 0.39 $ 0.40 ======= ======= ======= ======= 90 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 Corporation's disclosure controls and procedures (as defined in Rule 13(a)-15(e) of the Exchange Act was carried out under the supervision and with the participation of the Corporation's Chief Executive Officer, Chief Financial Officer and several other members of the Corporation's senior management as of the end of the period covered by this report. The Corporation's Chief Executive Officer and Chief Financial Officer concluded that the Corporation's disclosure controls and procedures as currently in effect are effective in ensuring that the information required to be disclosed by the Corporation in the reports it files or submits under the Exchange Act is (i) accumulated and communicated to the Corporation'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 March 31, 2008, that have materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. The Corporation continued, however, to implement suggestions from its internal auditor and independent auditors on ways to strengthen existing controls. The Corporation 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 Corporation 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 cost- effective control procedures, misstatements due to error or fraud may occur and not be detected. (c) Management's Annual Report on Internal Control over Financial Reporting. Management's report and the independent registered public accounting firm's attestation report are included in Item 8 of this Annual Report on Form 10-K for the year ended March 31, 2008 under the captions entitled "Management's Annual Report on Internal Control over Financial Reporting" and " Report of Independent Registered Public Accounting Firm." The Corporation intends to continually review and evaluate the design and effectiveness of its disclosure controls and procedures and to improve its controls and procedures over time and to correct any deficiencies that it may discover in the future. The goal is to ensure that senior management has timely access to all material financial and non-financial information concerning the Corporation's business. While the Corporation believes the present design of its disclosure controls and procedures is effective to achieve its goal, future events affecting its business may cause the Corporation to modify its disclosure controls and procedures. Item 9B. Other Information --------------------------- There was no information to be disclosed by the Corporation in a current report on Form 8-K during the fourth quarter of fiscal 2008 that was not so disclosed. 91 PART III Item 10. Directors, Executive Officers and Corporate Governance ---------------------------------------------------------------- Directors and Executive Officers The information contained under the section captioned "Proposal I -- Election of Directors" is included in the Company's Definitive Proxy Statement for the 2008 Annual Meeting of Stockholders ("Proxy Statement") and is incorporated herein by reference. For information regarding the executive officers of the Corporation and the Bank, see the information contained herein under the section captioned "Item 1. Business - Personnel - Executive Officers of the Registrant." Audit Committee Financial Expert The Audit Committee of the Corporation is composed of Directors James A. Strengholt (Chairman) and Robert C. Tauscher. Each member of the Audit Committee is "independent" as defined in the NASDAQ Stock Market listing standards. The Corporation's Board of Directors has determined that there is no "audit committee financial expert," as defined in the SEC's Regulation S-K. The Board believes that the current members of the Audit Committee are qualified to serve based on their experience and background. Code of Ethics The Board of Directors have adopted Officer and Director Codes of Ethics. The Codes are applicable to each of the Corporation's directors and officers, including the principal executive officer and senior financial officers, and requires individuals to maintain the highest standards of professional conduct. A copy of the Code of Ethics applicable to the principal executive officer and senior financial officers was filed as an exhibit to the Corporation's Annual Report on Form 10-K for the fiscal year ended March 31, 2007. The Corporation has not made the Codes of Ethics available on its website. The Corporation will provide a copy of the Codes of Ethics free of charge upon request. 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 Corporation's Proxy Statement and is incorporated herein by reference. Item 11. Executive Compensation -------------------------------- Information regarding management and director compensation and transactions with management and others is incorporated by reference to the section captioned "Executive Compensation" and "Director's Compensation" in the Proxy Statement. 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 Corporation'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 Corporation's Proxy Statement and are incorporated herein by reference. 92 (c) Changes In Control The Corporation is not aware of any arrangements, including any pledge by any person of securities of the Corporation, the operation of which may at a subsequent date result in a change in control of the Corporation. (d) Equity Compensation Plan Information The following table summarizes share and exercise price information about the Corporation's equity compensation plans as of March 31, 2008. Number of securities remaining available for Number of future issuance securities under equity to be issued Weighted-average compensation upon exercise of exercise price plans (excluding outstanding of outstanding securities options, warrants options, warrants reflected in Plan category and rights and rights column (a)) -------------------- ----------------- ----------------- ------------------ (a) (b) (c) Equity compensation plans approved by security holders: 1995 Stock Option and Incentive Plan............... 115,228 7.88 -- 2005 Incentive Stock Plan......... 77,993 19.19 795,903 Equity compensation plans not approved by security holders. -- -- Total............ 193,221 $12.45 795,903 Item 13. Certain Relationships and Related Transactions, and Director ---------------------------------------------------------------------- Independence ------------ The information contained under the sections captioned "Meetings and Committees of the Board of Directors and Corporate Governance -- Corporate Governance -- Related Party Transactions" and "Meetings and Committees of the Board of Directors and Corporate Governance Matters -- Corporate Governance -- Director Independence" are included in the Company's Proxy Statement and are incorporated herein by reference. Item 14. Principal Accounting Fees and Services ------------------------------------------------ The information contained under the section captioned "Independent Auditors" is included in the Corporation'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 Horizon Financial, Corp. (incorporated by reference to Exhibit 3.1 to the Registrant's Current Report on Form 8-K dated October 13, 1995) 3.2 Bylaws of Horizon Financial Corp. (incorporated by reference to Exhibit 3.2 to the Registrant's Current Report on Form 8-K dated October 13, 1995) 10.1 Amended and Restated Employment Agreement with V. Lawrence Evans (incorporated by reference to the Registrant's Annual Report on Form 10-K for the year ended March 31, 1996) 10.2 Deferred Compensation Plan (incorporated by reference to the Registrant's Annual Report on Form 10-K for the year ended March 31, 1996) 93 10.3 1986 Stock Option and Incentive Plan (incorporated by reference to Exhibit 99.1 to the Registrant's Registration Statement on Form S-8 (File No. 33-99780)) 10.4 1995 Stock Option Plan (incorporated by reference to Exhibit 99.2 to the Registrant's Registration Statement on Form S-8 (File No. 33-99780)) 10.5 Bank of Bellingham 1993 Employee Stock Option Plan (incorporated by reference to Exhibit 99 to the Registrant's Registration Statement on Form S-8 (File No. 33-88571)) 10.6 Severance Agreement with Dennis C. Joines (incorporated by reference to the Registrant's Annual Report on Form 10-K for the year ended March 31, 2002) 10.7 Severance Agreement with Richard P. Jacobson, as amended (incorporated by reference to the Registrant's Current Report on Form 8-K dated January 23, 2008) 10.8 Severance Agreement with Steve Hoekstra (incorporated by reference to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 2002) 10.9 Stock Incentive Plan (incorporated by reference to Exhibit 99 to the Registrant's Registration Statement on Form S-8 (File No. 333-127178)) 10.10 Form of Incentive Stock Option Award Agreement under the 2005 Stock Incentive Plan (incorporated by reference to Exhibit 99.1 contained in the Registrant's Current Report on Form 8-K dated July 27, 2005) 10.11 Form of Non-qualified Stock Option Award Agreement under the 2005 Stock Incentive Plan (incorporated by reference to Exhibit 99.1 contained in the Registrant's Current Report on Form 8-K dated July 27, 2005) 10.12 Form of Restricted Stock Award Agreement under the 2005 Stock Incentive Plan (incorporated by reference to Exhibit 99.1 contained in the Registrant's Current Report on Form 8-K dated July 27, 2005) 10.13 Transition Agreement with V. Lawrence Evans (incorporated by reference to the Registrant's Current Report on Form 8-K dated March 25, 2008) 14 Code of Ethics (incorporated by reference to the Registrant's Annual Report on Form 10-K for the year ended March 31, 2007) 21 Subsidiaries of the Registrant (incorporated by reference to the Registrant's Annual Report on Form 10-K for the year ended March 31, 2007) 23 Consent of Moss Adams LLP, Independent Registered Public Accounting Firm 31 Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act 32 Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act (b) Financial Statement Schedules The Consolidated Financial Statements and Notes thereto are included in Item 8 of this Form 10-K. 94 SIGNATURES Pursuant to the requirements of Section 13 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. HORIZON FINANCIAL CORP. Date: June 11, 2008 By: /s/Richard P. Jacobson -------------------------------------- Richard P. Jacobson Chief Executive Officer, President and Chief Financial Officer (Duly Authorized Representative) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By: /s/Richard P. Jacobson By: /s/Robert C. Diehl ---------------------------- -------------------------------------- Richard P. Jacobson Robert C. Diehl Chief Executive Officer, Director President and Chief Financial Officer (Principal Executive and Financial Officer) Date: June 11, 2008 Date: June 11, 2008 By: /s/V. Lawrence Evans By: /s/James A. Strengholt ---------------------------- -------------------------------------- V. Lawrence Evans James A. Strengholt Chairman of the Board Director Date: June 11, 2008 Date: June 11, 2008 By: /s/Dennis C. Joines By: /s/Robert C. Tauscher ---------------------------- -------------------------------------- Dennis C. Joines Robert C. Tauscher President, Chief Operating Director Officer and Director of Horizon Bank, and Executive Vice President and Director of Horizon Financial Corp. Date: June 11, 2008 Date: June 11, 2008 By: /s/Kelli J. Holz By: /s/Gary E. Goodman ---------------------------- -------------------------------------- Kelli J. Holz Gary E. Goodman Principal Accounting Officer Director Date: June 11, 2008 Date: June 11, 2008 95 By: /s/Richard R. Haggen -------------------------------- Richard R. Haggen Director Date: June 11, 2008 96 EXHIBIT INDEX Exhibit 23 Consent of Moss Adams LLP, Independent Registered Public Accounting Firm Exhibit 31 Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act Exhibit 32 Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act Exhibit 23 Consent of Independent Registered Public Accounting Firm CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors Horizon Financial Corp. and Subsidiary We consent to the incorporation by reference in the Registration Statements on Form S-8 (No. 33-99780 and No. 333-127178) of our report dated June 11, 2008 relating to the consolidated statement of financial position of Horizon Financial Corp. and Subsidiary as of March 31, 2008 and 2007, and the related consolidated statements of income, stockholders' equity and comprehensive income, and cash flows for each of the years in the three-year period ended March 31, 2008, and in our same report, with respect to Horizon Financial Corp. and Subsidiary's internal control over financial reporting as of March 31, 2008, appearing in this Annual Report on Form 10-K of Horizon Financial Corp. and Subsidiary, for the year ended March 31, 2008 and 2007. /s/Moss Adams LLP Bellingham, Washington June 11, 2008 Exhibit 31 Certification Required by Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934 I, Richard P. Jacobson, certify that: 1. I have reviewed this Annual Report on Form 10-K of Horizon Financial Corp.; 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. I am 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. 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: June 11, 2008 /s/Richard P. Jacobson ----------------------------------- Richard P. Jacobson Chief Executive Officer, President and Chief Financial Officer Exhibit 32 CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER OF HORIZON FINANCIAL CORP. 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. /s/Richard P. Jacobson --------------------------------- Richard P. Jacobson Chief Executive Officer and Chief Financial Officer Dated: June 11, 2008