-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, DgxHviFQOhUJNUGU49cy0qtx1tPLRioFGO5Xp2RhUbVqFsS6atVGn0SRv+WqVZDd RFznb1mfy7PP/lRIYJQQDg== 0000939057-99-000122.txt : 19991221 0000939057-99-000122.hdr.sgml : 19991221 ACCESSION NUMBER: 0000939057-99-000122 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990930 FILED AS OF DATE: 19991220 FILER: COMPANY DATA: COMPANY CONFORMED NAME: TIMBERLAND BANCORP INC CENTRAL INDEX KEY: 0001046050 STANDARD INDUSTRIAL CLASSIFICATION: SAVINGS INSTITUTIONS, NOT FEDERALLY CHARTERED [6036] IRS NUMBER: 911863696 STATE OF INCORPORATION: WA FISCAL YEAR END: 0930 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-23333 FILM NUMBER: 99777441 BUSINESS ADDRESS: STREET 1: 624 SIMPSON AVE CITY: HOQUIAM STATE: WA ZIP: 98550 BUSINESS PHONE: 3605334747 MAIL ADDRESS: STREET 1: 624 SIMPSON AVE CITY: HOQUIAM STATE: WA ZIP: 98550 10-K405 1 TIMBERLAND BANCORP, INC. FORM 10-K SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended September 30, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number: 0-23333 TIMBERLAND BANCORP, INC. - ------------------------------------------------------------------------------ (Exact name of registrant as specified in its charter) Washington 91-1863696 - ---------------------------------------------- -------------------- (State or other jurisdiction of incorporation (I.R.S. Employer or organization) I.D. Number) 624 Simpson Avenue, Hoquiam, Washington 98550 - ---------------------------------------------- -------------------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (360) 533-4747 -------------------- Securities registered pursuant to Section 12(b) of the Act: None -------------------- Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.01 per share -------------------------------------- (Title of Class) Check whether the Registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 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 ----- ----- Check if there is no disclosure of delinquent filers pursuant to Item 405 of Regulation S-K contained herein, and no disclosure will be contained, to the best of the Registrant's knowledge, in any definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K. X ------ As of December 6, 1999, there were issued and outstanding 5,116,626 shares of the registrant's Common Stock, which are listed on the Nasdaq National Market System under the symbol "TSBK." Based on the average of the bid and asked prices for the Common Stock on December 6, 1999, the aggregate value of the Common Stock outstanding held by nonaffiliates of the registrant was $60,440,145 (5,116,626 shares at $11.8125 per share). For purposes of this calculation, Common Stock held by officers and directors of the registrant and Timberland Savings Bank, SSB Employee Stock Ownership Plan and Trust are considered nonaffiliates. DOCUMENTS INCORPORATED BY REFERENCE 1. Portions of Definitive Proxy Statement for the 2000 Annual Meeting of Stockholders (Part III). TIMBERLAND BANCORP, INC. 1999 ANNUAL REPORT ON FORM 10-K TABLE OF CONTENTS Page PART I. ............................................................ 1 Item 1. Business............................................... 1 General................................................... 1 Market Area............................................... 1 Lending Activities........................................ 2 Investment Activities..................................... 18 Deposit Activities and Other Sources of Funds............. 19 Regulation of the Bank.................................... 23 Regulation of the Company................................. 29 Taxation.................................................. 30 Competition............................................... 32 Subsidiary Activities..................................... 32 Personnel................................................. 32 Item 2. Properties............................................. 32 Item 3. Legal Proceedings...................................... 33 Item 4. Submission of Matters to a Vote of Security Holders.... 34 PART II............................................................. 34 Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters............................ 34 Item 6. Selected Financial Data................................ 35 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.................... 37 General................................................ 37 Operating Strategy..................................... 37 Market Risk and Asset and Liability Management......... 38 Comparison of Financial Condition at September 30, 1999 and 1998.......................... 39 Comparison of Operating Results for Years Ended September 30, 1999 and 1998.......................... 40 Comparison of Operating Results for Years Ended September 30, 1998 and 1997.......................... 41 Nonperforming Assets................................... 42 Average Balances, Interest and Average Yields/Cost..... 42 Rate/Volume Analysis................................... 44 Liquidity and Capital Resources........................ 44 Year 2000 Issues....................................... 45 Effect of Inflation and Changing Prices................ 46 Item 7A. Quantitative and Qualitative Disclosures About Market Risk...................................... 46 Item 8. Financial Statements and Supplementary Data............ 47 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure................. 82 PART III............................................................ 82 Item 10. Directors and Executive Officers of the Registrant.... 82 Item 11. Executive Compensation................................ 82 Item 12. Security Ownership of Certain Beneficial Owners and Management................................. 82 Item 13. Certain Relationships and Related Transactions........ 83 PART IV............................................................. 83 Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K............................... 83 PART I Item 1. Business - ----------------- General Timberland Bancorp, Inc. ("Company"), a Washington corporation, was organized on September 8, 1997 for the purpose of becoming the holding company for Timberland Savings Bank, SSB ("Bank") upon the Bank's conversion from a Washington-chartered mutual to a Washington-chartered stock savings bank ("Conversion"). The Conversion was completed on January 12, 1998 through the sale and issuance of 6,612,500 shares of common stock by the Company. At September 30, 1999, the Company had total assets of $307.1 million, total deposits of $188.1 million and total equity of $72.2 million. The Company's business activities generally are limited to passive investment activities and oversight of its investment in the Bank. Accordingly, the information set forth in this report, including consolidated financial statements and related data, relates primarily to the Bank and its subsidiary. The Bank was established in 1915 as "Southwest Washington Savings and Loan Association." In 1935, the Bank converted from a state-chartered mutual savings and loan association to a federally chartered mutual savings and loan association, and in 1972, changed its name to "Timberland Federal Savings and Loan Association." In 1990, the Bank converted to a federally chartered mutual savings bank under the name "Timberland Savings Bank, FSB." In 1991, the Bank converted to a Washington-chartered mutual savings bank and adopted its current name. The Bank's deposits are insured by the FDIC up to applicable legal limits under the Savings Association Insurance Fund ("SAIF"). The Bank has been a member of the Federal Home Loan Bank ("FHLB") System since 1937. The Bank is regulated by the Washington Department of Financial Institutions, Division of Banks ("Division") and the FDIC. The Bank is a community oriented savings bank which has traditionally offered a variety of savings products to its retail customers while concentrating its lending activities on real estate mortgage loans. Lending activities have been focused primarily on the origination of loans secured by one- to- four family residential dwellings, including an emphasis on construction and land development loans, as well as the origination of multi-family and commercial real estate loans. The Bank actively originates adjustable rate residential mortgage loans that do not qualify for sale in the secondary market under Federal Home Loan Mortgage Corporation ("FHLMC") guidelines. Market Area The Bank considers Grays Harbor, Thurston, Pierce, King and Kitsap Counties as its primary market areas. The Bank conducts operations from its main office in Hoquiam (Grays Harbor County), three branch offices in Grays Harbor County (Aberdeen, Montesano and Ocean Shores), a branch office in King County (Auburn, opened in 1994), two branch offices in Pierce County (Edgewood, opened in 1980, and Puyallup, opened in 1996), two branch offices in Thurston County (Lacey, opened in 1997 and Yelm, opened in 1999) and a loan production office in Kitsap County (Silverdale, opened in 1995 in Port Orchard and subsequently relocated to Silverdale in 1998). In October 1999, the Bank converted the Silverdale loan production office to a full service branch in Poulsbo (Kitsap County), Washington, and in November 1999, the Bank opened a full service branch in Spanaway (Pierce County), Washington. See "Item 2. Properties." Hoquiam, population approximately 9,000, is located in Grays Harbor County which is situated along Washington State's central Pacific coast. Hoquiam is located approximately 110 miles southwest of Seattle and 145 miles northwest of Portland, Oregon. The Bank considers its primary market area to include three submarkets primarily rural Grays Harbor County with its historical dependence on the timber and fishing industries; Ocean Shores with its dependence on tourism and vacation home residents; and Pierce, King, Thurston and Kitsap Counties with their dependence on state government in Olympia, the state capital, and the aerospace and computer industries in the Seattle-Tacoma metropolitan area. Each of these markets present operating risks to the Bank. The Bank's recent expansion into 1 Counties and recent opening of a third branch office in Pierce County represents the Bank's strategy to diversify its primary market area to become less reliant on the economy of Grays Harbor County. Lending Activities General. Historically, the principal lending activity of the Bank has consisted of the origination of loans secured by first mortgages on owner-occupied, one- to- four family residences and loans for the construction of one- to- four family residences. In recent years, the Bank has increased its origination of loans secured by multi-family properties, construction and land development loans, land loans and commercial real estate loans. The Bank's net loans receivable, including loans held for sale, totaled approximately $256.1 million at September 30, 1999, representing approximately 83.4% of consolidated total assets and at that date construction and land development loans, land loans and loans secured by commercial and multi-family properties were $167.7 million, or 56.0%, of total loans. The Bank's internal loan policy limits the maximum amount of loans to one borrower to 25% of its capital. At September 30, 1999, the maximum amount which the Bank could have lent to any one borrower and the borrower's related entities was approximately $14.2 million under its policy. At September 30, 1999, the Bank had no loans with an aggregate outstanding balance in excess of this amount. At that date, the Bank had 45 borrowers or related borrowers with total loans outstanding in excess of $1.0 million. The largest amount outstanding to any one borrower and the borrower's related entities was approximately $6.1 million, which includes $2.5 million of undisbursed loans in process balance. Loan Portfolio Analysis. The following table sets forth the composition of the Bank's loan portfolio by type of loan as of the dates indicated. At September 30, ------------------------------------------------------------------------------------------ 1999 1998 1997 1996 1995 ---------------- ---------------- --------------- ---------------- --------------- Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent ----- ------- ------ ------- ------ ------- ------ ------- ------ ------- (Dollars in thousands) Mortgage Loans: One- to- four family(1)(2). $115,133 38.42% $100,921 43.48% $100,127 48.76% $ 95,978 48.51% $ 93,582 53.03% Multi-family.. 15,945 5.32 12,432 5.36 12,178 5.93 12,569 6.35 10,965 6.21 Commercial.... 52,049 17.37 32,906 14.18 29,410 14.32 26,529 13.41 15,592 8.83 Construction and land development.. 90,621 30.24 64,172 27.65 45,031 21.93 47,140 23.83 42,752 24.23 Land(2)....... 9,059 3.02 7,749 3.34 6,937 3.38 6,115 3.09 6,118 3.47 -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ Total mortgage loans....... 282,807 94.37 218,180 94.01 193,683 94.32 188,331 95.19 169,009 95.77 Consumer Loans: Home equity and second mortgage..... 7,978 2.66 8,740 3.77 8,142 3.97 6,576 3.32 5,201 2.95 Other......... 4,279 1.43 4,066 1.74 2,824 1.37 2,476 1.25 2,019 1.15 -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ 12,257 4.09 12,806 5.51 10,966 5.34 9,052 4.57 7,220 4.10 Commercial business loans......... 4,611 1.54 1,105 0.48 964 0.34 476 0.24 232 0.13 -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ Total loans. 299,675 100.00% 232,091 100.00% 205,343 100.00% 197,859 100.00% 176,461 100.00% -------- ====== -------- ====== -------- ====== -------- ====== -------- ====== Less: Undisbursed portion of loans in process... (37,781) (28,886) (14,820) (18,434) (17,262) Unearned income....... (3,170) (2,256) (1,761) (1,708) (1,554) Allowance for loan losses.. (2,056) (1,728) (1,716) (1,133) (1,119) Market value adjustment of loans held- for-sale.... (583) -- (19) (89) (3) -------- -------- -------- -------- -------- Total loans receivable, net........ $256,085 $199,221 $187,027 $176,495 $156,523 ======== ======== ======== ======== ======== - -------------- (1) Includes loans held-for-sale. (2) Includes real estate contracts totaling $1.6 million at September 30, 1999. See " --Lending Activities -- Real Estate Contracts." 2
Residential One- to- Four Family Lending. At September 30, 1999, $115.1 million, or 38.4%, of the Bank's loan portfolio consisted of loans secured by one- to- four family residences. The Bank originates both fixed-rate loans and adjustable-rate loans. Generally, 15- and 30-year fixed-rate loans are originated to meet the requirements for sale in the secondary market to the FHLMC, however, from time to time, a portion of these fixed-rate loans originated by the Bank may be retained in the Bank's loan portfolio to meet the Bank's asset/liability management objectives. The Bank has recently begun to utilize an automated underwriting program, which preliminarily qualifies a loan as conforming to FHLMC underwriting standards when the loan is originated. At September 30, 1999, $39.1 million, or 33.9%, of the Bank's one- to- four family loan portfolio consisted of fixed rate one- to- four family mortgage loans. The Bank also offers adjustable rate mortgage ("ARM") loans at rates and terms competitive with market conditions. All of the Bank's ARM loans are retained in its loan portfolio and not with a view toward sale in the secondary market. The Bank offers several ARM products which adjust annually after an initial period ranging from one to five years subject to a limitation on the annual increase of 2% and an overall limitation of 6%. These ARM products have utilized the weekly average yield on one year U.S. Treasury securities adjusted to a constant maturity of one year plus a margin of 2.875% to 3.500%. ARM loans held in the Bank's portfolio do not permit negative amortization of principal and carry no prepayment restrictions. Borrower demand for ARM loans versus fixed-rate mortgage loans is a function of the level of interest rates, the expectations of changes in the level of interest rates and the difference between the initial interest rates and fees charged for each type of loan. The relative amount of fixed-rate mortgage loans and ARM loans that can be originated at any time is largely determined by the demand for each in a competitive environment. At September 30, 1999, $76.0 million, or 66.1%, of the Bank's one- to- four family loan portfolio consisted of ARM loans. The material portion of the Bank's ARM loans are "non-conforming" because they do not satisfy acreage limits, or various other requirements imposed by the FHLMC. Some of these loans are also originated to meet the needs of borrowers who cannot otherwise satisfy the FHLMC credit requirements because of personal and financial reasons (i.e., divorce, bankruptcy, length of time employed, etc.), and other aspects, which do not conform to the FHLMC's guidelines. Many of these borrowers have higher debt to income ratios, or the loans are secured by unique properties in rural markets for which there are no comparable sales of comparable properties to support value according to secondary market requirements. These loans are known as non-conforming loans and the Bank may require additional collateral or lower loan-to-value ratios prior to the origination of the loan. The Bank believes that these loans satisfy a need in its local market area. As a result, subject to market conditions, the Bank intends to continue to originate such loans. The retention of ARM loans in the Bank's loan portfolio helps reduce the Bank's exposure to changes in interest rates. There are, however, unquantifiable credit risks resulting from the potential of increased interest to be paid by the customer due to increases in interest rates. It is possible that, during periods of rising interest rates, the risk of default on ARM loans may increase as a result of repricing and the increased costs to the borrower. Furthermore, because the ARM loans originated by the Bank generally provide, as a marketing incentive, for initial rates of interest below the rates which would apply were the adjustment index used for pricing initially, these loans are subject to increased risks of default or delinquency. The Bank attempts to reduce the potential for delinquencies and defaults on ARM loans by qualifying the borrower based on the borrower's ability to repay the ARM loan assuming that the maximum interest rate that could be charged at the first adjustment period remains constant during the loan term. Another consideration is that although ARM loans allow the Bank to increase the sensitivity of its asset base due to changes in the interest rates, the extent of this interest sensitivity is limited by the periodic and lifetime interest rate adjustment limits. Because of these considerations, the Bank has no assurance that yields on ARM loans will be sufficient to offset increases in the Bank's cost of funds. 3 While fixed-rate, single-family residential mortgage loans are normally originated with 15 to 30 year terms, such loans typically remain outstanding for substantially shorter periods. This is because borrowers often prepay their loans in full upon sale of the property pledged as security or upon refinancing the original loan. In addition, substantially all mortgage loans in the Bank's loan portfolio contain due-on-sale clauses providing that the Bank may declare the unpaid amount due and payable upon the sale of the property securing the loan. Typically, the Bank enforces these due-on-sale clauses to the extent permitted by law and as business judgment dictates. Thus, average loan maturity is a function of, among other factors, the level of purchase and sale activity in the real estate market, prevailing interest rates and the interest rates payable on outstanding loans. The Bank requires fire and extended coverage casualty insurance (and on loans originated since 1994, if appropriate, generally requires flood insurance) be maintained on all of its real estate secured loans. The Bank's lending policies generally limit the maximum loan-to-value ratio on mortgage loans secured by owner-occupied properties to 95% of the lesser of the appraised value or the purchase price. However, the Bank usually obtains private mortgage insurance ("PMI") on the portion of the principal amount that exceeds 80% of the appraised value of the security property. The maximum loan-to-value ratio on mortgage loans secured by non- owner-occupied properties is generally 75% (70% for loans originated for sale in the secondary market to the FHLMC). Construction and Land Development Lending. Prompted by unfavorable economic conditions in its primary market area in 1980, the Bank sought to establish a market niche and, as a result, began originating construction loans. In recent periods, construction lending activities have been primarily in the Pierce County, King County, Thurston County, and Kitsap County markets. Competition from other financial institutions has increased in recent periods and the Bank expects that its margins on construction loans may be reduced in the future. The Bank currently originates three types of residential construction loans: (i) speculative construction loans, (ii) custom construction loans and (iii) owner/builder loans. The Bank initiated its construction lending with the origination of speculative construction loans. As a result, the Bank began to establish contacts with the building community and increased the origination of custom construction and land development loans in rural market areas. The Bank believes that its in-house computer system has enabled it to establish processing and disbursement procedures to meet the needs of these borrowers. To a lesser extent, the Bank also originates construction loans for the development of multi-family and commercial properties. Subject to market conditions, the Bank intends to continue to emphasize its residential construction lending activities. At September 30, 1999, the composition of the Bank's construction and land development loan portfolio was as follows: Outstanding Percent of Balance Total ------- ----- (In thousands) Speculative construction....................... $22,106 24.39% Custom and owner/builder construction.......... 28,835 31.82 Multi-family................................... 20,879 23.04 Land development............................... 12,350 13.63 Commercial real estate......................... 6,451 7.12 ------- ------ Total........................................ $90,621 100.00% ======= ====== Speculative construction loans are made to home builders and are termed "speculative" because the home builder does not have, at the time of loan origination, a signed contract with a home buyer who has a commitment for permanent financing with either the Bank or another lender for the finished home. The home buyer may be identified either during or after the construction period, with the risk that the builder will have to debt service the speculative 4 construction loan and finance real estate taxes and other carrying costs of the completed home for a significant time after the completion of construction until the home buyer is identified. The Bank lends to approximately 75 builders located in the Bank's primary market area, each of which generally have three to six speculative loans outstanding from the Bank during a 12 month period. Rather than originating lines of credit to home builders to construct several homes at once, the Bank originates and underwrites a separate loan for each home. Speculative construction loans are originated for a term of 12 months, with fixed interest rates ranging from 9.5% to 10.0%, and with a loan-to-value ratio of no more than 80% of the appraised estimated value of the completed property. During this 12 month period, the borrower is required to make monthly payments of accrued interest on the outstanding loan balance. At September 30, 1999 speculative construction loans totaled $22.1million, or 24.4%, of the total construction loan portfolio. At September 30, 1999, the Bank had 11 borrowers each with aggregate outstanding speculative loan balances of more than $500,000, all of which were performing according to their respective terms and the largest of which amounted to $440,000. Unlike speculative construction loans, custom construction loans are made to home builders who, at the time of construction, have a signed contract with a home buyer who has a commitment for permanent financing for the finished home with the Bank or another lender. Custom construction loans are generally originated for a term of 12 months, with fixed interest rates ranging from 9.0% to 9.5%, and with loan-to-value ratios of 80% of the appraised estimated value of the completed property or sales price, whichever is less. During this 12 month period, the borrower is required to make monthly payments of accrued interest on the outstanding loan balance. Owner/builder construction loans are originated to the home owner rather than the home builder as a single loan that automatically converts to a permanent loan at the completion of construction. The construction phase of a owner/builder construction loan generally lasts six to nine months with fixed interest rates ranging from 9.0% to 9.5%, and with loan-to-value ratios of 80% (or up to 95% with PMI) of the appraised estimated value of the completed property or cost, whichever is less. During this 12 month period, the borrower is required to make monthly payments of accrued interest on the outstanding loan balance. At the completion of construction, the loan converts automatically to either a fixed-rate mortgage loan, which conforms to secondary market standards, or an ARM loan for retention in the Bank's portfolio. At September 30, 1999, custom and owner/builder construction loans totaled $28.8 million, or 31.8%, of the total construction loan portfolio. At September 30, 1999, the largest outstanding custom construction loan had an outstanding balance of $485,000 and was performing according to its terms. The Bank originates loans to local real estate developers with whom it has established relationships for the purpose of developing residential subdivisions (i.e., installing roads, sewers, water and other utilities) (generally with ten to 50 lots). At September 30, 1999, subdivision development loans totaled $12.4 million, or 13.6% of construction and land development loans receivable. Land development loans are secured by a lien on the property and made for a period of two to five years with generally fixed interest rates, and are made with loan-to-value ratios generally not exceeding 75%. Monthly interest payments are required during the term of the loan. Land development loans are structured so that the Bank is repaid in full upon the sale by the borrower of approximately 80% of the subdivision lots. Substantially all of the Bank's land development loans are secured by property located in its primary market area. In addition, in the case of a corporate borrower, the Bank also generally obtains personal guarantees from corporate principals and reviews their personal financial statements. At September 30, 1999, the largest land development loan had an outstanding loan balance of $2.7 million and was performing according to its terms. Land development loans secured by land under development involve greater risks than one- to- four family residential mortgage loans because such loans are advanced upon the predicted future value of the developed property. If the estimate of such future value proves to be inaccurate, in the event of default and foreclosure the Bank may be confronted with a property the value of which is insufficient to assure full repayment. The Bank attempts to minimize this risk by generally limiting the maximum loan-to-value ratio on land loans to 75% of the estimated developed value of the secured property. 5 The Bank also provides construction financing for multi-family and commercial properties. At September 30, 1999, such construction loans amounted to $27.3 million. These loans are secured by motels, apartment buildings, condominiums, office buildings and retail rental space located in the Bank's primary market area and typically range in amount from $300,000 to $2.0 million. At September 30, 1999, the largest outstanding multi-family construction loan had a balance of $5.7 million and was performing according to its terms. Periodically, the Bank purchases (without recourse to the seller other than for fraud) from other lenders participation interests in multi-family and commercial construction loans secured by properties located in the Bank's primary market area. The Bank underwrites such participation interests according to its own standards. At September 30, 1999, the largest participation interest had an outstanding balance of $2.7 million, which represented a 50% interest in a construction loan secured by a multi-family property located in Vancouver, Washington. The loan was performing according to its terms at September 30, 1999. All construction loans must be approved by the Bank's Loan Committee. See "-- Lending Activities -- Loan Solicitation and Processing." Prior to preliminary approval of any construction loan application, an independent fee appraiser inspects the site and the Bank reviews the existing or proposed improvements, identifies the market for the proposed project and analyzes the pro forma data and assumptions on the project. In the case of a speculative or custom construction loan, the Bank reviews the experience and expertise of the builder. After preliminary approval has been given, the application is processed, which includes obtaining credit reports, financial statements and tax returns on the borrowers and guarantors, an independent appraisal of the project, and any other expert reports necessary to evaluate the proposed project. In the event of cost overruns, the Bank requires that the borrower increase the funds available for construction by depositing its own funds into a loans in process account. Loan disbursements during the construction period are made to the builder based on a line item budget. Periodic on-site inspections are made by qualified Bank employees to document the reasonableness of the draw request. For most builders, the Bank disburses loan funds by providing vouchers to suppliers, which when used by the builder to purchase supplies are submitted by the supplier to the Bank for payment. The Bank regularly monitors the construction loan disbursements using an internal computer program. Property inspections are performed by Bank personnel for properties located within the Bank's primary market area and by independent inspectors for properties outside the primary market area. The Bank believes that its internal monitoring system helps reduce many of the risks inherent in its construction lending. The Bank originates construction loan applications through customer referrals, contacts in the business community and real estate brokers seeking financing for their clients. Construction lending affords the Bank the opportunity to achieve higher interest rates and fees with shorter terms to maturity than does its single-family permanent mortgage lending. Construction lending, however, is generally considered to involve a higher degree of risk than single-family permanent mortgage lending because of the inherent difficulty in estimating both a property's value at completion of the project and the estimated cost of the project. The nature of these loans is such that they are generally more difficult to evaluate and monitor. If the estimate of construction cost proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to permit completion of the project. If the estimate of value upon completion proves to be inaccurate, the Bank may be confronted with a project whose value is insufficient to assure full repayment. Projects may also be jeopardized by disagreements between borrowers and builders and by the failure of builders to pay subcontractors. Loans to builders to construct homes for which no purchaser has been identified carry more risk because the payoff for the loan depends on the builder's ability to sell the property prior to the time that the construction loan is due. The Bank has sought to address these risks by adhering to strict underwriting policies, disbursement procedures, and monitoring practices. In addition, because the Bank's construction lending is primarily secured by properties in its primary market area changes in the local and state economies and real estate markets could adversely affect the Bank's construction loan portfolio. 6 Real Estate Contracts. The Bank purchases real estate contracts and deeds of trust from individuals who have privately sold their homes or property. These contracts are generally secured by one- to- four family properties, building lots and undeveloped land and range in principal amount from $10,000 to $200,000, but typically are in amounts between $20,000 and $40,000. Real estate contracts purchased by the Bank are generally located within its primary market area. Prior to purchasing the real estate contract, the Bank reviews the contract and analyzes and assesses the collateral for the loan, the down payment made by the borrower and the credit history on the loan. As of September 30, 1999, the Bank had outstanding $1.6 million of real estate contracts. Multi-Family Lending. At September 30, 1999, the Bank had $15.9 million, or 5.3% of the Bank's total loan portfolio, secured by multi-family dwelling units (more than four units) located primarily in the Bank's primary market area. Subject to market conditions, the Bank intends to become a more active originator of multi-family loans within its primary market area. At September 30, 1999, approximately 22.8% of the Bank's multi-family loans represent participation interests in loans, secured by properties located in the Bank's primary market area, purchased from other lenders. Such participation interests are purchased without recourse to the seller other than for fraud. The Bank underwrites such participation interests according to its own standards. Multi-family loans are generally originated with variable rates of interest ranging from 3.00% to 3.50% over the one-year constant maturity U.S. Treasury Bill Index, with principal and interest payments fully amortizing over terms of up to 30 years. Multi-family loans generally range in principal balance from $300,000 to $3.0 million. At September 30, 1999, the largest multi-family loan had an outstanding principal balance of $2.0 million and was secured by an apartment building located in the Bank's primary market area. At September 30, 1999, this loan was performing according to its terms. The maximum loan-to-value ratio for multi-family loans is generally 75%. The Bank requires its multi- family loan borrowers to submit financial statements and rent rolls on the subject property annually. The Bank also inspects the subject property annually. The Bank generally imposes a minimum debt coverage ratio of approximately 1.10 for loans secured by multi-family properties. Multi-family mortgage lending affords the Bank an opportunity to receive interest at rates higher than those generally available from one- to- four family residential lending. However, loans secured by 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 multi-family properties are often dependent on the successful operation and management of the properties, repayment of such loans may be affected by adverse conditions in the real estate market or the economy. The Bank seeks to minimize these risks by strictly scrutinizing the financial condition of the borrower, the quality of the collateral and the management of the property securing the loan. If the borrower is a corporation, the Bank also generally obtains personal guarantees from corporate principals based on a review of personal financial statements. Commercial Real Estate Lending. Commercial real estate loans totaled $52.0 million, or 17.4% of total loans receivable at September 30, 1999, and consisted of 162 loans. The Bank originates commercial real estate loans generally at variable interest rates and secured by properties, such as restaurants, motels, office buildings and retail/wholesale facilities, located in its primary market area. The principal balance of a commercial real estate loan generally ranges between $100,000 and $3.0 million. At September 30, 1999, $1.7 million of commercial real estate loans were not performing according to terms. See "-- Lending Activities -- Nonperforming Assets and Delinquencies." The Bank requires appraisals of all properties securing commercial real estate loans. Appraisals are performed by an independent appraiser designated by the Bank, all of which are reviewed by management. 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 1.10 for originated loans secured by income producing commercial properties. Loan-to- value ratios on 7 commercial real estate loans are generally limited to 75%. The Bank generally obtains loan guarantees from financially capable parties based on a review of 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. The Bank seeks to minimize these risks by generally limiting the maximum loan-to-value ratio to 75% and strictly scrutinizing the financial condition of the borrower, the quality of the collateral and the management of the property securing the loan. Land Lending. The Bank occasionally originates loans for the acquisition of land upon which the purchaser can then build or make improvements necessary to build or to sell as improved lots. At September 30, 1999, land loans totaled $9.1 million, or 3.0% of the Bank's total loan portfolio. Land loans originated by the Bank are generally fixed-rate loans and have maturities of five to ten years. Land loans generally range in principal amount from $40,000 to $100,000. The largest land loan had an outstanding balance of $399,000 at September 30, 1999 and was performing according to its terms. Loans secured by undeveloped land or improved lots involve greater risks than one- to- four family residential mortgage loans because such loans are more difficult to evaluate. If the estimate of value proves to be inaccurate, in the event of default and foreclosure the Bank may be confronted with a property the value of which is insufficient to assure full repayment. The Bank attempts to minimize this risk by generally limiting the maximum loan-to-value ratio on land loans to 75%. Consumer Lending. Consumer lending has traditionally been a small part of the Bank's business. Consumer loans generally have shorter terms to maturity and higher interest rates than mortgage loans. Consumer loans include home equity lines of credit, Title I home improvement loans, second mortgage loans, savings account loans, automobile loans, boat loans, motorcycle loans, recreational vehicle loans and unsecured loans. Consumer loans are made with both fixed and variable interest rates and with varying terms. At September 30, 1999, consumer loans amounted to $12.3 million, or 4.1% of the total loan portfolio. At September 30, 1999, the largest component of the consumer loan portfolio consisted of second mortgage loans and home equity lines of credit, which totaled $8.0 million, or 2.7%, of the total loan portfolio. Home equity lines of credit and second mortgage loans are made for purposes such as the improvement of residential properties, debt consolidation and education expenses, among others. The majority of these loans are made to existing customers and are secured by a first or second mortgage on residential property. The Bank occasionally solicits these loans. The loan-to-value ratio is typically 80% or less, when taking into account both the first and second mortgage loans. Second mortgage loans typically carry fixed interest rates with a fixed payment over a term between five and 20 years. Home equity lines of credit are generally for a one year term and the interest rate is tied to the 26 week Treasury Bill plus 4.0%. In July 1997, the Bank began issuing VISA credit cards to its existing customers. At September 30, 1999, credit card loans amounted to $1.6 million. The Bank does not engage in direct mailings of pre-approved credit cards. Consumer loans entail greater risk than do residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by rapidly depreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and are more likely to be 8 adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount that can be recovered on such loans. The Bank believes that these risks are not as prevalent in the case of the Bank's consumer loan portfolio because a large percentage of the portfolio consists of second mortgage loans and home equity lines of credit that are underwritten in a manner such that they result in credit risk that is substantially similar to one- to- four family residential mortgage loans. Nevertheless, second mortgage loans and home equity lines of credit have greater credit risk than one- to- four family residential mortgage loans because they are secured by mortgages subordinated to the existing first mortgage on the property, which may or may not be held by the Bank. At September 30, 1999, there were $330,000 of consumer loans delinquent in excess of 90 days. Commercial Business Lending. Commercial business loans totaled $4.6 million, or 1.5% of total loans receivable at September 30, 1999, and consisted of 53 loans. In July 1998, the Bank established a business banking division staffed by three experienced commercial bankers to increase the Bank's origination of commercial business loans. Commercial business loans are generally secured by business equipment or other property and are made at variable rates of interest equal to a negotiated margin above the prime rate. The Bank also generally obtains personal guarantees from financially capable parties based on a review of personal financial statements. Commercial business lending generally involves greater risk than residential mortgage lending and involves risks that are different from those associated with residential and commercial real estate lending. Real estate lending is generally considered to be collateral based lending with loan amounts based on predetermined loan to collateral values and liquidation of the underlying real estate collateral is viewed as the primary source of repayment in the event of borrower default. Although commercial business loans are often collateralized by equipment, inventory, accounts receivable or other business assets, the liquidation of collateral in the event of a borrower default is often an insufficient source of repayment because accounts receivable may be uncollectible and inventories and equipment may be obsolete or of limited use, among other things. Accordingly, the repayment of a commercial business loan depends primarily on the creditworthiness of the borrower (and any guarantors), while liquidation of collateral is a secondary and often insufficient source of repayment. Loan Maturity. The following table sets forth certain information at September 30, 1999 regarding the dollar amount of loans maturing in the Bank's portfolio based on their contractual terms to maturity, but does not include scheduled payments or potential prepayments. Demand loans, loans having no stated schedule of repayments and no stated maturity, and overdrafts are reported as due in one year or less. 9 After After One Year 3 Years 5 Years Within Through Through Through After One Year 3 Years 5 Years 10 Years 10 Years Total -------- ------- ------- -------- -------- ----- (Dollars in thousands) Mortgage loans: One- to- four family........ $ 172 $ 1,095 $ 952 $ 4,139 $108,775 $115,133 Multi-family................ 903 2,614 46 6,260 6,122 15,945 Commercial.................. 515 459 3,372 21,307 26,396 52,049 Construction and land development(1).......... 26,845 29,432 -- 3,741 30,603 90,621 Land........................ 820 2,095 5,259 570 315 9,059 Consumer loans: Home equity and second mortgage.................. 2,575 463 1,144 1,505 2,291 7,978 Other....................... 1,393 1,133 1,078 199 476 4,279 Commercial business loans. 1,969 1,172 1,036 347 87 4,611 ------- -------- ------- ------- -------- -------- Total.................... $35,192 $ 38,463 $12,887 $38,068 $175,065 $299,675 ======= ======== ======= ======= ======== ======== Less: Undisbursed portion of loans in process ............... $(37,781) Unearned income............. (3,170) Allowance for loan losses... (2,056) Market value adjustment of loans held-for-sale ... (583) -------- Loans receivable, net...... $256,085 ======== - ----------- (1) Includes construction/permanent that convert to a permanent mortgage loan once construction is completed.
The following table sets forth the dollar amount of all loans due after September 30, 1999, which have fixed interest rates and have floating or adjustable interest rates. Fixed Floating or Rates Adjustable Rates Total ----- ---------------- ----- (In thousands) Mortgage loans: One- to- four family......... $ 39,085 $ 76,048 $115,133 Multi-family................. 6,093 9,852 15,945 Commercial................... 12,336 39,713 52,049 Construction and land development................ 81,514 9,107 90,621 Land......................... 8,871 188 9,059 Consumer loans: Home equity and second mortgage .................. 5,407 2,571 7,978 Other........................ 4,056 223 4,279 Commercial business loans..... 2,465 2,146 4,611 -------- -------- -------- Total...................... $159,827 $139,848 $299,675 ======== ======== ======== Scheduled contractual principal repayments of loans do not reflect the actual life of such assets. The average life of loans is substantially less than their contractual terms because of prepayments. In addition, due-on- sale clauses on loans generally give the Bank the right to declare loans immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life 10 of mortgage loans tends to increase, however, when current mortgage loan market rates are substantially higher than rates on existing mortgage loans and, conversely, decrease when rates on existing mortgage loans are substantially higher than current mortgage loan market rates. Loan Solicitation and Processing. Loan originations are obtained from a variety of sources, including walk-in customers, and referrals from builders and Realtors. Upon receipt of a loan application from a prospective borrower, a credit report and other data are obtained to verify specific information relating to the loan applicant's employment, income and credit standing. An appraisal of the real estate offered as collateral generally is undertaken by an appraiser retained by the Bank and certified by the State of Washington. Mortgage loan applications are initiated by loan officers and are required to be approved by the Bank's Loan Committee, which consists of the Bank's President, Executive Vice President and Vice President. All other loans up to and including $300,000 may be approved by any two of the Bank's President, Executive Vice President or Vice President, without Board approval. Commercial business loans up to and including $250,000 may also be approved by the Bank's Senior Vice President. Loans in excess of $300,000, as well as loans of any size granted to a single borrower whose aggregate lending relationship exceeds $300,000, must be approved by the Bank's Board of Directors. Loan Originations, Purchases and Sales. During the years ended September 30, 1998 and 1999, the Bank's total gross loan originations were $126.9 million and $144.4 million, respectively. Periodically, the Bank purchases participation interests in construction and land development loans and multi-family loans, secured by properties located in the Bank's primary market area, from other lenders. Such purchases are underwritten to the Bank's underwriting guidelines and are without recourse to the seller other than for fraud. See "-- Lending Activities -- Construction and Land Development Lending" and "-- Lending Activities -- Multi-Family Lending." Consistent with its asset/liability management strategy, the Bank's policy has been to retain in its portfolio all of the ARM loans and generally originates fixed rate loans with a view toward sale in the secondary market to FHLMC; however, from time to time, a portion of fixed-rate loans may be retained in the Bank's portfolio to meet its asset-liability objectives. Loans sold in the secondary market are generally sold on a servicing retained basis. At September 30, 1999, the Bank's loan servicing portfolio totaled $63.8 million. 11 The following table shows total loans originated, purchased, sold and repaid during the periods indicated. Year Ended September 30, -------------------------- 1999 1998 1997 ---- ---- ---- (Dollars in thousands) Loans originated: Mortgage loans: One- to- four family................... $ 41,084 $ 45,377 $27,149 Multi-family .......................... 6,952 5,461 1,229 Commercial............................. 15,722 6,750 3,635 Construction and land development...... 63,162 58,054 35,218 Land .................................. 4,605 3,265 2,644 Consumer................................ 6,845 7,437 6,446 Commercial business loans............... 6,069 525 363 -------- -------- ------- Total loans originated ................ 144,439 126,869 76,684 Loans purchased: Mortgage loans: One- to- four family................... 269 619 163 Multi-family........................... -- -- -- Commercial............................. 9,170 -- 546 Construction........................... 7,226 -- -- Land................................... 34 -- 347 -------- -------- ------- Total loans purchased................. 16,699 619 1,056 -------- -------- ------- Total loans originated and purchased...................... 161,138 127,488 77,740 Loans sold: Total whole loans sold................. (13,572) (25,236) (15,275) Participation loans.................... (6,249) -- -- -------- -------- ------- Total loans sold ...................... (19,821) (25,236) (15,275) Mortgage loan principal repayments ...... (73,733) (75,504) (54,981) Decrease (increase) in other items, net.. (10,720) (14,554) 3,048 -------- -------- ------- Net increase in loans receivable, net.... $ 56,864 $ 12,194 $10,532 ======== ======== ======= Loan Origination and Other Fees. The Bank, in some instances, receives loan origination fees. Loan fees are a percentage of the principal amount of the mortgage loan which are charged to the borrower for funding the loan. The amount of fees charged by the Bank is generally 1.0% to 2.0%. Current accounting standards require fees received (net of certain loan origination costs) for originating loans to be deferred and amortized into interest income over the contractual life of the loan. Net deferred fees or costs associated with loans that are prepaid are recognized as income at the time of prepayment. The Bank had $3.1 million of net deferred mortgage loan fees at September 30, 1999. Nonperforming Assets and Delinquencies. The Bank assesses late fees or penalty charges on delinquent loans of approximately 5% of the monthly loan payment amount. Substantially all fixed-rate and ARM loan payments are due on the first day of the month; however, the borrower is given a 15 day grace period to make the loan payment. When a mortgage loan borrower fails to make a required payment when due, the Bank institutes collection procedures. The first notice is mailed to the borrower eight days after the date the payment is due and, if necessary, a second written notice is sent on the sixteenth day giving the borrower 15 days to respond and correct the delinquency. Attempts to contact the borrower by telephone generally begin upon the thirtieth day of delinquency. If a satisfactory response is 12 not obtained, continuous follow-up contacts are attempted until the loan has been brought current. Before the 90th day of delinquency, attempts to interview the borrower, preferably in person, are made to establish (i) the cause of the delinquency, (ii) whether the cause is temporary, (iii) the attitude of the borrower toward the debt, and (iv) a mutually satisfactory arrangement for curing the default. If the borrower is chronically delinquent and all reasonable means of obtaining payment on time have been exhausted, foreclosure is initiated according to the terms of the security instrument and applicable law. Interest income on loans is reduced by the full amount of accrued and uncollected interest. When a consumer loan borrower fails to make a required payment on a consumer loan by the payment due date, the Bank institutes the same collection procedures as for its mortgage loan borrowers. The Bank's Board of Directors is informed monthly as to the status of all loans that are delinquent by more than 30 days, the status on all loans currently in foreclosure, and the status of all foreclosed and repossessed property owned by the Bank. The following table sets forth information with respect to the Bank's nonperforming assets at the dates indicated. At September 30, -------------------------------------------------------- 1999 1998 1997 1996 1995 ---- ---- ---- ---- ---- (Dollars in thousands) Loans accounted for on a nonaccrual basis: Mortgage loans: One- to- four family................... $ 941 $ 996 $ 776 $ 735 $ 646 Commercial............................. 1,675 2,919 2,886 -- -- Construction and land development...... 390 -- 3,891 771 391 Land................................... 253 397 -- -- -- Consumer loans.......................... 330 17 2 14 -- Commercial business loans............... -- 81 -- -- -- ------ ------ ------ ------ ----- Total............................... 3,589 4,410 7,555 1,520 1,037 Accruing loans which are contractually past due 90 days or more: Mortgage loans: Construction and land development...... 449 396 109 -- -- ------ ------ ------ ------ ----- Total.............................. 449 396 109 -- -- ------ ------ ------ ------ ----- Total of nonaccrual and 90 days past due loans.................. 4,038 4,806 7,664 1,520 1,037 Real estate owned and other repossessed assets...................... 867 1,724 434 125 209 ------ ------ ------ ------ ----- Total nonperforming assets.......... 4,905 6,530 8,098 1,645 1,246 Restructured loans....................... 509 236 70 158 207 (table continued, and footnotes located, on following page) 13
At September 30, -------------------------------------------------------- 1999 1998 1997 1996 1995 ---- ---- ---- ---- ---- (Dollars in thousands) Nonaccrual and 90 days or more past due loans as a percentage of loans receivable, net............... 1.56% 2.39% 4.06% 0.86% 0.66% Nonaccrual and 90 days or more past due loans as a percentage of total assets.. 1.31% 1.81% 3.62% 0.78% 0.58% Nonperforming assets as a percentage of total assets ............ 1.60% 2.46% 3.83% 0.85% 0.70% Loans receivable, net(1)................$258,141 $200,949 $188,743 $177,628 $157,642 ======== ======== ======== ======== ======== Total assets............................$307,116 $265,709 $211,553 $194,357 $177,761 ======== ======== ======== ======== ======== - ----------- (1) Includes loans held-for-sale and is before the allowance for loan losses.
The following is a discussion of the Bank's major problem assets at September 30, 1999: Convenience store/retail space and mini-storage, Kitsap County, Washington. The Bank had two loans that were originated in 1996 on two separate properties: a convenience store combined with retail space and a 436 unit mini-storage facility. These two loans had a combined balance of $2.9 million at September 30, 1998. These loans became delinquent primarily because of a dispute between the two borrowers. The Bank initiated foreclosure proceedings which were stayed due to a bankruptcy filing by the borrowers in January of 1998. The bankruptcy was subsequently dismissed and the mini-storage facility was sold at a trustees sale on March 12, 1999 for the full balance, accrued interest, late charges and fees owed. The foreclosure of the convenience store is in progress. As of September 30, 1999, the remaining loan was classified as substandard and had a principal balance of $1.4 million. Although no assurances can be given, the Bank does not expect to incur any material loss on this loan. See "-- Lending Activities -- Asset Classification." Real Estate Owned. Real estate acquired by the Bank as a result of foreclosure or by deed-in-lieu of foreclosure is classified as real estate owned until sold. When property is acquired it is recorded at the lower of its cost, which is the unpaid principal balance of the related loan plus foreclosure costs, or fair market value. Subsequent to foreclosure, the property is carried at the lower of the foreclosed amount or fair value, less estimated selling costs. At September 30, 1999, the Bank had $867,000 in real estate owned consisting primarily of five one- to- four family properties and several land parcels. Restructured Loans. Under generally accepted accounting principles ("GAAP"), the Bank is required to account for certain loan modifications or restructuring as a "troubled debt restructuring." In general, the modification or restructuring of a debt constitutes a troubled debt restructuring if the Bank for economic or legal reasons related to the borrower's financial difficulties grants a concession to the borrowers that the Bank would not otherwise consider. Debt restructuring or loan modifications for a borrower does not necessarily always constitute troubled debt restructuring, however, and troubled debt restructuring do not necessarily result in non-accrual loans. The Bank had $509,000 of restructured loans as of September 30, 1999, which consisted of two one- to- four family mortgage loans and several consumer loans. Asset Classification. Applicable regulations require that each insured institution review and classify its assets on a regular basis. In addition, in connection with examinations of insured institutions, regulatory examiners have 14 authority to identify problem assets and, if appropriate, require them to be classified. There are three classifications for problem assets: substandard, doubtful and loss. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified as loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. When an insured institution classifies problem assets as either substandard or doubtful, it is required to establish general allowances for loan losses in an amount deemed prudent by management. These allowances represent loss allowances which have been established to recognize the inherent risk associated with lending activities and the risks associated with particular problem assets. When an insured institution classifies problem assets as loss, it charges off the balance of the asset. Assets which do not currently expose the insured institution to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are required to be designated as special mention. The Bank's determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the FDIC and the Division which can order the establishment of additional loss allowances. The aggregate amounts of the Bank's classified assets (as determined by the Bank), and of the Bank's general loss allowances at the dates indicated, were as follows: At September 30, ----------------------- 1999 1998 1997 ---- ---- ---- (In thousands) Loss.................................. $ -- $ -- $ -- Doubtful ............................. 89 -- -- Substandard assets(1)................. 4,108 4,888 5,470 Special mention(1).................... 1,059 1,160 2,886 General loss allowances............... 2,006 1,728 1,716 Specific loss allowance............... 50 -- -- - ---------------- (1) For further information concerning the increase in classified assets, see "-- Lending Activities -- Nonperforming Assets and Delinquencies." Allowance for Loan Losses. The Bank has established a systematic methodology for the determination of provisions for loan losses that takes into consideration the need for an overall general valuation allowance. In originating loans, the Bank recognizes that losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower over the term of the loan, general economic conditions and, in the case of a secured loan, the quality of the security for the loan. The Bank increases its allowance for loan losses by charging provisions for loan losses against the Bank's income. The general valuation allowance is maintained to cover losses inherent in the loan portfolio. Management reviews the adequacy of the allowance at least quarterly based on management's assessment of current economic conditions, past loss and collection experience, and risk characteristics of the loan portfolio. A provision for losses is charged against income monthly to maintain the allowances. At September 30, 1999, the Bank had a general allowance for loan losses of $2.0 million and a specific allowance for loan losses of $50,000. Management believes that the amount maintained in the allowances will be adequate to absorb losses inherent in the portfolio. Although management believes that it uses the best information available to make such determinations, future adjustments to the allowance for loan losses may be necessary and results 15 of operations could be significantly and adversely affected if circumstances differ substantially from the assumptions used in making the determinations. While the Bank believes it has established its existing allowance for loan losses in accordance with GAAP, there can be no assurance that regulators, in reviewing the Bank's loan portfolio, will not request the Bank to increase significantly its allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that substantial increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above. Any material increase in the allowance for loan losses may adversely affect the Bank's financial condition and results of operations. The following table sets forth an analysis of the Bank's gross allowance for possible loan losses for the periods indicated. Year Ended September 30, ---------------------------------------- 1999 1998 1997 1996 1995 ---- ---- ---- ---- ---- (Dollars in thousands) Allowance at beginning of period.................... $ 1,728 $ 1,716 $ 1,133 $ 1,119 $ 1,120 Provision for loan losses...... 363 200 596 70 -- Recoveries: Consumer loans: Automobile................... -- -- -- -- -- Other........................ -- -- 9 -- -- ------ ------ ------ ------ ------ Total recoveries............ -- -- 9 -- -- Charge-offs: Mortgage loans: One- to- four family......... -- 4 19 -- -- Home equity and second mortgage................... -- -- -- -- -- Other........................ 5 4 -- 1 1 ------ ------ ------ ------ ------ Total charge-offs........... 5 8 19 1 1 ------ ------ ------ ------ ------ Net charge-offs............. 5 8 10 1 1 Transfers................... 30 180 3 55 -- ------ ------ ------ ------ ------ Balance at end of period.. $2,056 $1,728 $1,716 $1,133 $1,119 ====== ====== ====== ====== ====== Allowance for loan losses as a percentage of total loans (net)(1) outstanding at the end of the period............. 0.80% 0.86% 0.91% 0.64% 0.71% Net charge-offs as a percentage of average loans outstanding during the period............. --% --% 0.01% --% --% Allowance for loan losses as a percentage of nonperforming loans at end of period........ 50.92% 35.96% 22.39% 74.54% 107.91% - -------------- (1) Total loans (net) includes loans held for sale and is before the allowance for loan losses. 16 The following table sets forth the breakdown of the allowance for loan losses by loan category at the dates indicated. At September 30, ------------------------------------------------------------------------------------- 1999 1998 1997 1996 1995 ---------------- ---------------- --------------- ----------------- ----------------- Percent of Percent of Percent of Percent of Percent of Loans in Loans in Loans in Loans in Loans in Category Category Category Category Category to Total to Total to Total to Total to Total Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans ------ ----- ------ ----- ------ ----- ------ ----- ------ ----- (Dollars in thousands) Mortgage loans: One- to- four family............. $ 288 38.42% $ 311 43.48% $ 311 48.76% $ 261 48.51% $ 278 53.03% Multi-family......... 82 5.32 70 5.36 149 5.93 83 6.35 81 6.21 Commercial........... 674 17.37 706 14.18 409 14.32 317 13.41 271 8.84 Construction......... 633 30.24 368 27.65 646 21.93 316 23.83 337 24.23 Land................. 170 3.02 180 3.34 138 3.38 102 3.09 98 3.47 Non-mortgage loans: Consumer loans....... 126 4.09 65 5.51 50 5.34 46 4.57 44 4.09 Commercial business loans.............. 83 1.54 28 0.48 13 0.34 8 0.24 10 0.13 ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ Total allowance for loan losses... $2,056 100.00% $1,728 100.00% $1,716 100.00% $1,133 100.00% $1,119 100.00% ====== ====== ====== ====== ====== ====== ====== ====== ====== ====== 17
Investment Activities At September 30, 1999, the Company's investment portfolio totaled $31.7 million, consisting of $17.7 million of securities available for sale and $14.0 million of mortgage-backed securities available for sale. This compares with a total portfolio of $35.4 million at September 30, 1998, comprised of $17.8 million of securities available for sale and $17.6 million of mortgage-backed securities available for sale. The composition of the portfolios by type of security, at each respective date is presented in the table, which follows. The investment policies of the Company are established and monitored by the Board of Directors. The policies are designed primarily to provide and maintain liquidity, to generate a favorable return on investments without incurring undue interest rate and credit risk, and to compliment the Bank's lending activities. These policies dictate the criteria for classifying securities as either available for sale or held for investment. The policies permit investment in various types of liquid assets permissible under applicable regulations, which includes U.S. Treasury obligations, securities of various federal agencies, certain certificates of deposit of insured banks, banker's acceptances, federal funds, FHLB stock, and mortgage-backed securities. The Company's investment policy also permits investment in equity securities in certain financial service companies. The following table sets forth the investment securities portfolio and carrying values at the dates indicated. At September 30, ----------------------------------------------------------- 1999 1998 1997 ----------------- ----------------- ----------------- Percent Percent Percent Carrying of Carrying of Carrying of Value(1) Total Value(1) Total Value(1) Total -------- ----- -------- ----- -------- ----- (Dollars in thousands) Held-to-Maturity (at amortized cost): Mortgage-backed securities............... $ -- --% $ -- --% $ 3,991 71.56% Investment certificates of deposit........ -- -- -- -- -- -- ------- ------ ------- ------ ------- ------ Total held-to-maturity securities......... -- -- -- -- 3,991 71.56 Available-for-Sale (at fair value): U.S. Agency Securities.................... 6,419 20.28 8,937 25.23 -- -- Mortgage-backed securities................ 13,992 44.20 17,555 49.57 -- -- Mutual funds ............................. 8,845 27.94 7,121 20.11 -- -- FHLB stock................................ 2,338 7.39 1,713 4.84 1,586 28.44 Equity securities......................... 62 0.19 89 0.25 -- -- ------- ------ ------- ------ ------- ------ Total available-for-sale securities..... 31,656 100.00 35,415 100.00 1,586 28.44 ------- ------ ------- ------ ------- ------ Total portfolio........................... $31,656 100.00% $35,415 100.00% $ 5,577 100.00% ======= ====== ======= ====== ======= ====== - --------------- (1) The fair value of the Company's investment portfolio amounted to $31.7 million as of September 30, 1999, $35.4 million as of September 30, 1998 and $5.6 million as of September 30, 1997. 18
The following table sets forth the maturities and weighted average yields of the debt and mortgage-backed securities in the Company's investment securities portfolio at September 30, 1999. Less Than One to Five to Over Ten One Year Five Years Ten Years Years -------------- -------------- -------------- -------------- Amount Yield Amount Yield Amount Yield Amount Yield ------ ----- ------ ----- ------ ----- ------ ----- (Dollars in thousands) Available-for-Sale: U.S. Agency securities........ $ -- --% $6,419 5.91% $ -- --% $ -- --% Mortgage-backed securities.... -- -- 34 4.93 1,558 6.18 12,400 5.95 Mutual funds.................. 8,845 5.58 -- -- -- -- -- -- FHLB Stock.................... 2,338 7.25 -- -- -- -- -- -- Equity securities............. 62 1.06 -- -- -- -- -- -- ------- ---- ------ ---- ------ ---- ------- ---- Total available-for-sale securities.................. 11,245 5.87 6,453 5.91 1,558 6.18 12,400 5.95 ------- ------ ------ ------- Total portfolio............... $11,245 5.87% $6,453 5.91% $1,558 6.18% $12,400 5.95% ======= ==== ====== ==== ====== ==== ======= ====
Deposit Activities and Other Sources of Funds General. Deposits and loan repayments are the major sources of the Bank's funds for lending and other investment purposes. Scheduled loan repayments are a relatively stable source of funds, while deposit inflows and outflows and loan prepayments are influenced significantly by general interest rates and money market conditions. Borrowings through the FHLB-Seattle may be used to compensate for reductions in the availability of funds from other sources. Presently, the Bank has no other borrowing arrangements. Deposit Accounts. Substantially all of the Bank's depositors are residents of Washington. Deposits are attracted from within the Bank's market area through the offering of a broad selection of deposit instruments, including money market deposit accounts, regular savings accounts and certificates of deposit. Deposit account terms vary, according to the minimum balance required, the time periods the funds must remain on deposit and the interest rate, among other factors. In determining the terms of its deposit accounts, the Bank considers current market interest rates, profitability to the Bank, matching deposit and loan products and its customer preferences and concerns. In recent periods, the Bank has used deposit interest rate promotions in connection with the opening of new branch offices. At September 30, 1999 the Bank had $25.1 million of jumbo certificates of deposit, which includes $7.7 million in public unit funds. The Bank does not solicit brokered deposits and believes that its jumbo certificates of deposit, which represented 13.3% of total deposits at September 30, 1999, present similar interest rate risk compared to its other deposit products. 19 The following table sets forth information concerning the Bank's deposits at September 30, 1999. Weighted Average Percentage Interest of Total Category Rate Amount Deposits - -------- ---- ------ -------- (In thousands) Non-Interest Bearing --% $ 8,360 4.44% Negotiable order of withdrawal ("NOW ") Checking 1.75 21,239 11.29 Passbook Savings 2.62 29,396 15.62 Money Market Accounts 3.86 18,774 9.98 Other Deposits -- 2,871 1.53 Certificates of Deposit(1) - -------------------------- Maturing within 1 year 5.14 78,427 41.68 Maturing after 1 year but within 2 years 5.32 22,910 12.18 Maturing after 2 years but within 5 years 5.58 5,318 2.83 Maturing after 5 years 5.78 853 0.45 -------- ------ 3.96 $188,148 100.00% - ------------- ======== ====== (1) Based on remaining maturity of certificates. The following table indicates the amount of the Bank's jumbo certificates of deposit by time remaining until maturity as of September 30, 1999. Jumbo certificates of deposit have principal balances of $100,000 or more and the rates paid on such accounts are generally negotiable. Maturity Period Amount - --------------- ------ (In thousands) Three months or less...................... $11,194 Over three through six months............. 3,509 Over six through twelve months............ 7,740 Over twelve months........................ 2,893 ------- Total................................. $25,066 ======= 20 Deposit Flow. The following table sets forth the balances of savings deposits in the various types of savings accounts offered by the Bank at the dates indicated. At September 30, ----------------------------------------------------------------------------- 1999 1998 1997 --------------------------- ---------------------------- --------------- Percent Percent Percent of Increase of Increase of Amount Total (Decrease) Amount Total (Decrease) Amount Total ------ ----- ---------- ------ ----- ---------- ------ ----- (Dollars in thousands) Non-interest-bearing........ $ 8,360 4.44% $ 2,521 $ 5,839 3.42% $ 675 $ 5,164 2.99% NOW checking................ 21,239 11.29 (356) 21,595 12.64 2,008 19,587 11.32 Passbook savings accounts... 29,396 15.62 2,081 27,315 15.99 1,046 26,269 15.18 Money market deposit........ 18,774 9.98 3,761 15,013 8.79 589 14,424 8.34 Certificates of deposit which mature in the year ending: Within 1 year............. 78,427 41.68 6,097 72,330 42.34 (3,954) 76,284 44.09 After 1 year, but within 2 years.......... 22,910 12.18 3,517 19,393 11.35 (2,957) 22,350 12.92 After 2 years, but within 5 years.......... 5,318 2.83 144 5,174 3.03 (563) 5,737 3.32 Certificates maturing thereafter.............. 853 0.45 189 664 0.39 277 387 .22 Other....................... 2,871 1.53 (640) 3,511 2.05 710 2,801 1.62 -------- ------ ------- -------- ------ -------- -------- ------ Total.................. $188,148 100.00% $17,314 $170,834 100.00% $ (2,169) $173,003 100.00% ======== ====== ======= ======== ====== ======== ======== ======
21 Time Deposits by Rates. The following table sets forth the time deposits in the Bank classified by rates as of the dates indicated. At September 30, ---------------------------- 1999 1998 1997 ---- ---- ---- (In thousands) 2.00 - 3.99% ................. $ 222 $ 227 $ 153 4.00 - 4.99% ................. 28,687 381 -- 5.00 - 5.99% ................. 74,565 80,539 79,205 6.00 - 6.99% ................. 3,527 11,548 20,351 7.00% and over ............... 507 4,866 5,049 -------- ------- -------- Total......................... $107,508 $97,561 $104,758 ======== ======= ======== Time Deposits by Maturities. The following table sets forth the amount and maturities of time deposits at September 30, 1999. Amount Due ---------------------------------------------- After One to Two to Less Than Two Five After One Year Years Years Five Years Total -------- ----- ----- ---------- ----- (In thousands) 2.00 - 3.99%................. $ 222 $ -- $ -- $ -- $ 222 4.00 - 4.99% ................ 26,569 2,110 8 -- 28,687 5.00 - 5.99%................. 49,204 19,801 4,808 752 74,565 6.00 - 6.99% ................ 2,307 821 399 -- 3,527 7.00% and over............... 125 178 103 101 507 ------- ------- ------- ------- -------- Total........................ $78,427 $22,910 $ 5,318 $ 853 $107,508 ====== ======= ======= ======= ========= Deposit Activities. The following table sets forth the savings activities of the Bank for the periods indicated. Year Ended September 30, ---------------------------- 1999 1998 1997 ---- ---- ---- (In thousands) Beginning balance...................... $170,834 $173,003 $156,549 Net deposits (withdrawals) before interest credited................... 10,038 (9,639) 8,938 Interest credited ..................... 7,276 7,470 7,516 Net increase (decrease) in deposits.... 17,314 (2,169) 16,454 -------- -------- -------- Ending balance......................... $188,148 $170,834 $173,003 ======== ======== ======== Borrowings. Savings deposits are the primary source of funds for the Bank's lending and investment activities and for general business purposes. The Bank has the ability to use advances from the FHLB-Seattle to supplement its supply of lendable funds and to meet deposit withdrawal requirements. The FHLB-Seattle functions as a central reserve bank providing credit for savings and loan associations and certain other member financial institutions. As a member of the FHLB-Seattle, the Bank is required to own capital stock in the FHLB-Seattle and is authorized to apply for advances on the security of such stock and certain of its mortgage loans and other assets (principally securities which are obligations of, or guaranteed by, the U.S. Government) provided certain creditworthiness standards have been met. 22 Advances are made pursuant to several different credit programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based on the financial condition of the member institution and the adequacy of collateral pledged to secure the credit. At September 30, 1999, the Bank maintained an uncommitted credit facility with the FHLB-Seattle that provided for immediately available advances up to an aggregate amount of $59.8 million, under which $45.1 million was outstanding. The following table sets forth certain information regarding short-term borrowings by the Bank at the end of and during the periods indicated using monthly average balance: At or For the Year Ended September 30, ------------------------ 1999 1998 ---- ---- (Dollars in thousands) Maximum amount of short-term FHLB advances at any month end.................. $33,600 $500 Approximate average short-term FHLB advances outstanding...................... 10,150 250 Approximate weighted average rate paid on short-term FHLB advances........... 5.41% 6.70% Total short-term FHLB advances at end of period ............................. 33,600 -- REGULATION OF THE BANK General As a state-chartered, federally insured savings bank, the Bank is subject to extensive regulation. Lending activities and other investments must comply with various statutory and regulatory requirements, including prescribed minimum capital standards. The Bank is regularly examined by the FDIC and the Division and files periodic reports concerning the Bank's 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 law and the laws of Washington, especially in such matters as the ownership of savings accounts and the form and content of mortgage 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 should be deemed to constitute an unsafe and unsound practice. The respective primary federal regulators of the Company 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 savings bank, the Bank is subject to applicable provisions of Washington law and the regulations of the Division adopted thereunder. Washington law and regulations govern the Bank's ability to take deposits and pay interest thereon, to make loans on or invest in residential and other real estate, to make consumer loans, to invest in securities, to offer various banking services to its customers, and to establish branch offices. Under 23 state law, savings banks in Washington also generally have all of the powers that federal savings banks have under federal laws and regulations. The Bank is subject to periodic examination and reporting requirements by and of the Division. Deposit Insurance The FDIC is an independent federal agency that insures the deposits, up to prescribed statutory limits, of depository institutions. The FDIC currently maintains two separate insurance funds: the Bank Insurance Fund ("BIF") and the SAIF. As insurer of the Bank's deposits, the FDIC has examination, supervisory and enforcement authority over the Bank. The Bank's accounts are insured by the SAIF to the maximum extent permitted by law. The Bank pays deposit insurance premiums based on a risk-based assessment system established by the FDIC. Under applicable regulations, institutions are assigned to one of three capital groups that are based solely on the level of an institution's capital "well capitalized," "adequately capitalized," and "undercapitalized" which are defined in the same manner as the regulations establishing the prompt corrective action system, as discussed below. These three groups are then divided into three subgroups which reflect varying levels of supervisory concern, from those which are considered to be healthy to those which are considered to be of substantial supervisory concern. The matrix so created results in nine assessment risk classifications. On September 30, 1996, the Deposit Insurance Fund Act was enacted to assist depository institutions insured by the SAIF in meeting its designated reserve ratio. Pursuant to the Federal Deposit Insurance Act, the FDIC imposed an assessment on SAIF and BIF insured financial institutions beginning January 1, 1997, for the purpose of paying interest on the obligations issued by the Financing Corporation in the 1980s to help fund the thrift industry cleanup. BIF-assessable deposits are charged an assessment to help pay interest on the Financing Corporation bonds at a rate of approximately .013%. Full pro rata sharing of the Financing Corporation payments between BIF and SAIF members will occur until the date upon which the last savings association ceases to exist, after which time the assessment will be the same for all insured deposits. The FDIC may terminate the deposit insurance of any insured depository institution 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 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 that could result in termination of the deposit insurance of the Bank. Prompt Corrective Action The FDIA requires each federal banking agency to implement a system of prompt corrective action for institutions which it regulates. The federal banking agencies have promulgated substantially similar regulations to implement this system of prompt corrective action. Under the regulations, an institution shall be deemed to be: (i) "well capitalized" if it has a total risk-based capital ratio of 10.0% or more, has a Tier I risk-based capital ratio of 6.0% or more, has a Tier I leverage capital ratio of 5.0% or more and is not subject to specified requirements to meet and maintain a specific capital level for any capital measure; (ii) "adequately capitalized" if it has a total risk-based capital ratio of 8.0% or more, a Tier I risk-based capital ratio of 4.0% or more and a Tier I leverage capital ratio of 4.0% or more (3.0% under certain circumstances) and does not meet the definition of "well capitalized;" (iii) "undercapitalized" if it has a total risk-based capital ratio that is less than 8.0%, a Tier I risk-based capital ratio that is less than 4.0% or a Tier I leverage capital ratio that is less than 4.0% (3.0% under certain circumstances); (iv) "significantly undercapitalized" if it has a total risk-based capital ratio that is less than 6.0%, a Tier I risk-based capital ratio that 24 is less than 3.0% or a Tier I leverage capital ratio that is less than 3.0%; and (v) "critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%. The FDIA also provides that a federal banking agency may, after notice and an opportunity for a hearing, reclassify a well capitalized institution as adequately capitalized and may require an adequately capitalized institution or an undercapitalized institution to comply with supervisory actions as if it were in the next lower category if the institution is in an unsafe or unsound condition or engaging in an unsafe or unsound practice. (The FDIC may not, however, reclassify a significantly undercapitalized institution as critically undercapitalized.) An institution generally must file a written capital restoration plan which meets specified requirements, as well as a performance guaranty by each company that controls the institution, with the appropriate federal banking agency within 45 days of the date that the institution receives notice or is deemed to have notice that it is undercapitalized, significantly undercapitalized or critically undercapitalized. Immediately upon becoming undercapitalized, an institution shall become subject to the provisions of Section 38 of the FDIA, which sets forth various mandatory and discretionary restrictions on its operations. At September 30, 1999, the Bank was categorized as "well capitalized" under the prompt corrective action regulations of the FDIC. Standards for Safety and Soundness The federal banking regulatory agencies have prescribed, by regulation, standards for all insured depository institutions relating to: (i) internal controls, information systems and internal audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate risk exposure; (v) asset growth; (vi) asset quality; (vii) earnings; and (viii) compensation, fees and benefits ("Guidelines"). The Guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If the FDIC determines that the Bank fails to meet any standard prescribed by the Guidelines, the agency may require the Bank to submit to the agency an acceptable plan to achieve compliance with the standard. Management is aware of no conditions relating to these safety and soundness standards which would require submission of a plan of compliance. Capital Requirements The FDIC's minimum capital standards applicable to FDIC-regulated banks and savings banks require the most highly-rated institutions to meet a "Tier 1" leverage capital ratio of at least 3% of total assets. Tier 1 (or "core capital") consists of common stockholders' equity, noncumulative perpetual preferred stock and minority interests in consolidated subsidiaries minus all intangible assets other than limited amounts of purchased mortgage servicing rights and certain other accounting adjustments. All other banks must have a Tier 1 leverage ratio of at least 100-200 basis points above the 3% minimum. The FDIC capital regulations establish a minimum leverage ratio of not less than 4% for banks that are not the most highly rated or are anticipating or experiencing significant growth. Any insured bank with a Tier 1 capital to total assets ratio of less than 2% is deemed to be operating in an unsafe and unsound condition unless the insured bank enters into a written agreement, to which the FDIC is a party, to correct its capital deficiency. Insured banks operating with Tier 1 capital levels below 2% (and which have not entered into a written agreement) are subject to an insurance removal action. Insured banks operating with lower than the prescribed minimum capital levels generally will not receive approval of applications submitted to the FDIC. Also, inadequately capitalized state nonmember banks will be subject to such administrative action as the FDIC deems necessary. FDIC regulations also require that banks meet a risk-based capital standard. The risk-based capital standard requires the maintenance of total capital (which is defined as Tier 1 capital and Tier 2 or supplementary capital) to risk 25 weighted assets of 8% and Tier 1 capital to risk-weighted assets of 4%. In determining the amount of risk-weighted assets, all assets, plus certain off balance sheet items, are multiplied by a risk-weight of 0% to 100%, based on the risks the FDIC believes are inherent in the type of asset or item. The components of Tier 1 capital are equivalent to those discussed above under the 3% leverage requirement. The components of supplementary capital currently include cumulative perpetual preferred stock, adjustable-rate perpetual preferred stock, mandatory convertible securities, term subordinated debt, intermediate-term preferred stock and allowance for possible loan and lease losses. Allowance for possible loan and lease losses includable in supplementary capital is limited to a maximum of 1.25% of risk-weighted assets. Overall, the amount of capital counted toward supplementary capital cannot exceed 100% of Tier 1 capital. The Division requires that net worth equal at least 5% of total assets. Intangible assets must be deducted from net worth and assets when computing compliance with this requirement. At September 30, 1999, the Bank had a Tier 1 leverage capital ratio of 19.8% and net worth of 19.0% of total assets. FDIC capital requirements are designated as the minimum acceptable standards for banks whose overall financial condition is fundamentally sound, which are well-managed and have no material or significant financial weaknesses. The FDIC capital regulations state that, where the FDIC determines that the financial history or condition, including off-balance sheet risk, managerial resources and/or the future earnings prospects of a bank are not adequate and/or a bank has a significant volume of assets classified substandard, doubtful or loss or otherwise criticized, the FDIC may determine that the minimum adequate amount of capital for that bank is greater than the minimum standards established in the regulation. The Bank's management believes that, under the current regulations, the Bank will continue to meet its minimum capital requirements in the foreseeable future. However, events beyond the control of the Bank, such as a downturn in the economy in areas where the Bank has most of its loans, could adversely affect future earnings and, consequently, the ability of the Bank to meet its capital requirements. The table below sets forth the Bank's capital position relative to its FDIC capital requirements at September 30, 1999. The definitions of the terms used in the table are those provided in the capital regulations issued by the FDIC. At September 30, 1999 ----------------------------- Percent of Adjusted Amount Total Assets(1) ------ --------------- (Dollars in thousands) Tier 1 (leverage) capital................. $56,864 19.81% Tier 1 (leverage) capital requirement..... 11,484 4.00 ------- ----- Excess ................................... $45,380 15.81% ======= ===== Tier 1 risk adjusted capital.............. $56,864 25.89% Tier 1 risk adjusted capital requirement.. 8,787 4.00 ------- ----- Excess.................................... $48,077 21.89% ======= ===== Total risk-based capital ................. $58,920 26.82% Total risk-based capital requirement...... 17,573 8.00 ------- ----- Excess.................................... $41,347 18.82% ======= ===== - ------------- (1) For the Tier 1 (leverage) capital and Washington regulatory capital calculations, percent of total average assets of $287.1 million. For the Tier 1 risk-based capital and total risk-based capital calculations, percent of total risk-weighted assets of $219.6 million. (footnotes continued on following page) 26 (2) As a Washington-chartered savings bank, the Bank is subject to the capital requirements of the FDIC and the Division. The FDIC requires state-chartered savings banks, including the Bank, to have a minimum leverage ratio of Tier 1 capital to total assets of at least 3%, provided, however, that all institutions, other than those (i) receiving the highest rating during the examination process and (ii) not anticipating any significant growth, are required to maintain a ratio of 1% to 2% above the stated minimum, with an absolute total capital to risk-weighted assets of at least 8%. The Bank has not been notified by the FDIC of any leverage capital requirement specifically applicable to it. Activities and Investments of Insured State-Chartered Banks Federal law generally limits the activities and equity investments of FDIC-insured, state-chartered banks to those that are permissible for national banks. Under regulations dealing with equity investments, an insured state bank generally may not directly or indirectly acquire or retain any equity investment of a type, or in an amount, that is not permissible for a national bank. An insured state bank is not prohibited from, among other things, (i) acquiring or retaining a majority interest in a subsidiary, (ii) investing as a limited partner in a partnership the sole purpose of which is direct or indirect investment in the acquisition, rehabilitation or new construction of a qualified housing project, provided that such limited partnership investments may not exceed 2% of the bank's total assets, (iii) acquiring up to 10% of the voting stock of a company that solely provides or reinsures directors', trustees' and officers' liability insurance coverage or bankers' blanket bond group insurance coverage for insured depository institutions, and (iv) acquiring or retaining the voting shares of a depository institution if certain requirements are met. Federal law provides that an insured state-chartered bank may not, directly, or indirectly through a subsidiary, engage as "principal" in any activity that is not permissible for a national bank unless the FDIC has determined that such activities would pose no risk to the insurance fund of which it is a member and the bank is in compliance with applicable regulatory capital requirements. Any insured state-chartered bank directly or indirectly engaged in any activity that is not permitted for a national bank or for which the FDIC has granted and exception must cease the impermissible activity. Environmental Issues Associated With Real Estate Lending The Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"), a federal statute, generally imposes strict liability on, among other things, all prior and present "owners and operators" of hazardous waste sites. However, the U.S. Congress created a safe harbor provision for secured creditors by providing that the term "owner and operator" excludes a person who, without participating in the management of the site, holds indicia of ownership primarily to protect its security interest in the site. Since the enactment of the CERCLA, this "secured creditor exemption" has been the subject of judicial interpretations which have left open the possibility that lenders could be liable for cleanup costs on contaminated property that they hold as collateral for a loan. In response to the uncertainty created by judicial interpretations, in April 1992, the United States Environmental Protection Agency ("EPA"), an agency within the Executive Branch of the government, promulgated a regulation clarifying when and how secured creditors could be liable for cleanup costs under the CERCLA. Generally, the regulation protected a secured creditor that acquired full title to collateral property through foreclosure as long as the creditor did not participate in the property's management before foreclosure and undertook certain due diligence efforts to divest itself of the property. However, in February 1994, the U.S. Court of Appeals for the District of Columbia Circuit held that the EPA lacked authority to promulgate such regulation on the grounds that Congress meant for decisions on liability under the CERCLA to be made by the courts and not the Executive Branch. In January 1995, the U.S. Supreme Court denied to review the U.S. Court of Appeal's decision. In light of this adverse court ruling, in October 1995 the EPA issued a statement entitled "Policy on CERCLA Enforcement Against Lenders and Government Entities that Acquire Property Involuntarily" explaining that as an enforcement policy, the EPA intended to apply as guidance the provisions of the EPA lender liability rule promulgated in 1992. 27 To the extent that legal uncertainty exists in this area, all creditors, including the Bank, that have made loans secured by properties with potential hazardous waste contamination (such as petroleum contamination) could be subject to liability for cleanup costs, which costs often substantially exceed the value of the collateral property. Federal Reserve System The Federal Reserve Board requires under Regulation D that all depository institutions, including savings banks, maintain reserves on transaction accounts or non-personal time deposits. These reserves may be in the form of cash or non-interest-bearing deposits with the regional Federal Reserve Bank. NOW accounts and other types of accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to Regulation D reserve requirements, as are any nonpersonal time deposits at a bank. Under Regulation D, a bank must establish reserves equal to 0% of the first $4.9 million of net transaction accounts, 3% of the next $41.6 million, and 10% plus $1.56 million of the remainder. The reserve requirement on non-personal time deposits with original maturities of less than 1.5 years is 0%. As of September 30, 1999, the Bank met its reserve requirements. Affiliate Transactions The Company and the Bank are legal entities separate and distinct. Various legal limitations restrict the Bank from lending or otherwise supplying funds to the Company (an "affiliate"), generally limiting such transactions with the affiliate to 10% of the bank's capital and surplus and limiting all such transactions to 20% of the bank's capital and surplus. Such transactions, including extensions of credit, sales of securities or assets and provision of services, also must be on terms and conditions consistent with safe and sound banking practices, including credit standards, that are substantially the same or at least as favorable to the bank as those prevailing at the time for transactions with unaffiliated companies. Federally insured banks are subject, with certain exceptions, to certain restrictions on extensions of credit to their parent holding companies or other affiliates, on investments in the stock or other securities of affiliates and on the taking of such stock or securities as collateral from any borrower. In addition, such banks are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or the providing of any property or service. Community Reinvestment Act Banks are also subject to the provisions of the Community Reinvestment Act of 1977 ("CRA"), which requires the appropriate federal bank regulatory agency, in connection with its regular examination of a bank, to assess the bank's record in meeting the credit needs of the community serviced by the bank, including low and moderate income neighborhoods. The regulatory agency's assessment of the bank's record is made available to the public. Further, such assessment is required of any bank which has applied, among other things, to establish a new branch office that will accept deposits, relocate an existing office or merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution. The Bank received a "satisfactory" rating during its most recent CRA examination. Dividends Dividends from the Bank constitute the major source of funds for dividends which may be paid by the Company. The amount of dividends payable by the Bank to the Company depends upon the Bank's earnings and capital position, and is limited by federal and state laws, regulations and policies. According to Washington law, the Bank may not declare or pay a cash dividend on its capital stock if it would cause its net worth to be reduced below (i) the amount required for liquidation accounts or (ii) the net worth requirements, if any, imposed by the Director of the Division. Dividends on the Bank's capital stock may not be paid in an aggregate amount greater than the aggregate retained earnings of the Bank, without the approval of the Director of the Division. 28 The amount of dividends actually paid during any one period will be strongly affected by the Bank's management policy of maintaining a strong capital position. Federal law further provides that no insured depository institution may make any capital distribution (which would include a cash dividend) if, after making the distribution, the institution would be "undercapitalized," as defined in the prompt corrective action regulations. Moreover, the federal bank regulatory agencies also have the general authority to limit the dividends paid by insured banks if such payments should be deemed to constitute an unsafe and unsound practice. REGULATION OF THE COMPANY General The Company, as the sole shareholder of the Bank is a bank holding company and is registered as such with the Federal Reserve. Bank holding companies are subject to comprehensive regulation by the Federal Reserve under the Bank Holding Company Act of 1956, as amended ("BHCA"), and the regulations of the Federal Reserve. As a bank holding company, the Company is required to file with the Federal Reserve annual reports and such additional information as the Federal Reserve may require and will be subject to regular examinations by the Federal Reserve. The Federal Reserve also has extensive enforcement authority over bank holding companies, including, among other things, the ability to assess civil money penalties, to issue cease and desist or removal orders and to require that a holding company divest subsidiaries (including its bank subsidiaries). In general, enforcement actions may be initiated for violations of law and regulations and unsafe or unsound practices. Under the BHCA, a bank holding company must obtain Federal Reserve approval before: (1) acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, after such acquisition, it would own or control more than 5% of such shares (unless it already owns or controls the majority of such shares); (2) acquiring all or substantially all of the assets of another bank or bank holding company; or (3) merging or consolidating with another bank holding company. The BHCA also prohibits a bank holding company, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. Under the BHCA, the Federal Reserve is authorized to approve the ownership of shares by a bank holding company in any company, the activities of which the Federal Reserve has determined to be so closely related to the business of banking or managing or controlling banks as to be a proper incident thereto. The list of activities determined by regulation to be closely related to banking within the meaning of the BHCA includes, among other things: operating a savings institution, mortgage company, finance company, credit card company or factoring company; performing certain data processing operations; providing certain investment and financial advice; underwriting and acting as an insurance agent for certain types of credit-related insurance; leasing property on a full-payout, non-operating basis; selling money orders, travelers' checks and U.S. Savings Bonds; real estate and personal property appraising; providing tax planning and preparation services; and, subject to certain limitations, providing securities brokerage services for customers. Interstate Banking The Federal Reserve must approve an application of an adequately capitalized and adequately managed bank holding company to acquire control of, or acquire all or substantially all of the assets of, a bank located in a state other than such holding company's home state, without regard to whether the transaction is prohibited by the laws of any state. The Federal Reserve may not approve the acquisition of a bank that has not been in existence for the minimum time period, not exceeding five years, specified by the statutory law of the host state. Nor may the Federal Reserve approve an application if the applicant, and its depository institution affiliates, controls or would control more than 10% of the insured deposits in the United States or 30% or more of the deposits in the target bank's home state or in any state in which the target bank maintains a branch. Federal law does not affect the authority of states to limit the 29 percentage of total insured deposits in the state which may be held or controlled by a bank holding company to the extent such limitation does not discriminate against out-of-state banks or bank holding companies. Individual states may also waive the 30% state-wide concentration limit contained in the federal law. The Federal banking agencies are authorized to approve interstate merger transactions without regard to whether such transaction is prohibited by the law of any state, unless the home state of one of the banks adopted a law prior to June 1, 1997 which applies equally to all out-of-state banks and expressly prohibits merger transactions involving out-of-state banks. Interstate acquisitions of branches will be permitted only if the law of the state in which the branch is located permits such acquisitions. Interstate mergers and branch acquisitions will also be subject to the nationwide and statewide insured deposit concentration amounts described above. Dividends The Federal Reserve has issued a policy statement on the payment of cash dividends by bank holding companies, which expresses the Federal Reserve's view that a bank holding company should pay cash dividends only to the extent that the company's net income for the past year is sufficient to cover both the cash dividends and a rate of earnings retention that is consistent with the company's capital needs, asset quality and overall financial condition. The Federal Reserve also indicated that it would be inappropriate for a company experiencing serious financial problems to borrow funds to pay dividends. Furthermore, under the prompt corrective action regulations adopted by the Federal Reserve, the Federal Reserve may prohibit a bank holding company from paying any dividends if the holding company's bank subsidiary is classified as "undercapitalized" under the prompt corrective action regulations. Stock Repurchases Bank holding companies, except for certain "well-capitalized" and highly rated bank holding companies, are required to give the Federal Reserve prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of their consolidated net worth. The Federal Reserve may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe or unsound practice or would violate any law, regulation, Federal Reserve order, or any condition imposed by, or written agreement with, the Federal Reserve. Capital Requirements The Federal Reserve has established capital adequacy guidelines for bank holding companies that generally parallel the capital requirements of the FDIC for the Bank. The Federal Reserve regulations provide that capital standards will be applied on a consolidated basis in the case of a bank holding company with $150 million or more in total consolidated assets. The Company's total risk based capital must equal 8% of risk-weighted assets and one half of the 8%, or 4%, must consist of Tier 1 (core) capital. As of September 30, 1999, the Company's total risk based capital was 33.4% of risk-weighted assets and its risk based capital of Tier 1 (core) capital was 32.5% of risk-weighted assets. TAXATION Federal Taxation General. The Company and the Bank report their income on a fiscal year basis using the accrual method of accounting and are subject to federal income taxation in the same manner as other corporations with some exceptions, including particularly the Bank's reserve for bad debts discussed below. The following discussion of tax matters is 30 intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to the Bank or the Company. Bad Debt Reserve. Historically, savings institutions such as the Bank which met certain definitional tests primarily related to their assets and the nature of their business ("qualifying thrift") were permitted to establish a reserve for bad debts and to make annual additions thereto, which may have been deducted in arriving at their taxable income. The Bank's deductions with respect to "qualifying real property loans," which are generally loans secured by certain interest in real property, were computed using an amount based on the Bank's actual loss experience, or a percentage equal to 8% of the Bank's taxable income, computed with certain modifications and reduced by the amount of any permitted additions to the non-qualifying reserve. Due to the Bank's loss experience, the Bank generally recognized a bad debt deduction equal to 8% of taxable income. The provisions repealing the current thrift bad debt rules were passed by Congress as part of "The Small Business Job Protection Act of 1996." The new rules eliminate the 8% of taxable income method for deducting additions to the tax bad debt reserves for all thrifts for tax years beginning after December 31, 1995. These rules also require 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 will be 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 new rules allow an institution to suspend bad debt reserve recapture for the 1996 and 1997 tax years if the institution's lending activity for those years is equal to or greater than the institutions average mortgage lending activity for the six taxable years preceding 1996 adjusted for inflation. For this purpose, only home purchase or home improvement loans are included and the institution can elect to have the tax years with the highest and lowest lending activity removed from the average calculation. If an institution is permitted to postpone the reserve recapture, it must begin its six year recapture no later than the 1998 tax year. The unrecaptured base year reserves will not be subject to recapture as long as the institution continues to carry on the business of banking. In addition, the balance of the pre-1988 bad debt reserves continue to be subject to provisions of present law referred to below that require recapture in the case of certain excess distributions to shareholders. Distributions. To the extent that the Bank makes "nondividend distributions" to the Company, such distributions will be considered to result in distributions from the balance of its bad debt reserve as of December 31, 1987 (or a lesser amount if the Bank's loan portfolio decreased since December 31, 1987) and then from the supplemental reserve for losses on loans ("Excess Distributions"), and an amount based on the Excess Distributions will be included in the Bank's taxable income. Nondividend distributions include distributions in excess of the Bank's current and accumulated earnings and profits, distributions in redemption of stock and distributions in partial or complete liquidation. However, dividends paid out of the Bank's current or accumulated earnings and profits, as calculated for federal income tax purposes, will not be considered to result in a distribution from the Bank's bad debt reserve. The amount of additional taxable income created from an Excess Distribution is an amount that, when reduced by the tax attributable to the income, is equal to the amount of the distribution. Thus, if, after the Conversion, the Bank makes a "nondividend distribution," then approximately one and one-half times the Excess Distribution would be includable in gross income for federal income tax purposes, assuming a 34% corporate income tax rate (exclusive of state and local taxes). See "REGULATION OF THE BANK -- Dividends" for limits on the payment of dividends by the Bank. The Bank does not intend to pay dividends that would result in a recapture of any portion of its tax bad debt reserve. Corporate Alternative Minimum Tax. The Code imposes a tax on alternative minimum taxable income ("AMTI") at a rate of 20%. In addition, only 90% of AMTI can be offset by net operating loss carryovers. AMTI is increased by an amount equal to 75% of the amount by which the Bank's adjusted current earnings exceeds its AMTI (determined without regard to this preference and prior to reduction for net operating losses). 31 Dividends-Received Deduction. The Company may exclude from its income 100% of dividends received from the Bank as a member of the same affiliated group of corporations. The corporate dividends-received deduction is generally 70% in the case of dividends received from unaffiliated corporations with which the Company and the Bank will not file a consolidated tax return, except that if the Company or the Bank owns more than 20% of the stock of a corporation distributing a dividend, then 80% of any dividends received may be deducted. Audits. The Bank's federal income tax returns have been audited through September 30, 1997. The Bank did not incur any net increase in tax liability as a result of the audit. Washington Taxation The Bank is subject to a business and occupation tax imposed under Washington law at the rate of 1.50% of gross receipts. Interest received on loans secured by mortgages or deeds of trust on residential properties is exempt from such tax. Competition The Bank operates in an intensely competitive market for the attraction of savings deposits (its primary source of lendable funds) and in the origination of loans. Historically, its most direct competition for savings deposits has come from large commercial banks, thrift institutions and credit unions in its primary market area. Particularly in times of high interest rates, the Bank has faced additional significant competition for investors' funds from short-term money market securities and other corporate and government securities. The Bank's competition for loans comes principally from mortgage bankers, commercial banks and other thrift institutions. Such competition for deposits and the origination of loans may limit the Bank's future growth and earnings prospects. Subsidiary Activities The Bank has one wholly-owned subsidiary, Timberland Service Corporation ("Timberland Service"), whose primary function is to act as the Bank's escrow department. Personnel As of September 30, 1999, the Bank had 102 full-time employees and 11 part-time employees. The employees are not represented by a collective bargaining unit and the Bank believes its relationship with its employees is good. Item 2. Properties - ------------------- The Bank operates nine full-service facilities. The Bank owns all of its offices except for the Silverdale Loan Center, which is leased. The lease expires in November 2000. In October 1999, the Bank converted the Silverdale loan production office to a full service branch in Poulsbo (Kitsap County), Washington, and in November 1999, the Bank opened a full service branch in Spanaway (Pierce County), Washington. The following table sets forth certain information regarding the Bank's offices at September 30, 1999, all of which are owned except for the loan center, which is leased. 32 Approximate Location Year Opened Square Footage Deposits - -------- ----------- -------------- -------- (In thousands) Main Office: 624 Simpson Avenue 1966 7,700 $63,524 Hoquiam, Washington 98550 300 N. Boone Street 1974 3,400 25,302 Aberdeen, Washington 98520 314 Main South 1975 2,800 19,212 Montesano, Washington 98563 361 Damon Road 1977 2,100 19,130 Ocean Shores, Washington 98569 2418 Meridian East 1980 2,400 32,173 Edgewood, Washington 98371 12814 Meridian East (South Hill) 1996 4,200 10,140 Puyallup, Washington 98373 202 Auburn Way South 1994 4,200 12,020 Auburn, Washington 98002 1201 Marvin Road, N.E. 1997 4,400 5,574 Lacey, Washington 98516 101 Yelm Avenue W. 1999 1,800 1,073 Yelm, Washington 98597 Loan Center: Silverdale Loan Center 1995 1,225 N/A 10030 Silverdale Way, Suite 106 Silverdale, Washington 98383 Data Center: 422 6th Street 1990 2,700 N/A Hoquiam, Washington 98550 The Bank also operates ten proprietary ATMs that are part of a nationwide cash exchange network. Item 3. Legal Proceedings - -------------------------- Periodically, there have been various claims and lawsuits involving the Bank, such as claims to enforce liens, condemnation proceedings on properties in which the Bank holds security interests, claims involving the making and servicing of real property loans and other issues incident to the Bank's business. The Bank is not a party to any pending legal proceedings that it believes would have a material adverse effect on the financial condition or operations of the Bank. 33 Item 4. Submission of Matters to a Vote of Security Holders - ------------------------------------------------------------ No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended September 30, 1999. PART II Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters - -------------------------------------------------------------------------- The Company's common stock is traded on the Nasdaq National Market under the symbol "TSBK". As of September 30, 1999, there were 5,217,422 shares of common stock outstanding and approximately 930 shareholders of record, excluding persons or entities who hold stock in nominee or "street name" accounts with brokers. Dividend payments by the Company are dependent primarily on dividends received by the Company from the Bank. Under federal regulations, the dollar amount of dividends the Bank may pay is dependent upon its capital position and recent net income. Generally, if the Bank satisfies its regulatory capital requirements, it may make dividend payments up to the limits prescribed in the FDIC regulations. However, institutions that have converted to a stock form of ownership may not declare or pay a dividend on, or repurchase any of, its common stock if the effect thereof would cause the regulatory capital of the institution to be reduced below the amount required for the liquidation account which was established in connection with the mutual to stock conversion. The following table sets forth the market price range of the Company's common stock for the year ended September 30, 1999. This information was provided by the Nasdaq Stock Market. High Low Dividends ---- --- --------- Fiscal 1999 ----------- First Quarter $14.38 $10.00 $0.06 Second Quarter $13.00 $11.41 $0.06 Third Quarter $12.06 $10.69 $0.07 Fourth Quarter $13.25 $11.44 $0.08 Fiscal 1998 ----------- First Quarter N/A N/A N/A Second Quarter $18.75 $14.50 N/A Third Quarter $18.50 $15.50 $0.06 Fourth Quarter $16.75 $10.75 $0.06 34 Item 6. Selected Financial Data - -------------------------------- The following table sets forth certain information concerning the consolidated financial position and results of operations of the Company at and for the dates indicated. Since the Company had not commenced operations prior to the Bank's mutual-to-stock conversion in January 1998, the financial information presented for the periods prior to 1998 is that of the Bank only. The consolidated data is derived in part from, and should be read in conjunction with, the Consolidated Financial Statements of the Company and its subsidiary presented herein. At September 30, -------------------------------------------- 1999 1998 1997 1996 1995 ---- ---- ---- ---- ---- (In thousands) SELECTED FINANCIAL CONDITION DATA: Total assets................ $307,116 $265,709 $211,553 $194,357 $177,761 Loans receivable and loans loans held for sale, net... 256,085 199,221 187,027 176,495 156,523 Investment securities held-to-maturity .......... -- -- -- -- 3,504 Investment securities available-for-sale......... 17,664 17,860 1,587 1,572 1,449 Mortgage-backed securities held-to-maturity........... -- -- 3,990 4,951 6,352 Mortgage-backed securities available-for-sale......... 13,992 17,555 -- -- -- Cash and due from financial institutions interest- bearing deposits in banks.. 8,126 21,784 11,446 5,055 4,860 Deposits ................... 188,148 170,834 173,003 156,549 143,084 FHLB advances............... 45,084 11,618 12,241 14,354 14,958 Shareholders' equity ....... 72,245 81,780 24,645 21,329 18,653 Year Ended September 30, -------------------------------------------- 1999 1998 1997 1996 1995 ---- ---- ---- ---- ---- (In thousands, except per share data) SELECTED OPERATING DATA: Interest and dividend income..................... $ 23,109 $20,650 $17,947 $16,500 $14,454 Interest expense............ 8,363 8,144 8,386 7,629 6,360 -------- ------- ------- ------- ------- Net interest income......... 14,746 12,506 9,561 8,871 8,094 Provision for loan losses... 363 200 597 70 -- -------- ------- ------- ------- ------- Net interest income after provision for loan losses . 14,383 12,306 8,964 8,801 8,094 Noninterest income.......... 592 1,540 1,235 688 598 Noninterest expense......... 7,160 6,340 5,040 5,392 4,089 Income before income taxes . 7,815 7,506 5,159 4,097 4,603 Provision for income taxes . 2,597 2,410 1,830 1,419 1,603 -------- ------- ------- ------- ------- Net income.................. $ 5,218 $ 5,096 $ 3,329 $ 2,678 $ 3,000 ======== ======= ======= ======= ======= Earnings per common share: Basic ..................... $1.03 $ 0.84 N/A N/A N/A Diluted.................... $1.03 $ 0.84 N/A N/A N/A 35 At September 30, -------------------------------------------- 1999 1998 1997 1996 1995 ---- ---- ---- ---- ---- OTHER DATA: Number of real estate loans outstanding.................. 2,797 2,708 2,679 2,512 2,535 Deposit accounts ............. 22,527 22,014 21,668 19,994 18,681 Full-service offices.......... 9 8 8 7 6 At or For the Year Ended September 30, -------------------------------------------- 1999 1998 1997 1996 1995 ---- ---- ---- ---- ---- KEY FINANCIAL RATIOS: Performance Ratios: Return on average assets(1)................... 1.89% 1.99% 1.62 % 1.46% 1.82% Return on average equity(2).. 6.95 7.56 14.39 13.21 17.44 Interest rate spread(3)...... 4.25 3.87 4.18 4.34 4.56 Net interest margin(4)....... 5.56 5.13 4.84 4.97 5.08 Average interest-earning assets to averageinterest- bearing liabilities.........141.50 137.84 115.60 114.76 113.05 Noninterest expense as a percent of average total assets...................... 2.60 2.47 2.46 2.93 2.49 Efficiency ratio(5)......... 47.81 45.79 46.68 56.82 47.04 Book value per share ....... 13.85 13.02 N/A N/A N/A Asset Quality Ratios: Nonaccrual and 90 days or more past due loans as a percent of loans receivable, net(6)...................... 1.56 2.39 4.06 0.86 0.66 Nonperforming assets as a percent of total assets..... 1.60 2.46 3.83 0.85 0.70 Allowance for loan losses as a percent of total loans receivable, net(6).......... 0.80 0.86 0.91 0.64 0.71 Allowance for losses as a percent of nonperforming loans ...................... 50.92 36.00 22.39 74.54 107.91 Net charge-offs to average outstanding loans .......... -- -- 0.01 -- -- Capital Ratios: Total equity-to-assets ratio. 23.52 30.78 11.65 10.97 10.49 Average equity to average assets(7)................... 27.25 26.27 11.28 11.02 10.45 - --------------- (1) Net income divided by average total assets. (2) Net income divided by average total equity. (3) Difference between weighted average yield on interest-earning assets and weighted average interest-bearing liabilities. (4) Net interest income (before provision for loan losses) as a percentage of average interest-earning assets. (5) Other expenses (excluding federal income tax expense) divided by the sum of net interest income and noninterest income. (6) Loans receivable includes loans held for sale and is not net of allowance for loan losses. (7) Average total equity divided by average total assets. 36 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - ------------------------------------------------------------------------ MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General Management's Discussion and Analysis of Financial Condition and Results of Operations is intended to assist in understanding the consolidated financial condition and results of operations of the Company. The information contained in this section should be read in conjunction with the Consolidated Financial Statements and accompanying notes thereto. Management's Discussion and Analysis of Financial Condition and Results of Operations and other portions of this Annual Report contain certain "forward-looking statements" concerning the future operations of Timberland Bancorp, Inc. Management desires to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 and is including this statement for the express purpose of availing the Company of the protections of such safe harbor with respect to all "forward-looking statements" contained in our Annual Report. We have used "forward-looking statements" to describe future plans and strategies, including our expectations of the Company's future financial results. Management's ability to predict results or the effect of future plans or strategies is inherently uncertain. Factors which could affect actual results include interest rate trends, the general economic climate in the Company's market area and the country as a whole, the ability of the Company to control costs and expenses, the ability of the Company to efficiently incorporate acquisitions into its operations, the ability of the Company to successfully address Year 2000 (Y2K) issues, competitive products and pricing, loan delinquency rates, and changes in federal and state regulation. These factors should be considered in evaluating the "forward-looking statements," and undue reliance should not be placed on such statements. Operating Strategy The Bank is a community-oriented bank which has traditionally offered a wide variety of savings products to its retail customers while concentrating its lending activities on real estate loans. The primary elements of the Bank's operating strategy include: Emphasize Residential Mortgage Lending and Residential Construction Lending. The Bank has attempted to establish itself as a niche lender in its primary market areas by focusing its lending activities primarily on the origination of loans secured by one- to- four family residential dwellings, including an emphasis on loans for the construction of residential dwellings. In an effort to meet the credit needs of borrowers in its primary area, the Bank actively originates one- to- four family mortgage loans that do not qualify for sale in the secondary market under FHLMC guidelines. The Bank also originates loans secured by multi-family and commercial real estate properties and, to a lesser extent, originates consumer loans. The Bank has also been an active participant in the secondary market, originating residential loans for sale to the FHLMC on a servicing retained basis. The Bank also established a business banking division in July 1998 to increase the Bank's origination of commercial business loans. Diversify Primary Market Area by Expanding Branch Office Network. In an effort to lessen its dependence on the Grays Harbor County market whose economy has historically been tied to the timber and fishing industries, the Bank has opened branch offices in Pierce, King and Thurston Counties and a loan production office in Kitsap County. Thurston, Pierce, King and Kitsap Counties contain the Olympia, Bremerton, and Seattle-Tacoma metropolitan areas and their economies are more diversified with the presence of government, aerospace and computer industries. Limit Exposure to Interest Rate Risk. In recent years, the loans that the Bank has retained in its portfolio generally have periodic interest rate adjustment features or have been relatively short-term in nature. Loans originated for portfolio primarily have included ARM loans and short-term construction loans. Longer fixed-rate mortgage loans have generally been originated for sale in the secondary market. Management believes that the interest rate sensitivity of these adjustable rate and short-term loans more closely match the interest rate sensitivity of the Bank's funding sources than do other longer duration assets with fixed interest rates. Due to the current interest rate environment, the 37 Bank has increased its retention of 15 and 30 year fixed-rate mortgage loans. Such loans are retained and designated as loans held for sale. Market Risk and Asset and Liability Management General. Market risk is the risk of loss from adverse changes in market prices and rates. The Company's market risk arises primarily from interest rate risk inherent in its lending, investment, deposit and borrowing activities. The Bank, like other financial institutions, is subject to interest rate risk to the extent that its interest-earning assets reprice differently than its interest-bearing liabilities. Management actively monitors and manages its interest rate risk exposure. Although the Bank manages other risks, such as credit quality and liquidity risk, in the normal course of business management considers interest rate risk to be its most significant market risk that could potentially have the largest material effect on the Bank's financial condition and results of operations. The Bank does not maintain a trading account for any class of financial instruments nor does it engage in hedging activities or derivative instruments. Furthermore, the Bank is not subject to foreign currency exchange rate risk or commodity price risk. Qualitative Aspects of Market Risk. The Bank's principal financial objective is to achieve long-term profitability while reducing its exposure to fluctuating market interest rates. The Bank has sought to reduce the exposure of its earnings to changes in market interest rates by attempting to manage the mismatch between asset and liability maturities and interest rates. The principal element in achieving this objective is to increase the interest-rate sensitivity of the Bank's interest-earning assets by retaining for its portfolio, loans with interest rates subject to periodic adjustment to market conditions and selling fixed- rate one- to- four family mortgage loans. The Bank relies on retail deposits as its primary source of funds. Management believes retail deposits, compared to brokered deposits, reduce the effects of interest rate fluctuations because they generally represent a more stable source of funds. As part of its interest rate risk management strategy, the Bank promotes transaction accounts and certificates of deposit with terms of up to six years. The Bank has adopted a strategy that is designed to maintain or improve the interest rate sensitivity of assets relative to its liabilities. The primary elements of this strategy involve the origination of ARM loans for its portfolio; maintaining residential construction loans as a portion of total net loans receivable because of their generally shorter terms and higher yields than other one- to- four family residential mortgage loans; matching asset and liability maturities; investing in short-term securities; and the origination of fixed-rate loans for retention or sale in the secondary market and the retention of the related loan servicing rights. Sharp decreases in interest rates may adversely affect the Bank's earnings while increases in interest rates may beneficially affect the Bank's earnings because a larger portion of the Bank's interest rate sensitive assets than interest rate sensitive liabilities would reprice within a one year period. Management has sought to sustain the match between asset and liability maturities and rates, while maintaining an acceptable interest rate spread. Pursuant to this strategy, the Bank actively originates adjustable rate loans for retention in its loan portfolio. Fixed-rate mortgage loans generally are originated for the intended purpose of resale in the secondary mortgage market. At September 30, 1999, adjustable rate mortgage loans and adjustable rate mortgage-backed securities constituted $137.6 million or 46.4%, of the Bank's total combined mortgage loan and mortgage-backed securities portfolio. Although the Bank has sought to originate ARM loans, the ability to originate such loans depends to a great extent on market interest rates and borrowers' preferences. Particularly in lower interest rate environments, borrowers often prefer to obtain fixed rate loans. Consumer loans and construction and land development loans typically have shorter terms and higher yields than permanent residential mortgage loans, and accordingly reduce the Bank's exposure to fluctuations in interest rates. At September 30, 1999, the construction and land development, and consumer loan portfolios amounted to $90.6 million and $12.3 million, or 30.2% and 4.1% of total loans receivable (including loans held for sale), respectively. Quantitative Aspects of Market Risk. Management of the Bank monitors the Bank's interest rate sensitivity through the use of a model provided for the Bank by the FHLB of Seattle. The model estimates the changes in NPV 38 (net portfolio value) and net interest income in response to a range of assumed changes in market interest rates. The model first estimates the level of the Bank's NPV (market value of assets, less market value of liabilities, plus or minus the market value of any off-balance sheet items) under the current rate environment. In general, market values are estimated by discounting the estimated cash flows of each instrument by appropriate discount rates. The model then recalculates the Bank's NPV under different interest rate scenarios. The change in NPV under the different interest rate scenarios provides a measure of the Bank's exposure to interest rate risk. The following table is provided by the FHLB of Seattle based on data at September 30, 1999. Projected Net Interest Income Current Market Value Interest ------------------------------- ------------------------------- Rate Estimated $ Change % Change Estimated $ Change % Change Scenario Value from Base from Base Value from Base from Base - -------- ----- --------- --------- ----- --------- --------- (Dollars in thousands) +400 $12,508 $(456) (3.52)% $47,463 $(9,639) (16.88)% +300 12,787 (177) (1.37) 50,437 (6,665) (11.67) +200 13,051 86 0.66 53,090 (4,012) (7.03) +100 13,189 225 1.73 55,529 (1,573) (2.75) BASE 12,964 -- -- 57,102 -- -- - -100 12,290 (675) (5.21) 57,078 (24) (0.04) - -200 11,451 (1,514) (11.68) 55,158 (1,944) (3.40) - -300 10,684 (2,280) (17.59) 53,482 (3,620) (6.34) - -400 10,011 (2,953) (22.78) 52,729 (4,373) (7.66) Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan repayments and deposit decay, and should not be relied upon as indicative of actual results. Furthermore, the computations do not reflect any actions management may undertake in response to changes in interest rates. In the event of a 200 basis point decrease in interest rates, the Bank would be expected to experience an 3.4% decrease in NPV and a 11.7% decrease in net interest income. In the event of a 200 basis point increase in interest rates, a 7.0% decrease in NPV and an 0.7% increase in net interest income would be expected. Based upon the modeling described above, the Bank's asset and liability structure results in decreases in NPV and decreases in net interest income in a declining interest rate scenario and decreases in NPV and generally increases in net interest income in a rising interest rate scenario. However, the amount of change in value of specific assets and liabilities due to changes in rates is not the same in a rising rate environment as in a falling rate environment. As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets have features which restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, expected rates of prepayments on loans and early withdrawals from certificates could possibly deviate significantly from those assumed in calculating the table. Comparison of Financial Condition at September 30, 1999 and 1998 Total Assets: Total assets increased 15.6% from $265.7 million at September 30, 1998 to $307.1 million at September 30, 1999, primarily as a result of a $56.9 million increase in loans receivable and loans held for sale, net of allowance for loan losses, which was primarily funded by increased FHLB borrowings and increased deposits. The 39 asset growth due to the increase in the loan portfolio was partially offset by the use of $13.1 million to repurchase shares of the Company's stock. Cash and Due from Financial Institutions: Cash and due from financial institutions and interest-bearing deposit balances in banks decreased by 62.7% from $21.8 million at September 30, 1998 to $8.1 million at September 30, 1999. This decrease is primarily due to $13.1 million in funds used to repurchase 1,064,453 shares of the Company's stock. These shares were repurchased in October 1998, February 1999 and September 1999. Investments and Mortgage-backed Securities: Investments and mortgage-backed securities decreased by 10.6% from $35.4 million at September 30, 1998 to $31.7 million at September 30, 1999, primarily as a result of scheduled amortization, prepayments, maturities, and sales. For additional details on investments and mortgage- backed securities see Note 3 to the Notes to Consolidated Financial Statements contained in "Item 8., Financial Statements and Supplementary Data." Loans Receivable, and Loans Held-for-Sale, Net of Allowance for Loan Losses: Loans receivable, including loans held-for-sale, net, increased by 28.5% from $199.2 million at September 30, 1998 to $256.1 million at September 30, 1999. This increase is primarily a result of an increase in one-to-four family mortgage loans, construction and land development loans, commercial mortgage loans, multi-family loans, and commercial business loans held in the Bank's portfolio. Real Estate Owned, Net: Real estate owned, net, decreased from $1.7 million at September 30, 1998 to $867,000 at September 30, 1999. This decrease is primarily attributable to a $741,000 decrease in the real estate owned balance of the condominium project that the Bank accepted a deed in lieu of foreclosure on in November 1997. For additional information see "Item 1. Business -- Lending Activities --Nonperforming Assets." Deposits: Deposits increased by 10.1% from $170.8 million at September 30, 1998 to $188.1 million at September 30, 1999. This increase is primarily attributable to growth of $9.9 million in the Bank's certificate of deposit accounts and smaller increases in non-interest bearing accounts, passbook savings accounts, and money market accounts. Borrowings: Borrowings increased by 288.1% from $11.6 million at September 30, 1998 to $45.1 million at September 30, 1999 due to increased FHLB advances, which were primarily used to fund loan portfolio growth. Shareholders' Equity: Total shareholders' equity decreased by 11.7% from $81.8 million at September 30, 1998 to $72.2 million at September 30, 1999, primarily as a result of the repurchase of 1,064,453 shares of the Company's stock for $13.1 million, and is partially offset by net income of $5.2 million (less dividends paid of $1.5 million). Comparison of Operating Results for Years Ended September 30, 1999 and 1998 Net Income: Net income increased from $5.1 million, or $0.84 per basic share ($0.84 per diluted share) for the year ended September 30, 1998 to $5.2 million, or $1.03 per basic share ($1.03 per diluted share) for the year ended September 30, 1999. Net Interest Income: Net interest income increased 17.9% from $12.5 million for the year ended September 30, 1998 to $14.7 million for the year ended September 30, 1999, primarily as a result of increased interest income from growth in the Bank's loan portfolio. Interest and dividend income increased by 11.9% from $20.7 million for the year ended September 30, 1998 to $23.1 million for the year ended September 30, 1999 primarily due to increased interest income on loans receivable. This increase was primarily a result of growth in the Bank's loan portfolio as average loans receivable increased from 40 $192.1 million for the year ended September 30, 1998 to $223.7 million for the year ended September 30, 1999. Interest income was also increased by $442,000 of delinquent interest and fee income that was received on two large nonperforming loans. Interest expense increased by 2.7% from $8.1 million for the year ended September 30, 1998 to $8.4 million for the year ended September 30, 1999, primarily due to increased interest expense on FHLB advances. Provision for Loan Losses: Provision for loan losses increased from $200,000 for the year ended September 30, 1998 to $363,000 for the year ended September 30, 1999. Management increased the provision primarily due to growth in the Bank's loan portfolio. Management deemed the loan loss reserves of $2.1 million at September 30, 1999 (0.80% of loans receivable and loans held for sale and 50.9% of non-performing loans) adequate to provide for estimated losses based on an evaluation of known and inherent risks in the loan portfolio at that date. For additional information, see "Item 1. Business -- Lending Activities -- Nonperforming Assets" included herein. Noninterest Income: Total noninterest income decreased 61.6% from $1.5 million for the year ended September 30, 1998 to $592,000 for the year ended September 30, 1999, primarily due to market value writedowns on loans held for sale of $583,000. Decreases in servicing income on loans sold of $269,000 and gains on sale of loans of $205,000 also contributed to the overall decrease. These decreases were partially offset by a $123,000 increase in service charges on deposits. Noninterest Expense: Total noninterest expense increased 12.9% from $6.3 million for the year ended September 30, 1998 to $7.2 million for the year ended September 30, 1999. The largest portion of this increase is a result of a $374,000 increase in salary and employee benefit expense, which is primarily a result of hiring additional employees to staff the new branches. Smaller increases in expenses relating to premises and equipment, advertising, and ATMs accounted for the majority of the remaining increase. Provision for Income Taxes: The provision for income taxes increased from $2.4 million for the year ended September 30, 1998 to $2.6 million for the year ended September 30, 1999 primarily as a result of higher income before income taxes. Comparison of Operating Results for the Years Ended September 30, 1998 and 1997 Net Income: Net income increased 53.1% from $3.3 million for the year ended September 30, 1997 to $5.1 million for the year ended September 30, 1998. Basic earnings per share for the current year were $.84. Earnings per share for the prior comparative period are not applicable because the Company had no stock issued and outstanding at that time. Net Interest Income: Net interest income increased 30.8% from $9.6 million for the year ended September 30, 1997 to $12.5 million for the year ended September 30, 1998 as a result of interest income increasing and interest expense decreasing. Total interest income increased 15.1% from $17.9 million for the year ended September 30, 1997 to $20.7 million for the year ended September 30, 1998 primarily as a result of increased funds to invest from the Company's January stock offering. Total interest expense decreased 2.9% from $8.4 million for the year ended September 30, 1997 to $8.1 million for the year ended September 30, 1998, primarily as a result of a decrease in the average rate paid on interest- bearing liabilities from 4.91% for the year ended September 30, 1997 to 4.60% for the year ended September 30, 1998. 41 Net interest margin increased from 4.84% for the year ended September 30, 1997 to 5.13% for the year ended September 30, 1998, primarily as a result of average interest-earning assets increasing more than average interest-earning liabilities due primarily to the receipt of proceeds from the Company's stock offering. Provision for Loan Losses: The provision for loan losses decreased from $597,000 for the year ended September 30, 1997 to $200,000 for the year ended September 30, 1998. Management decreased the provision for loan losses because it deemed the general loan loss reserves of $1.7 million at September 30, 1998 (.86% of loans receivable, net, and 36.0% of non-performing loans) adequate to provide for estimated losses based on an evaluation of known and inherent risks in the loan portfolio at that date. For additional information see "Item 1. Business -- Lending Activities -- Nonperforming Assets" included herein. Noninterest Income: Total noninterest income increased 24.7% from $1.2 million for the year ended September 30, 1997 to $1.5 million for the year ended September 30, 1998. The largest portion of this increase was attributable to a $133,000 increase in escrow fees and a $92,000 increase in servicing income on loans sold. These increases are due to increased escrow activity and a larger volume of fixed rate loans being sold to FHLMC. Increases in miscellaneous fees account for the remaining portion of the increase. Noninterest Expense: Total noninterest expense increased 25.8% from $5.0 million for the year ended September 30, 1997 to $6.3 million for the year ended September 30, 1998. The largest portion of this increase is a result of increased salary and employee benefit expense which increased from $2.9 million for the year ended September 30, 1997 to $3.9 million for the year ended September 30, 1998. The release of ESOP shares accounted for $364,000 of the increased compensation expense. The remaining portion of the increased compensation expense is a result of adding additional employees, cost of living increases for current employees and increased health insurance costs. The number of full-time equivalent employees increased from 86 at September 30, 1997 to 97 at September 30, 1998 as a result of restructuring the loan origination department and the loan servicing department, hiring three commercial loan officers, hiring additional personnel for the Auburn Escrow Department, elevating several part-time positions to full-time positions, and hiring an individual to assist in preparing the reports required of the Company as a public company. Provision for Income Taxes: The provision for income taxes increased from $1.8 million for the year ended September 30, 1997 to $2.4 million for the year ended September 30, 1998 primarily as a result of higher income before income taxes. Nonperforming Assets Information with respect to the Bank's nonperforming assets at September 30, 1999 and September 30, 1998 is contained in "Item 1. Business -- Lending Activities -- Nonperforming Assets and Delinquencies." Average Balances, Interest and Average Yields/Cost The earnings of the Company depend largely on the spread between the yield on interest-earning assets and the cost of interest-bearing liabilities, as well as the relative amount of the Company's interest-earning assets and interest- bearing liability portfolios. The following table sets forth, for the periods indicated, information regarding average balances of assets and liabilities as well as the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities and average yields and costs. Such yields and costs for the periods indicated are derived by dividing income or expense by the average weekly balance of assets or liabilities, respectively, for the periods presented. Average balances are derived from weekly balances. Management does not believe that the use of weekly balances instead of daily balances has caused any material difference in the information presented. 42 Year Ended September 30, --------------------------------------------------------------------------------- 1999 1998 1997 --------------------------- --------------------------- ------------------------- Interest Interest Interest Average and Yield/ Average and Yield/ Average and Yield/ Balance Dividends Cost Balance Dividends Cost Balance Dividends Cost ------- --------- ---- ------- --------- ---- ------- -------- ---- (Dollars in thousands) Interest-earning assets: Loans receivable (1)(2). $223,691 $20,721 9.26% $192,082 $17,712 9.22% $188,729 $17,418 9.23% Mortgage-backed and investment securities . 23,087 1,382 5.99 17,013 1,067 6.27 4,484 279 6.22 FHLB stock and equity securities............. 13,106 766 5.84 2,824 189 6.69 1,550 116 7.48 Interest-bearing deposits............... 5,132 240 4.68 31,901 1,682 5.27 2,758 134 4.86 -------- ------- -------- ------- -------- ------- Total interest-earning assets................. 265,016 23,109 8.72 243,820 20,650 8.47 197,521 17,947 9.09 Non-interest-earning assets................... 10,653 12,816 7,598 -------- -------- -------- Total assets............. $275,669 $256,636 $205,119 ======== ======== ======== Interest-bearing liabilities: Passbook accounts....... $ 26,783 695 2.59 $ 33,025 906 2.74 $ 25,068 750 2.99 Money market accounts... 16,752 628 3.75 14,299 543 3.80 12,985 514 3.96 NOW accounts............ 21,283 363 1.71 20,139 390 1.94 17,997 445 2.47 Certificates of deposit. 102,506 5,590 5.45 97,434 5,631 5.78 98,842 5,807 5.88 FHLB advances-other borrowed money......... 19,967 1,087 5.44 11,991 674 5.62 15,980 870 5.44 -------- ------- -------- ------- -------- ------- Total interest bearing liabilities ......... 187,291 8,363 4.47 176,888 8,144 4.60 170,872 8,386 4.91 Non-interest bearing liabilities ............. 13,271 12,337 11,107 -------- -------- -------- Total liabilities..... 200,562 189,225 181,979 Shareholders' equity ..... 75,107 67,411 23,140 -------- -------- -------- Total liabilities and shareholders' equity. $275,669 $256,636 $205,119 ======== ======== ======== Net interest income....... $14,746 $12,506 $ 9,561 ======= ======= ======= Interest rate spread...... 4.25% 3.87% 4.18% ====== ====== ====== Net interest margin (3)... 5.56% 5.13% 4.84% ====== ====== ====== Ratio of interest-earning assets to average interest- bearing liabilities...... 141.50% 137.84% 115.60% ====== ====== ====== - ----------------- (1) Does not include interest on loans 90 days or more past due. Includes loans originated for sale. (2) Average balance includes nonaccrual loans. (3) Net interest income divided by total interest earning assets.
43 Rate/Volume Analysis The following table sets forth the effects of changing rates and volumes on net interest income on the Company. Information is provided with respect to the (i) effects on interest income attributable to changes in volume (changes in volume multiplied by prior rate); and (ii) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume); (iii) changes in rate/volume (change in rate multiplied by change in volume); and (iv) the net change (sum of the prior columns). Year Ended September 30, Year Ended September 30, 1999 Compared to Year 1998 Compared to Year Ended September 30, 1998 Ended September 30, 1997 Increase (Decrease) Increase (Decrease) Due to Due to ---------------------------------- ---------------------------------- Rate/ Net Rate/ Net Rate Volume Volume Change Rate Volume Volume Change ---- ------ ------ ------ ---- ------ ------ ------ (In thousands) Interest-earning assets: Loans receivable (1)............. $ 78 $2,916 $ 15 $3,009 $ (18) $ 310 $ -- $ 292 Investments and mortgage- backed securities............. (49) 382 (18) 315 3 780 8 791 FHLB stock and equity securities. (24) 688 (87) 577 (12) 95 (10) 73 Interest-bearing deposits ....... (189) (1,411) 158 (1,442) 11 1,416 120 1,547 ----- ------ ----- ------ ------ ------ ------ ------ Total net change in income on interest-earning assets ...... (184) 2,575 68 2,459 (16) 2,601 118 2,703 Interest-bearing liabilities: Passbook accounts................ (50) (171) 10 (211) (62) 238 (20) 156 NOW accounts..................... (48) 23 (2) (27) (95) 53 (11) (53) Money market accounts............ (8) 94 (1) 85 (20) 52 (2) 30 Certificate accounts............. (317) 293 (17) (41) (99) (82) 1 (180) FHLB advances and other borrowed money ................. (21) 448 (14) 413 29 (217) (7) (195) ----- ------ ----- ------ ------ ------ ------ ------ Total net change in expense on interest-bearing liabilities . (444) 687 (24) 219 (247) 44 (39) (242) ----- ------ ----- ------ ------ ------ ------ ------ Net change in net interest income. $ 260 $1,888 $ 92 $2,240 $ 231 $2,557 $ 157 $2,945 ===== ====== ===== ====== ====== ====== ====== ====== - ---------------- (1) Excludes interest on loans 90 days or more past due. Includes loans originated for sale.
Liquidity and Capital Resources The Company's primary sources of funds are customer deposits, proceeds from principal and interest payments on and the sale of loans, maturing securities and FHLB advances. The Company also raised $65.0 million in net proceeds from the January 1998 stock offering. While the maturity and scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition. The Bank must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund loan originations and deposit withdrawals, to satisfy other financial commitments and to take advantage of investment opportunities. The Bank generally maintains sufficient cash and short-term investments to meet short-term liquidity 44 needs. At September 30, 1999, the Bank's regulatory liquidity ratio (net cash, and short-term and marketable assets, as a percentage of net deposits and short-term liabilities) was 23.6%. At September 30, 1999, the Bank also maintained an uncommitted credit facility with the FHLB of Seattle that provided for immediately available advances up to an aggregate amount of $59.8 million, under which $45.1 million was outstanding. Liquidity management is both a short- and long-term responsibility of the Bank's management. The Bank adjusts its investments in liquid assets based upon management's assessment of (i) expected loan demand, (ii) projected loan sales, (iii) expected deposit flows, and (iv) yields available on interest- bearing deposits. Excess liquidity is invested generally in interest-bearing overnight deposits and other short-term government and agency obligations. If the Bank requires funds beyond its ability to generate them internally, it has additional borrowing capacity with the FHLB and collateral for repurchase agreements. The Bank's primary investing activity is the origination of one- to- four family mortgage loans and construction and land development loans. During the years ended September 30, 1999, 1998 and 1997, the Bank originated $41.1 million, $45.4 million and $27.1 million of one- to- four family mortgage loans and $63.2 million, $58.1 million and $35.2 million of construction and land development loans, respectively. At September 30, 1999, the Bank had mortgage loan commitments totaling $6.6 million and undisbursed loans in process totaling $37.8 million. The Bank anticipates that it will have sufficient funds available to meet current loan commitments. Certificates of deposit that are scheduled to mature in less than one year from September 30, 1999 totaled $78.4 million. Historically, the Bank has been able to retain a significant amount of its deposits as they mature. Federally-insured state-chartered banks are required to maintain minimum levels of regulatory capital. Under current FDIC regulations, insured state- chartered banks generally must maintain (i) a ratio of Tier 1 leverage capital to total assets of at least 3.0% (4.0% to 5.0% for all but the most highly rated banks), (ii) a ratio of Tier 1 capital to risk weighted assets of at least 4.0% and (iii) a ratio of total capital to risk weighted assets of at least 8.0%. At September 30, 1999, the Bank was in compliance with all applicable capital requirements. For additional details see the regulatory capital table in Note 18 to the Notes to Consolidated Financial Statements contained in "Item 8., Financial Statements and Supplementary Data" and "Item 1. -- Business -- Regulation of the Bank -- Capital Requirements." Year 2000 Issues The Year 2000 issue exists because many computer systems and applications use two-digit date fields to designate a year. As the century date change occurs, date-sensitive systems may recognize the year 2000 as 1900, or not at all. This inability to recognize or properly treat the year 2000 may cause systems to fail or process financial and operational information incorrectly. The Bank has established a committee to address Year 2000 issues. The committee has conducted a comprehensive review of its computer systems and equipment to identify applications that could be affected by Year 2000 issues and has implemented a plan designed to ensure that all software used in connection with the Bank's business will function correctly with dates past 1999. The Bank has an in-house data processing department which maintains the Bank's main system on an IBM AS400. The Bank has completed the extensive project of reprogramming all of its internal codes on this system to be Year 2000 compliant. The Bank also completed testing of the system with regulatory suggested dates in November 1998. The test results have indicated that this system is compliant in all material respects. The Bank also uses software from third party vendors for applications such as accounts payable, fixed assets, loan processing, and wire transfers. The Bank has installed and tested Year 2000 compliant software updates for all mission critical software. 45 The Bank's Year 2000 committee has also assessed credit risk within the Bank's loan portfolio. The Bank realizes that commercial borrowers, like itself, must also address the Year 2000 issue. To help assess each individual commercial loan, the Bank sent out questionnaires to its commercial borrowers asking them if they were aware of the Year 2000 issues and if they were taking steps to address the issues. The committee then assigned each commercial loan a Year 2000 risk rating (low, moderate, or high) based on a variety of factors, which include: responses to the Year 2000 questionnaire, industry vulnerability, loan size, and collateral position. Although no assurances can be given, the committee does not believe credit risk to the Bank will be material, based on the assessment analysis. In addition, when underwriting a prospective commercial loan, the Bank considers what effect, if any, the Year 2000 issue may have on the business of the prospective borrower as well as the borrower's ability to meet contractual obligations with the Bank in the event that Year 2000 issues affect the borrower's business. The Bank's Year 2000 committee has developed contingency plans in the event of a business disruption due to power outages or natural disasters. The contingency plan has been validated and tested. The Year 2000 committee will continue to review and retest aspects of the Year 2000 Readiness Plan throughout the remainder of the year. The Bank has budgeted approximately $163,000 towards its Year 2000 compliance efforts. To date, the Bank has expended approximately $148,000 towards Year 2000 compliance issues. The Bank does not believe that the ultimate costs associated with its Year 2000 compliance efforts will be material to the Bank. However, no assurances can be given that such costs will not be higher and have a material adverse effect on the Bank's financial condition and results of operations. The above discussion contains certain forward-looking statements. The discussion is based on the Bank's current assessment and is subject to uncertainties that could cause the implementation schedule, the costs and the results contemplated by the plan to differ materially from the Bank's expectation. Effect of Inflation and Changing Prices The consolidated financial statements and related financial data presented herein have been prepared in accordance with generally accepted accounting principles which require the measurement of financial position and operating results in terms of historical dollars, without considering the change in the relative purchasing power of money over time due to inflation. The primary impact of inflation on the operation of the Company is reflected in increased operating costs. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on a financial institution's performance than do general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services. Item 7A. Quantitative and Qualitative Disclosures About Market Risk - -------------------------------------------------------------------- The information contained under the Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Market Risk and Asset and Liability Management" of this Form 10-K is incorporated herein by reference. 46 Item 8. Financial Statements and Supplementary Data - ---------------------------------------------------- TIMBERLAND BANCORP, INC. AND SUBSIDIARY Index to Consolidated Financial Statements Page ---- Independent Auditors Report 48 Consolidated Balance Sheets as of September 30, 1999 and 1998 49 Consolidated Statements of Income For the Years Ended September 30, 1999, 1998 and 1997 50 Consolidated Statements of Shareholders' Equity For the Years Ended September 30, 1999, 1998 and 1997 51 Consolidated Statements of Cash Flows For the Years Ended September 30, 1999, 1998 and 1997 52-53 Consolidated Statements of Comprehensive Income For the Years Ended September 30, 1999, 1998 and 1997 54 Notes to Consolidated Financial Statements 55 47 [Letterhead of Knight Vale & Gregory Inc., P.S.] Independent Auditors' Report October 29, 1999 The Board of Directors Timberland Bancorp, Inc. Hoquiam, Washington We have audited the accompanying consolidated balance sheets of Timberland Bancorp, Inc. and Subsidiaries as of September 30, 1999 and 1998, and the related consolidated statements of income, shareholders' equity, cash flows and comprehensive income for the years then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. The consolidated statements of income, shareholders' equity, cash flows and comprehensive income of Timberland Bancorp, Inc. and Subsidiaries for the year ended September 30, 1997 were audited by other auditors whose report, dated November 13, 1997, expressed an unqualified opinion on those statements. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the 1999 and 1998 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Timberland Bancorp, Inc. and Subsidiaries as of September 30, 1999 and 1998, and the results of their operations and their cash flows for the years then ended, in conformity with generally accepted accounting principles. /s/Knight, Vale & Gregory, Inc., P.S. 48 Consolidated Balance Sheets - ------------------------------------------------------------------------------ (Dollars in Thousands) Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 1999 1998 Assets Cash and due from financial institutions $ 6,810 $ 7,039 Interest bearing deposits in banks 1,316 14,745 Investments and mortgage-backed securities 31,656 35,415 Loans receivable 233,597 191,007 Loans held for sale 22,488 8,214 256,085 199,221 Accrued interest receivable 1,480 1,389 Premises and equipment 7,621 5,340 Real estate owned 867 1,724 Other assets 1,281 836 Total assets $307,116 $265,709 Liabilities and Shareholders' Equity Liabilities Deposits $188,148 $170,834 Federal Home Loan Bank advances 45,084 11,618 Other liabilities and accrued expenses 1,639 1,477 Total liabilities 234,871 183,929 Commitments and Contingencies -- -- Shareholders' Equity Preferred stock, $0.01 par value; 1,000,000 shares authorized; none issued -- -- Common stock, $0.01 par value; 50,000,000 shares authorized; 6,612,500 shares issued, 5,217,422 and 6,281,875 shares outstanding 52 63 Additional paid-in capital 46,943 60,183 Unearned shares issued to employee stock ownership trust (7,005) (7,534) Retained earnings 32,646 28,948 Accumulated other comprehensive income (loss) (391) 120 Total shareholders' equity 72,245 81,780 Total liabilities and shareholders' equity $307,116 $265,709 See notes to consolidated financial statements. 49 Consolidated Statements of Income - ------------------------------------------------------------------------------ (Dollars in Thousands, Except Per Share Amounts) Timberland Bancorp, Inc. and Subsidiaries Years Ended September 30, 1999, 1998 and 1997 1999 1998 1997 Interest and Dividend Income Loans receivable $20,721 $17,712 $17,418 Investments and mortgage-backed securities 1,382 1,067 279 Dividends 766 189 116 Deposits in other financial institutions 240 1,682 134 Total interest and dividend income 23,109 20,650 17,947 Interest Expense Deposits 7,276 7,470 7,516 Federal Home Loan Bank advances 1,087 674 870 Total interest expense 8,363 8,144 8,386 Net interest income 14,746 12,506 9,561 Provision for Loan Losses 363 200 597 Net interest income after provision for loan losses 14,383 12,306 8,964 Non-Interest Income Service charges on deposits 440 317 314 Gain on sale of loans, net 74 279 269 Market value adjustment on loans held for sale (583) 19 70 Gain on sale of securities available for sale, net -- 22 -- Escrow and annuity fees 240 242 109 Servicing income (expenses) on loans sold (17) 252 160 Other 438 409 313 Total non-interest income 592 1,540 1,235 Non-Interest Expense Salaries and employee benefits 4,246 3,872 2,894 Premises and equipment 856 730 723 Advertising 299 234 234 Other 1,759 1,504 1,189 Total non-interest expense 7,160 6,340 5,040 Income before income taxes 7,815 7,506 5,159 Provision for Income Taxes 2,597 2,410 1,830 Net income $ 5,218 $ 5,096 $ 3,329 Earnings Per Common Share Basic $1.03 $.84 N/A Diluted 1.03 .84 N/A See notes to consolidated financial statements. 50 Consolidated Statements of Shareholders' Equity - ----------------------------------------------------------------------------------------------------------- (Dollars in Thousands) Timberland Bancorp, Inc. and Subsidiaries Years Ended September 30, 1999, 1998 and 1997 Unearned Shares Accumulated Issued to Other Employee Compre- Common Stock Additional Stock hensive Paid-in Ownership Retained Income Shares Amount Capital Trust Earnings (Loss) Total Balance, September 30, 1996 -- $ -- $ -- $ -- $21,316 $ 13 $21,329 Net income -- -- -- -- 3,329 -- 3,329 Realized gain on sale of securities, net of tax -- -- -- -- -- (13) (13) Balance, September 30, 1997 -- -- -- -- 24,645 -- 24,645 Issuance of common stock 6,612,500 66 64,884 -- -- -- 64,950 Net income -- -- -- -- 5,096 -- 5,096 Repurchase of common stock (330,625) (3) (4,732) -- -- -- (4,735) Cash dividends ($.12 per share) -- -- -- -- (793) -- (793) Shares acquired for ESOP -- -- -- (7,930) -- -- (7,930) Earned ESOP shares -- -- 31 396 -- -- 427 Unrealized gain on securities available for sale, net of tax -- -- -- -- -- 120 120 Balance, September 30, 1998 6,281,875 63 60,183 (7,534) 28,948 120 81,780 Net income -- -- -- -- 5,218 -- 5,218 Repurchase of common stock (1,064,453) (11) (13,139) -- -- -- (13,150) Cash dividends ($.27 per share) -- -- -- -- (1,520) -- (1,520) Earned ESOP shares -- -- (101) 529 -- -- 428 Unrealized loss on securities available for sale, net of tax -- -- -- -- -- (511) (511) Balance, September 30, 1999 5,217,422 $52 $46,943 ($7,005) $32,646 ($391) $72,245 See notes to consolidated financial statements. 51
Consolidated Statements of Cash Flows - ------------------------------------------------------------------------------ (Dollars in Thousands) Timberland Bancorp, Inc. and Subsidiaries Years Ended September 30, 1999, 1998 and 1997 1999 1998 1997 Cash Flows from Operating Activities Net income $ 5,218 $ 5,096 $ 3,329 Noncash revenues, expenses, gains and losses included in income: Depreciation 364 348 304 Deferred federal income taxes (449) (33) (42) Earned ESOP shares 428 427 -- Federal Home Loan Bank stock dividends (134) (126) (116) Market value adjustment on loans held for sale 583 (19) (70) (Gain) loss on sale of real estate owned, net -- 25 (12) Gain on sale of securities available for sale -- (22) -- (Gain) loss on sale of loans (74) 279 269 Provision for loan and real estate owned losses 363 200 598 Net (increase) decrease in loans originated for sale (14,783) (4,618) 2,072 Net change in accrued interest receivable and other assets,and other liabilities and accrued expenses 1,339 (714) (755) Net cash provided by (used in) operating activities (7,145) 843 5,577 Cash Flows from Investing Activities Net (increase) decrease in interest-bearing deposits in banks 13,429 (8,295) (5,326) Purchases of securities available for sale (26,826) (17,025) -- Purchases of securities held to maturity -- (20,371) -- Proceeds from maturities of securities held to maturity -- -- 948 Proceeds from maturities of securities available for sale 29,889 7,548 101 Proceeds from sales of securities available for sale -- 312 -- Increase in loans receivable, net (44,568) (11,846) (13,400) Additions to premises and equipment (2,664) (257) (879) Additions to real estate owned -- (663) (568) Proceeds from sale of real estate owned 1,526 3,097 271 Proceeds from sale of premises and equipment 20 -- -- Net cash used in investing activities (29,194) 47,500) (18,853) Cash Flows from Financing Activities Increase (decrease) in deposits 17,314 (2,169) 16,454 Increase (decrease) in Federal Home Loan Bank advances 33,466 (623) (2,113) Proceeds from the issuance of common stock, net of related costs -- 64,950 -- Repurchase of common stock (13,150) (4,735) -- Payment of dividends (1,520) (793) -- Common stock purchased for ESOP -- (7,930) -- Net cash provided by financing activities 36,110 48,700 14,341 Net increase (decrease) in cash (229) 2,043 1,065 Cash and Due from Financial Institutions Beginning of year 7,039 4,996 3,931 End of year $ 6,810 $ 7,039 $ 4,996 (continued) See notes to consolidated financial statements. 52 Consolidated Statements of Cash Flows - ------------------------------------------------------------------------------ (concluded) (Dollars in Thousands) Timberland Bancorp, Inc. and Subsidiaries Years Ended September 30, 1999, 1998 and 1997 1999 1998 1997 Supplemental Disclosures of Cash Flow Information Income taxes paid $2,975 $3,012 $1,578 Interest paid 8,171 8,202 8,377 Supplemental Disclosures of Non-Cash Investing Activities Transfer of securities from held to maturity to available for sale $ -- $20,375 $ -- Market value adjustment of securities held for sale, net of tax (511) 120 (13) Loans transferred to real estate owned 581 3,909 507 See notes to consolidated financial statements. 53 Consolidated Statements of Comprehensive Income - ------------------------------------------------------------------------------ (Dollars in Thousands) Timberland Bancorp, Inc. and Subsidiaries Years Ended September 30, 1999, 1998 and 1997 1999 1998 1997 Comprehensive Income Net income $5,218 $5,096 $3,329 Change in unrealized gains (losses) on securities available for sale, net of tax (511) 120 (13) Total comprehensive income $4,707 $5,216 $3,316 See notes to consolidated financial statements. 54 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 1 - Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of Timberland Bancorp, Inc. (the Company) and its wholly owned subsidiary, Timberland Savings Bank, SSB (the Bank), and the Bank's wholly owned subsidiary, Timberland Service Corp. All significant intercompany transactions and balances have been eliminated. Nature of Operations The Company is a holding company which operates primarily through its subsidiary, the Bank. The Bank was established in 1915 and, through its ten branches located in Grays Harbor, Pierce, Thurston, Kitsap, and King Counties in Washington State, attracts deposits from the general public, and uses those funds, along with other borrowings, to provide primarily real estate loans to borrowers in western Washington, and to invest in investment securities and mortgage-backed securities. Consolidated Financial Statement Presentation The accounting principles followed by the Company and the methods of applying them conform with generally accepted accounting principles and with general industry practice. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities, as of the date of the balance sheet, and the reported amounts of revenues and expenses during the reporting period. Actual amounts could differ significantly from those amounts. Certain prior year amounts have been reclassified to conform to the 1999 presentation. Conversion In connection with the January 1998 conversion of the Bank from a Washington-chartered mutual savings bank to a Washington-chartered stock savings bank, a holding company, Timberland Bancorp, Inc. was formed. The simultaneous conversion of the Bank to stock form, the issuance of the Bank's common stock to the Company, and the offering and sale of the Company's common stock to the public are referred to herein as "the conversion." In the conversion, 6,612,500 common shares were sold at a subscription price of $10 per share, resulting in net proceeds of approximately $64,950,000 to the Company after $1,175,000 in offering expenses. (continued) 55 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 1 - Summary of Significant Accounting Policies (continued) Investments and Mortgage-Backed Securities Debt and equity securities that will be held for indefinite periods of time, including securities that may be sold in response to changes in market interest rates, prepayment rates, need for liquidity, and changes in the availability of and the yield of alternative investments are considered securities available for sale, and are reported at fair value. Fair value is determined using published quotes as of the close of business. Unrealized gains and losses are excluded from earnings, and are reported as a separate component of shareholders' equity, net of the related deferred tax effect entitled "Accumulated other comprehensive income." Realized gains and losses on securities available for sale, determined using the specific identification method, are included in earnings. Amortization of premiums and accretion of discounts are recognized in interest income over the period to maturity. Loans Receivable Loans are stated at the amount of unpaid principal, reduced by the undisbursed portion of loans in process, unearned income and an allowance for loan losses. Allowances for Losses Allowances for losses on specific problem loans and real estate owned are charged to earnings when it is determined that the value of these loans and properties, in the judgment of management, is impaired. In addition to specific reserves, the Bank also maintains general provisions for loan losses based on evaluating known and inherent risks in the loan portfolio, including management's continuing analysis of the factors and trends underlying the quality of the loan portfolio. These factors include changes in the size and composition of the loan portfolio, actual loan loss experience, current and anticipated economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. 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 in the consolidated financial statements. The Bank accounts for impaired loans in accordance with SFAS No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118. These statements address the disclosure requirements and allocation of the allowance for loan losses for certain impaired loans. A loan within the scope of these statements is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement, including scheduled interest payments. The Bank excludes smaller balance homogenous loans, including single-family residential and consumer loans, from the scope of these statements. (continued) 56 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 1 - Summary of Significant Accounting Policies (continued) Allowances for Losses (concluded) When a loan has been identified as being impaired, the amount of the impairment is measured by using discounted cash flows, except when it is determined that the sole source of repayment for the loan is the operation or liquidation of the underlying collateral. In such case, impairment is measured at current fair value of the collateral, reduced by estimated selling costs. When the measurement of the impaired loan is less than the recorded investment in the loan (including accrued interest and net unamortized deferred loan fees or costs), loan impairment is recognized by establishing or adjusting an allocation of the allowance for loan losses. SFAS No. 114, as amended, does not change the timing of charge-offs of loans to reflect the amount ultimately expected to be collected. At September 30, 1999, the Bank had one loan deemed to be impaired for which a specific allocation of the allowance for loan losses was required. There were no such loans at September 30, 1998. Loans Held for Sale Mortgage loans originated and intended for sale in the secondary market are stated 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. Gains or losses on sales of loans are recognized at the time of sale. The gain or loss is determined by the difference between the net sales proceeds and the recorded value of the loans, including any remaining unamortized deferred loan fees. Premises and Equipment Premises and equipment are recorded at cost. Depreciation is computed on the straight-line method over the following estimated useful lives: buildings - thirty to forty years; furniture and equipment - three to five years; automobile - five years. The cost of maintenance and repairs is charged to expense as incurred. Gains and losses on dispositions are reflected in earnings. Real Estate Owned Real estate owned (REO) consists of properties acquired through or in lieu of, foreclosure and is initially recorded at the fair value of the properties less estimated costs of disposal. Costs relating to development and improvement of the properties are capitalized, whereas costs relating to holding the properties are expensed. Valuations are periodically performed by management, and an allowance for losses is established by a charge to earnings if the recorded value of a property exceeds its estimated net realizable value. (continued) 57 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 1 - Summary of Significant Accounting Policies (continued) Interest on Loans and Loan Fees Interest on loans is recorded as income when borrowers' monthly payments become due. Allowances are established for uncollected interest on loans for which the interest is determined to be uncollectible. Generally, all loans past due three or more payments are placed on nonaccrual status and internally classified as substandard. Any interest income recorded in the current reporting period is fully reserved. Subsequent collections are applied proportionately to past due principal and interest. Loans are removed from nonaccrual status only when the loan is deemed current, and the collectibility of principal and interest is no longer doubtful. The Bank charges fees for originating loans. That portion of loan fees exceeding the estimated direct cost of originating loans is deferred and amortized to income, on the level-yield basis, over the loan term. If the loan is repaid prior to maturity, the remaining unamortized deferred loan fee is recognized in income at the time of repayment. Loan Servicing Fees Effective for loans originated after December 31, 1997, the Bank records its mortgage servicing rights at fair value in accordance with SFAS No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, which requires the Bank to allocate the total cost of all mortgage loans, whether originated or purchased, to the loans (without the mortgage servicing rights), and to mortgage servicing rights based on their relative fair values. The Bank is amortizing the mortgage servicing assets, which totaled $358,000 and $374,000 at September 30, 1999 and 1998, respectively, over the period of the estimated servicing income. Prior to December 31, 1996, fees were reported as income when the related mortgage loan payments were collected. Loan servicing costs were charged to expense as incurred. Income Taxes The Company files a consolidated federal income tax return with its subsidiaries. Prior to fiscal year 1997, the Bank qualified under provisions of the Internal Revenue Code which permitted, as a deduction from taxable income, an allowance for bad debts based on a percentage of taxable income. The percentage method bad debt deduction available was 8% for the year ended September 30, 1997. In 1996, the percentage-of-income bad debt deduction for federal tax purposes was eliminated. In addition, federal tax bad debt reserves which had been accumulated since October 1, 1988, that exceed the reserves which would have been accumulated based on actual experience, are subject to recapture over a six-year recapture period effective for tax years beginning October 1, 1996. However, the six-year recapture period may be postponed for up to two years, provided the Bank satisfies a mortgage origination test. As of September 30, 1999, the Bank's federal tax bad debt reserves subject to recapture approximated $1,700,000. (continued) 58 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 1 - Summary of Significant Accounting Policies (concluded) Income Taxes (concluded) Deferred federal income taxes result from temporary differences between the tax basis of assets and liabilities, and their reported amounts in the consolidated financial statements. These will result in differences between income for tax purposes and income for financial statement purposes in future years. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Employee Stock Ownership Plan The Bank sponsors a leveraged Employee Stock Ownership Plan (ESOP). The ESOP is accounted for in accordance with the American Institute of Certified Public Accountants Statement of Position 93-6, Employers' Accounting for Employee Stock Ownership Plan. Accordingly, the debt of the ESOP is recorded as other borrowed funds of the Bank and the shares pledged as collateral are reported as unearned shares issued to the employee stock ownership trust on the consolidated balance sheets. The debt of the ESOP is with the Company and is thereby eliminated in the consolidated financial statements. As shares are released from collateral, compensation expense is recorded equal to the average market price of the shares for the period, and the shares become outstanding for earnings per share calculations. Cash dividends on unallocated shares which are collateral for debt are used to reduce scheduled principal and interest payments, and are recorded as a reduction of compensation expense. Cash Equivalents The Company considers all amounts included in the balance sheet caption "Cash and due from financial institutions" to be cash equivalents. Stock-Based Compensation The Company accounts for stock-based awards to employees using the intrinsic value method, in accordance with APB No. 25, Accounting for Stock Issued to Employees. Accordingly, no comprehensive expense has been recognized in the financial statements for employee stock arrangements. However, the required pro forma disclosures have been provided in accordance with SFAS No. 123, Accounting for Stock-Based Compensation. Earnings Per Share Basic earnings per share exclude dilution and are computed by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per share reflect the potential dilution that could occur if common shares were issued pursuant to the exercise of options under the Company's stock option plans. 59 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 2 - Accounting Changes Effective October 1, 1998 the Company adopted statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income (SFAS No.130), which was effective for years beginning after December 15,1997. SFAS No. 130 requires that an entity report and display comprehensive income in a financial statement that is displayed with the same prominence as other financial statements. Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. With regard to the Company, comprehensive income includes net income reported on the consolidated statements of income, and changes in fair value of its securities available for sale, reported as a component of shareholders' equity. There was no effect on previously reported net income as a result of this reporting change. Note 3 - Investments and Mortgage-Backed Securities Investments and mortgage-backed securities have been classified according to management's intent. Gross Gross Un- Un- Amortized realized realized Fair Cost Gains Losses Value Available for Sale September 30, 1999 U.S. agency securities $ 6,506 $ -- ($ 87) $ 6,419 Mortgage-backed securities 14,267 6 (281) 13,992 Mutual funds 9,017 -- (172) 8,845 FHLB stock 2,338 -- -- 2,338 Equity securities 121 -- (59) 62 Total $32,249 $ 6 ($599) $ 31,656 September 30, 1998 U.S. agency securities $ 8,915 $ 22 $ -- $ 8,937 Mortgage-backed securities 17,457 140 (42) 17,555 Mutual funds 7,028 93 -- 7,121 FHLB stock 1,713 -- -- 1,713 Equity securities 121 -- (32) 89 Total $35,234 $255 ($74) $35,415 The FHLB stock has a par value of $100 per share and is recorded at cost. Stock owned in excess of required amounts can only be redeemed by the Federal Home Loan Bank of Seattle. (continued) 60 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 3 - Investments and Mortgage-Backed Securities (concluded) Mortgage-backed securities pledged as collateral for public fund deposits totaled $1,012,000 and $1,327,000 at September 30, 1999 and 1998, respectively. The scheduled maturity of debt securities at September 30, 1999 follows (dollars in thousands). Expected maturities may differ from scheduled maturities due to the prepayment of principal or call provisions. Available for Sale Amortized Fair Cost Value Due within one year $ -- $ -- Due from one year to five years 6,540 6,453 Due from five to ten years 1,581 1,558 Due after ten years 12,652 12,400 Total $20,773 $20,411 Note 4 - Loans Receivable and Loans Held for Sale Loans receivable, including loans held for sale, consisted of the following at September 30 (dollars in thousands): 1999 1998 Mortgage loans: One-to four-family $ 92,062 $ 92,707 Multi-family 15,945 12,432 Commercial 52,049 32,906 Construction and land development 90,621 64,172 Land 9,059 7,749 Total mortgage loans 259,736 209,966 Consumer loans: Home equity and second mortgage 7,978 8,740 Other 4,279 4,066 Total consumer loans 12,257 12,806 (continued) 61 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 4 - Loans Receivable and Loans Held for Sale (continued) 1999 1998 Commercial business loans $ 4,611 $ 1,105 Total loans receivable 276,604 223,877 Less: Undisbursed portion of loans in process 37,781 28,886 Unearned income 3,170 2,256 Allowance for loan losses 2,056 1,728 43,007 32,870 Loans receivable, net 233,597 191,007 Loans held for sale (one to four-family) 23,071 8,214 Market value adjustment (583) -- Loans held for sale, net 22,488 8,214 Total loans receivable and loans held for sale $256,085 $199,221 The weighted average interest rate on all loans at September 30, 1999 and 1998 was 8.37% and 8.62%, respectively. Loans serviced for the Federal Home Loan Mortgage Corporation and others at September 30, 1999 and 1998 were $63,765,000 and $60,347,000, respectively. Certain related parties of the Bank, principally Bank directors and officers, were loan customers of the Bank in the ordinary course of business during 1999 and 1998. An analysis of the loans outstanding at September 30 to key officers and directors is as follows (dollars in thousands): 1999 1998 Balance, beginning of year $768 $805 New loans 32 377 Repayments (26) (414) Balance, end of year $774 $768 (continued) 62 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 4 - Loans Receivable and Loans Held for Sale (concluded) At September 30, 1999 and 1998, the Bank had non-accruing loans totaling approximately $3,589,000 and $4,410,000, respectively. At September 30, 1999 and 1998, approximately $449,000 and $396,000, respectively, of loans were 90 days or more past due and still accruing interest. Loans over 90 days past due and still accruing interest are secured and in the process of collection. No interest income was recorded on non-accrual loans for the years ended September 30, 1999, 1998 and 1997. The average investment in non-accrual loans for the years ended September 30, 1999, 1998 and 1997 was $3,565,000, $5,014,000, and $4,788,000, respectively. An analysis of the allowance for loan losses for the years ended September 30 follows (dollars in thousands): 1999 1998 1997 Balance, beginning of year $1,728 $1,716 $1,133 Provision for loan losses 363 200 597 Transfers to allowance for possible losses on REO (30) (180) (3) Loans charged off (5) (8) (19) Recoveries -- -- 8 Balance, end of year $2,056 $1,728 $1,716 Note 5 - Premises and Equipment Premises and equipment consisted of the following at September 30 (dollars in thousands): 1999 1998 Land $ 1,877 $1,804 Buildings and improvements 4,701 4,271 Furniture and equipment 2,084 1,866 Automobiles 22 22 Property held for future expansion 96 21 Construction and purchases in progress 1,857 34 10,637 8,018 Less accumulated depreciation 3,016 2,678 Total premises and equipment $ 7,621 $5,340 63 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 6 - Real Estate Owned Real estate owned consisted of the following at September 30 (dollars in thousands): 1999 1998 Real estate acquired through foreclosure $1,060 $1,916 Allowance for possible losses (193) (192) Total real estate owned $ 867 $1,724 An analysis of the allowance for possible losses follows (dollars in thousands): 1999 1998 1997 Balance, beginning of year $192 $ 32 $70 Provision for additional losses 28 -- 1 Transfers from allowance for loan losses 30 180 3 Write-downs (57) (20) (42) Balance, end of year $193 $192 $32 Note 7 - Accrued Interest Receivable Accrued interest receivable consisted of the following at September 30 (dollars in thousands): 1999 1998 Loans receivable $1,688 $1,718 Less reserve for uncollected interest 386 573 1,302 1,145 Investment securities and interest bearing deposits 178 244 Total accrued interest receivable $1,480 $1,389 64 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 8 - Deposits Deposits consisted of the following at September 30 (dollars in thousands): 1999 1998 Non-interest bearing $ 8,360 $ 5,839 N.O.W. checking 21,239 21,595 Passbook savings 29,396 27,315 Money market accounts 18,774 15,013 Certificates of deposit 107,508 97,561 Other 2,871 3,511 Total deposits $188,148 $170,834 The weighted average interest rate on all deposits at September 30, 1999 and 1998 was 3.96% and 4.23%, respectively. Time deposits of $100,000 or greater totaled $25,066,000 and $14,557,000 at September 30,1999 and 1998, respectively. Scheduled maturities of certificates of deposit at September 30, 1999 are as follows (dollars in thousands): Within one year $ 78,427 Over one to two years 22,910 Over two to five years 5,318 After five years 853 Total $107,508 Interest expense by account type is as follows for the years ended September 30 (dollars in thousands): 1999 1998 1997 Certificates of deposit $5,590 $5,631 $5,807 Money market accounts 628 543 514 Passbook savings 695 906 750 N.O.W. checking 363 390 445 Total $7,276 $7,470 $7,516 65 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 9 - Federal Home Loan Bank Advances The Bank has been approved for participation in the Federal Home Loan Bank of Seattle Cash Management Advance Program, maturing January 2000, with a maximum facility of $12,262,000. Advances requested under this program are payable on demand or, if no demand is made, in one year from the date of advance, and bear interest at the rate in effect at that time. Advances are subject to the existing Advances, Security and Deposit Agreement, and are granted at the sole discretion of the Federal Home Loan Bank of Seattle. There were no advances outstanding under the Cash Management Advance Program at September 30, 1999 or 1998. The Advances, Security and Deposit Agreement, which includes the Cash Management Advance Program, is maintained at 20% of total assets. The Bank had advances at September 30, 1999 as follows (dollars in thousands): Weighted Average Interest Rate Amount Maturities in years ending September 30: 2000 Fixed rate set maturity 5.59% $33,600 2002 Fixed rate monthly amortization 6.11 330 2002 Fixed rate callable 5.39 10,000 2006 Fixed rate monthly amortization 6.55 1,154 5.57% $45,084 Under the Advances, Security and Deposit Agreement, virtually all of the Bank's assets, not otherwise encumbered, are pledged as collateral for advances. Note 10 - Other Liabilities and Accrued Expenses 1999 1998 Federal income taxes $ 7 $ 168 Accrued pension and profit sharing 683 628 Accrued interest on deposits and FHLB advances 281 89 Accounts payable and accrued expenses - other 668 592 Total $1,639 $1,477 66 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 11 - Federal Income Taxes The Bank has qualified under provisions of the Internal Revenue Code that permit federal income taxes to be computed after deduction of additions to bad debt reserves. Accordingly, retained earnings include approximately $2,200,000 for which no provision for federal income taxes has been made. If in the future this portion of retained earnings is used for any purpose other than to absorb bad debt losses, federal income taxes at the current applicable rates would be imposed. The components of the provision for income taxes at September 30 are as follows (dollars in thousands): 1999 1998 1997 Current $3,046 $2,443 $1,872 Deferred benefit (449) (33) (42) Total federal income taxes $2,597 $2,410 $1,830 The components of the Company's deferred tax assets and liabilities at September 30 are as follows (dollars in thousands): 1999 1998 Deferred Tax Assets Accrued interest on loans $ 23 $ 25 Depreciation 42 30 Accrued vacation 26 26 Deferred compensation 81 75 Unearned ESOP shares 118 55 Allowance for loan losses 278 63 Loans held for sale market value adjustment 198 -- Unrealized securities losses 201 -- Other 3 -- Total deferred tax assets 970 274 Deferred Tax Liabilities FHLB stock dividends 395 349 Real estate sale, installment basis 32 32 Unrealized securities gains -- 61 Total deferred tax liabilities 427 442 Net deferred tax assets (liabilities) $543 ($168) (continued) 67 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 11 - Federal Income Taxes (concluded) The provision for federal income taxes differs from that computed at the statutory corporate tax rate as follows (dollars in thousands): 1999 1998 1997 Amount Percent Amount Percent Amount Percent Tax provision at statutory rate $2,657 34.0% $2,552 34.0% $1,754 34.0% Other - net (60) .8 (142) (1.9) 76 1.5 Total tax expense $2,597 33.2% $2,410 32.1% $1,830 35.5% Note 12 - Profit Sharing Plans The Bank maintains a tax-qualified profit sharing plan for the benefit of all eligible employees who are at least 21 years of age and work a minimum of 501 hours. The Bank contributed $249,000, $226,000 and $172,000 to the plan for the years ended September 30, 1999, 1998 and 1997, respectively. Contributions are made on a discretionary basis. In addition, the Bank has an employee bonus plan based on net income. Bonuses accrued for the years ended September 30, 1999, 1998 and 1997 totaled $195,000, $181,000 and $144,000, respectively. Note 13 - Employee Stock Ownership Plan In 1998, the Bank established an Employee Stock Ownership Plan (ESOP) that benefits all employees with at least one year of service who are 21 years of age or older. The ESOP is funded by Bank contributions in cash or stock. Employee vesting occurs over six years. The amount of the annual contribution is discretionary, except that it must be sufficient to enable the ESOP to service its debt. In January 1998 the ESOP borrowed $7,930,000 from the Company to purchase 529,000 shares of common stock of the Company. The loan will be repaid primarily from the Company's contributions to the ESOP over 15 years. The interest rate on the loan is 8.5%. Shares held by the ESOP as of September 30, 1999 were classified as follows: Unallocated shares 467,283 Shares released for allocation 61,717 Total ESOP shares 529,000 The approximate fair market value of the Bank's unallocated shares (including those released for allocation) at September 30, 1999 is $6,050,000. The expense under the ESOP was $285,000 and $364,000 for the years ended September 30, 1999 and 1998, respectively. 68 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 14 - Stock Options During the year ended September 30, 1999, the Company adopted a stock-based option plan, which is described below. The Company applies APB Opinion No. 25 and related interpretations in accounting for this plan. Accordingly, no compensation cost has been recognized for the plan. Had compensation cost for the Company's stock option plan been determined based on the fair value at the grant dates for awards granted under this plan, consistent with the method of SFAS No. 123, the Company's net income and earnings per share for the year ended September 30, 1999 would have been reduced to these pro forma amounts: Net income: As reported $5,218,000 Pro forma 4,737,000 Earnings per share: Basic: As reported $1.03 Pro forma .93 Diluted: As reported 1.03 Pro forma .93 Under the Company's stock option plan, the Company may grant options for up to 661,250 shares of its common stock to certain key employees and directors. The exercise price of each option equals the fair market value of the Company's stock on the date of grant. An option's maximum term is ten years. Options are exercisable on a cumulative basis in annual installments of 10% on each of the ten anniversaries from the date of grant. Vesting will be accelerated to 20% per year if certain criteria relating to Company performance are met. The fair value of each option grant is estimated on the date of grant, based on the Black-Scholes option-pricing model using the following weighted-average assumptions: dividend yield of 2.25% for all years; risk-free interest rates of 6% and expected lives of ten years. The weighted average fair value of options granted during the year ended September 30, 1999 was $3.26. During the year ended September 30, 1999, 582,494 shares were granted with a weighted average exercise price of $12.02. The exercise prices range from $12.00 to $12.38. There were no options exercised or forfeited during the year, and there were no options exercisable as of September 30, 1999. 69 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 15 - Deferred Compensation/NonCompetition Agreement and Severance Compensation Agreement The Bank has a deferred compensation/noncompetition arrangement with its chief executive officer which will provide monthly payments of $2,000 per month if retirement occurs at or after age 65. Once payments have commenced they will continue until his death, at which time payments will continue to his surviving spouse until her death or for 60 months. The present value of the payments, based on the life expectancy of the chief executive officer, has been accrued based on a retirement age of 65 and is included in other liabilities in the consolidated financial statements. As of September 30, 1999 and 1998, $239,000 and $221,000, respectively, has been accrued under the agreement. In connection with the January 1998 conversion, the Bank adopted an Employee Severance Compensation Plan, which expires in ten years, to provide benefits to eligible employees in the event of a change in control of the Company or the Bank (as defined in the plan). In general, all employees with two or more years of service will be eligible to participate in the plan. Under the plan, in the event of a change in control of the Company or the Bank, eligible employees who are terminated or who terminate employment (but only upon the occurrence of events specified in the plan) within 12 months of the effective date of a change in control would be entitled to a payment based on years of service with the Bank. The maximum payment for any eligible employee would be equal to 24 months of their current compensation. Note 16 - Management Recognition and Development Plan On November 10, 1998, the Board of Directors adopted a Management Recognition and Development Plan. The Plan allows for the purchase, in the open market or through the issuance of authorized and unissued shares, of up to 264,500 shares of stock. The Plan is intended to award restricted stock to the Company's employees and directors. As of September 30, 1999, no restricted stock had been awarded under the Plan. Note 17 - Commitments and Contingencies The Bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit. These instruments involve, to varying degrees, elements of credit risk is excess of the amount recognized in the consolidated balance sheets. The Bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments as it does for on-balance-sheet instruments. A summary of the Bank's commitments at September 30 is as follows (dollars in thousands): 1999 1998 Commitments to extend credit $14,753 $14,042 (continued) 70 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 17 - Commitments and Contingencies (concluded) Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's creditworthiness on a case- by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the party. Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate, and income-producing commercial properties. Because of the nature of its activities, the Company is subject to various pending and threatened legal actions which arise in the ordinary course of business. In the opinion of management, liabilities arising from these claims, if any, will not have a material effect on the financial position of the Company. Note 18 - Regulatory Matters The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's consolidated financial statements. Under capital adequacy guidelines of the regulatory framework for prompt corrective action, the Bank must meet specific capital adequacy guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital classification is also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios as defined in the regulations (set forth in the table below) of Tier 1 capital to average assets, and minimum ratios of Tier 1 and total capital to risk-weighted assets. Under the regulatory framework for prompt corrective action, the Bank must maintain minimum Tier 1 leverage, Tier 1 risk-based, and total risk-based ratios as set forth in the table. As of September 30, 1998, the most recent notification from the Bank's regulator categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank's category. (continued) 71 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 18 - Regulatory Matters (continued) The Company's and the Bank's actual capital amounts (dollars in thousands) and ratios are also presented in the table. To be Well Capitalized Under Prompt Capital Corrective Adequacy Action Actual Purposes Provisions Amount Ratio Amount Ratio Amount Ratio September 30, 1999 Tier 1 capital (to average assets): Consolidated $72,391 24.5% $11,832 4.0% N/A N/A Timberland Savings Bank, SSB 56,864 19.8 11,484 4.0 $14,356 5.0% Tier 1 capital (to risk- weighted assets): Consolidated 72,391 32.5 8,911 4.0 N/A N/A Timberland Savings Bank, SSB 56,864 25.9 8,787 4.0 13,180 6.0 Total capital (to risk-w weighted assets): Consolidated 74,447 33.4 17,822 8.0 N/A N/A Timberland Savings Bank, SSB 58,920 26.8 17,573 8.0 21,967 10.0 September 30, 1998 Tier 1 capital (to average assets): Consolidated $81,780 31.0% $10,541 4.0% N/A N/A Timberland Savings Bank, SSB 53,865 22.4 9,636 4.0 $12,045 5.0% Tier 1 capital (to risk- weighted assets): Consolidated 81,780 49.9 6,560 4.0 N/A N/A Timberland Savings Bank, SSB 53,865 33.4 6,453 4.0 9,680 6.0 Total capital (to risk- weighted assets): Consolidated 83,508 50.9 13,121 8.0 N/A N/A Timberland Savings Bank, SSB 55,593 33.9 12,906 8.0 16,133 10.0 (continued) 72 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 18 - Regulatory Matters (concluded) Restrictions on Retained Earnings The Bank is subject to certain restrictions on the amount of dividends that it may declare without prior regulatory approval. At the time of conversion, the Bank established a liquidation account in an amount equal to its retained earnings of $23,866,000 as of June 30, 1997, the date of the latest statement of financial condition used in the final conversion prospectus. The liquidation account will be maintained for the benefit of eligible withdrawable account holders who have maintained their deposit accounts in the Bank after conversion. The liquidation account will be reduced annually to the extent that eligible account holders have reduced their qualifying deposits as of each anniversary date. Subsequent increases will not restore an eligible account holder's interest in the liquidation account. In the event of a complete liquidation of the Bank (and only in such an event), eligible depositors who have continued to maintain accounts will be entitled to receive a distribution from the liquidation account before any liquidation may be made with respect to common stock. The Bank may not declare or pay cash dividends if the effect thereof would reduce its regulatory capital below the amount required for the liquidation account. Note 19 - Condensed Financial Information - Parent Company Only Condensed Balance Sheet - September 30 (Dollars in Thousands) 1999 1998 Assets Noninterest bearing deposits $ 5 $ 3 Interest bearing deposits 219 6,904 Investments and mortgage-backed securities available for sale 7,801 13,222 Loan receivable from Bank 7,405 7,697 Investment in Bank 56,784 53,865 Other assets 90 134 Total assets $72,304 $81,825 (continued) 73 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 19 - Condensed Financial Information - Parent Company Only (continued) Condensed Balance Sheets- September 30 (concluded) 1999 1998 Liabilities and Shareholders' Equity Liabilities and accrued expenses $ 59 $ 45 Shareholders' equity 72,245 81,780 Total liabilities and shareholders' equity $72,304 $81,825 Condensed Statements of Income - Years Ended September 30: (Dollars in Thousands) Operating Income Interest on investment and mortgage-backed securities $ 287 $ 907 Interest on loan receivable from Bank 645 469 Dividends 352 63 Gain (loss) on sale of investment securities available for sale (1) 22 Total operating income 1,283 1,461 Operating Expenses 245 70 Income before income taxes and equity in undistributed income of Bank 1,038 1,391 Income Taxes 304 473 Income before equity in undistributed income of Bank 734 918 Equity in Undistributed Income of Bank 4,484 4,178 Net income $5,218 $5,096 (continued) 74 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 19 - Condensed Financial Information - Parent Company Only (concluded) Condensed Statements of Cash Flows - Years Ended September 30 (Dollars in Thousands) 1999 1998 Cash Flows from Operating Activities Net income $ 5,218 $ 5,096 Adjustments to reconcile net income to net cash provided: Equity in undistributed income of Bank (4,484) (4,178) ESOP shares earned428427 Gain on sale of securities available for sale (1) (22) Accretion of discount on securities available for sale (8) (3) Other, net 125 (542) Net cash provided by operating activities 1,278 778 Cash Flows from Investing Activities Investment in Bank 1,183 (32,475) Purchases of securities available for sale (12,575) (17,224) Proceeds from maturities of securities available for sale 17,809 3,700 Proceeds from sale of securities available for sale -- 403 Funding provided to the Bank for purchase of common stock for ESOP -- (7,930) Principal repayments on loan receivable from Bank 292 233 Net cash provided by (used in) investing activities 6,709 (53,293) Cash Flows from Financing Activities Proceeds from the issuance of common stock, net of related costs -- 64,950 Repurchase of common stock (13,150) (4,735) Payment of dividends (1,520) (793) Net cash provided by (used in) financing activities (14,670) 59,422 Net increase (decrease) in cash (6,683) 6,907 Cash and Due from Financial Institutions Beginning of year 6,907 -- End of year $ 224 $ 6,907 75 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 20 - Earnings Per Share Disclosures Basic earnings per share is computed by dividing net income applicable to common stock by the weighted average number of common shares outstanding during the period, without considering any dilutive items. Diluted earnings per share is computed by dividing net income applicable to common stock by the weighted average number of common shares and common stock equivalents for items that are dilutive, net of shares assumed to be repurchased using the treasury stock method at the average share price for the Company's common stock during the period. Common stock equivalents arise from assumed conversion of outstanding stock options. In accordance with Statement of Position 93-6, Employers' Accounting for Employee Stock Ownership Plans, issued by the American Institute of Certified Public Accountants, shares owned by the Bank's Employee Stock Ownership Plan that have not been allocated are not considered to be outstanding for the purpose of computing earnings per share. Information regarding the calculation of basic and diluted earnings per share for the years ended September 30, 1999 and 1998, respectively, is as follows (dollars in thousands, except per share amounts). 1999 1998 Basic EPS Computation Numerator -- net income $5,218 $5,096 Denominator -- weighted average common shares outstanding 5,089,414 6,036,597 Basic EPS $1.03 $.84 Diluted EPS computation Numerator -- net income $5,218 $5,096 Denominator -- weighted average common shares outstanding 5,089,414 6,036,597 Effect of dilutive stock option -- -- Weighted average common shares and common stock equivalents 5,089,414 6,036,597 Diluted EPS $1.03 $.84 76 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 21 Comprehensive Income Net unrealized gains and losses included in comprehensive income were computed as follows for the years ended September 30 (dollars in thousands): Before- Tax Net-of Tax (Benefit) Tax Amount Expense Amount 1999 Unrealized holding losses arising during the year ($774) ($263) ($511) Less reclassification adjustments for gains included in net income -- -- -- Net unrealized losses ($774) ($263) ($511) 1998 Unrealized holding gains arising during the year $203 $69 $134 Less reclassification adjustments for gains included in net income 22 8 14 Net unrealized gains $181 $61 $120 1997 Realized holding gains arising during the year $20 $7 $13 77 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 22 - Fair Values of Financial Instruments Statement of Financial Accounting Standards No. 107, Disclosures About Fair Value of Financial Instruments, requires disclosure of estimated fair values for financial instruments. Such estimates are subjective in nature, and significant judgment is required regarding the risk characteristics of various financial instruments at a discrete point in time. Therefore, such estimates could vary significantly if assumptions regarding uncertain factors were to change. Major assumptions, methods, and fair value estimates for the Bank's significant financial instruments are set forth below: Cash and Due from Financial Institutions The recorded amount is a reasonable estimate of fair value. Investments, Mortgage-Backed Securities and Loans Held for Sale The fair value of investments, mortgage-backed securities and loans held for sale has been based on quoted market prices or dealer quotes. Loans Receivable Fair values for loans are estimated for portfolios of loans with similar financial characteristics. Fair value is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers for the same remaining maturities. Prepayments are based on the historical experience of the Bank. Deposits The fair value of deposits with no stated maturity date is included at the amount payable on demand. The fair value of fixed maturity certificates of deposit is estimated by discounting future cash flows using the rates currently offered by the Bank for deposits of similar remaining maturities. Federal Home Loan Bank Advances The fair value of borrowed funds is estimated by discounting the future cash flows of the borrowings at a rate which approximates the current offering rate of the borrowings with a comparable remaining life. (continued) 78 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 22 - Fair Values of Financial Instruments (concluded) The estimated fair values of financial instruments at September 30, 1999 and 1998 were as follows (dollars in thousands): 1999 1998 Recorded Fair Recorded Fair Amount Value Amount Value Financial Assets Cash and due from financial institutions $ 8,126 $ 8,126 $ 21,784 $ 21,784 Investments and mortgage backed securities 31,656 31,656 35,415 35,415 Loans receivable 256,085 261,894 199,221 200,912 Financial Liabilities Deposits $188,148 $188,401 $170,834 $171,129 Federal Home Loan Bank advances 45,084 44,916 11,618 11,945 Note 23 - Stock Repurchase Plan In August 1999, the Company initiated a stock repurchase plan for the purchase of 269,296 shares of stock. As of September 30, 1999, 168,500 shares had been repurchased. The remainder is anticipated to be purchased during the year ending September 30, 2000. Note 24 - Subsequent Event Subsequent to September 30, 1999, the Company approved a dividend in the amount of $.08 per share to be paid on November 19, 1999 for shareholders of record as of November 5, 1999. Note 25 - Year 2000 Issues As the year 2000 approaches, business issues are emerging regarding how existing computer software programs and operating systems can accommodate the date value. Many software systems are designed to recognize only a two-digit date field, and may read the year 2000 as the year 1900. Thus, computations of interest and other similar calculations may be based on wrong dates, or the systems may not be able to process information at all. (continued) 79 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 25 - Year 2000 Issues (concluded) The Bank has implemented a year 2000 compliance program, which is aggressively reviewing year 2000 issues that may be faced by its outside vendors and customers, and that affect its internal computer systems. In the event that significant suppliers or customers do not successfully and timely achieve year 2000 compliance, the Bank's business could be adversely affected. However, management believes that the Bank's own internal systems, networks and resources would allow the Bank to effectively operate and service its customers. To the extent necessary, the Bank will engage alternative vendors and suppliers to facilitate normal operations after January 1, 2000. The costs incurred to date on year 2000 compliance issues have not been material. While it is impossible to estimate the potential impact on the Bank's business after January 1, 2000, management estimates that the costs the Bank will incur prior to that date in its activities necessary to ensure year 2000 compliance will not have a significant effect on its financial position or results of operations. Note 26 - Selected Quarterly Financial Data (Unaudited) The following selected financial data are presented for the quarters ended (dollars in thousands, except per share amounts): September 30, June 30, March 31, December 31, 1999 1999 1999 1998 Interest and dividend income $6,255 $5,600 $5,742 $5,512 Interest expense (2,337) (2,026) (1,985) (2,015) Net interest income 3,918 3,574 3,757 3,497 Provision for loan losses (219) (70) (30) (44) Noninterest income 161 (60) 216 275 Noninterest expense (1,797) (1,792) (1,820) (1,751) Income before income taxes 2,063 1,652 2,123 1,977 Provision for income taxes 684 546 707 660 Net income $1,379 $1,106 $1,416 $1,317 Basic earnings per share $.28 $.23 $.28 $.24 Diluted earnings per share .28 .23 .28 .24 (continued) 80 Notes to Consolidated Financial Statements - ------------------------------------------------------------------------------ Timberland Bancorp, Inc. and Subsidiaries September 30, 1999 and 1998 Note 26 - Selected Quarterly Financial Data (Unaudited) (concluded) September 30, June 30, March 31, December 31, 1998 1998 1998 1997 Interest and dividend income $5,402 $5,319 $5,274 $4,655 Interest expense (1,956) (1,928) (2,019) (2,241) Net interest income 3,446 3,391 3,255 2,414 Provision for loan losses (45) (45) (50) (60) Noninterest income 341 418 457 324 Noninterest expense (1,746) (1,571) (1,532) (1,491) Income before income taxes 1,996 2,193 2,130 1,187 Provision for income taxes 569 742 716 383 Net income $1,427 $1,451 $1,414 $ 804 Basic earnings per share $.24 $.24 $.23 $.13 81 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure - ------------------------------------------------------------------------ Not applicable. PART III Item 10. Directors and Executive Officers of the Registrant - ------------------------------------------------------------ The information contained under the section captioned "Proposal I -- Election of Directors" is included in the Company's Definitive Proxy Statement for the 2000 Annual Meeting of Stockholders ("Proxy Statement") and is incorporated herein by reference. The following table sets forth certain information with respect to the executive officers of the Company and the Bank. Each of the executive officers holds the same position with the Company and the Bank. Executive Officers of the Company and Bank Age at Position September ------------------------------------------------------------------------- Name 30, 1999 Company Bank - ---- -------- ------- ---- Clarence E. Hamre 65 Chairman of the Board, President Chairman of the Board, President and Chief Executive Officer and Chief Executive Officer Michael R. Sand 45 Executive Vice President Chief Financial Officer and Executive and Secretary Vice President, Secretary and Director Paul G. MacLeod 55 Treasurer Treasurer
Biographical Information Clarence E. Hamre has served as the Bank's President and Chief Executive Officer since 1969. Michael R. Sand has been affiliated with the Bank since 1977 and has served as the Bank's Executive Vice President since 1986. Paul G. MacLeod is the Bank's Treasurer and has been with the Bank since 1987. Item 11. Executive Compensation - ---------------------------------- The information contained under the section captioned "Proposal I -- Election of Directors" is included in the Company's Proxy Statement and is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management - -------------------------------------------------------------------------- (a) Security Ownership of Certain Beneficial Owners. The information contained under the section captioned "Security Ownership of Certain Beneficial Owners and Management" is included in the Company's Proxy Statement and is incorporated herein by reference. 82 (b) Security Ownership of Management. The information contained under the sections captioned "Security Ownership of Certain Beneficial Owners and Management" and "Proposal I -- Election of Directors" is included in the Company's Proxy Statement and are incorporated herein by reference. (c) Changes In Control The Company is not aware of any arrangements, including any pledge by any person of securities of the Company, the operation of which may at a subsequent date result in a change in control of the Company. Item 13. Certain Relationships and Related Transactions - ---------------------------------------------------------- The information contained under the section captioned "Proposal I -- Election of Directors -- Transactions with Management" is included in the Company's Proxy Statement and is incorporated herein by reference. PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K - -------------------------------------------------------------------------- (a) Exhibits 3.1 Articles of Incorporation of the Registrant* 3.2 Bylaws of the Registrant* 10.1 Employee Severance Compensation Plan** 10.2 Employee Stock Ownership Plan** 10.3 1999 Stock Option Plan*** 10.3 Management Recognition and Development Plan*** (21) Subsidiaries of the Registrant (27) Financial Data Schedule - -------------- * Filed as an exhibit to the Registrant's Registration Statement on Form S-1 (333-35817). ** Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q for the quarter ended december 31, 1997. *** Incorporated by reference to the Registrant's 1999 Annual Meeting Proxy Statement dated December 15, 1998. (b) Reports on Form 8-K No Reports on Form 8-K were filed during the quarter ended September 30, 1999. 83 SIGNATURES Pursuant to the requirements of section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. TIMBERLAND BANCORP, INC. Date: December 17, 1999 By: /s/ Clarence E. Hamre -------------------------------------- Clarence E. Hamre Chairman of the Board, President and Chief Executive Officer Pursuant to the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. SIGNATURES TITLE DATE - ---------- ----- ---- /s/Clarence E. Hamre Chairman of the Board, December 17, 1999 - ------------------------ President, Chief Executive Clarence E. Hamre Officer and Director (Principal Executive Officer) /s/Michael R. Sand Executive Vice President, December 17, 1998 - ------------------------ Secretary and Director Michael R. Sand (Principal Financial and Accounting Officer) /s/Andrea M. Clinton Director December 17, 1999 - ------------------------ Andrea M. Clinton /s/Robert Backstrom Director December 17, 1999 - ------------------------ Robert Backstrom Director - ------------------------ Richard R. Morris /s/Alan E. Smith Director December 17, 1999 - ------------------------ Alan E. Smith /s/Peter J. Majar Director December 17, 1999 - ------------------------ Peter J. Majar /s/Jon C. Parker Director December 17, 1999 - ------------------------ Jon C. Parker /s/James C. Mason Director December 17, 1999 - ------------------------ James C. Mason Exhibit 21 Subsidiaries of the Registrant Parent Timberland Bancorp, Inc. Percentage Jurisdiction or Subsidiaries of Ownership State of Incorporation - ------------ ------------ ---------------------- Timberland Savings Bank SSB 100% Washington Timberland Service Corporation (1) 100% Washington - ------- (1) This corporation is a wholly owned subsidiary of Timberland Savings Bank, SSB. EX-27 2
9 1000 YEAR SEP-30-1999 SEP-30-1999 6810 1316 0 0 31656 0 0 258141 2056 307116 188148 33600 1639 11484 0 0 52 72193 307116 20721 2148 240 23109 7276 8363 14746 363 0 7160 7815 7815 0 0 5218 1.03 1.03 8.72 3589 449 509 0 1728 35 0 2056 2056 0 0
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