10-Q 1 q33108.htm RAINIER PACIFIC FINANCIAL GROUP, INC. q33108.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

[ X ]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 
For the quarterly period ended ………………………………………  March 31, 2008

[     ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 
For the transition period from ________________ to _________________

 
   Commission File Number 000-50362                   

 
RAINIER PACIFIC FINANCIAL GROUP, INC.           
 
(Exact name of registrant as specified in its charter)          

                                          Washington                                                                                                                                                                      87-0700148
                           (State or other jurisdiction of                                                                                                                                                    (I.R.S.  Employer
                            incorporation or organization)                                                                                                                                                 Identification No.)

1498 Pacific Avenue, Suite 400, Tacoma, WA 98402
 (Address of principal executive offices and zip code)

(253) 926-4000
(Registrant’s telephone number, including area code)
                                                                                                         .
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes      X     No  ____  

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definition of “accelerated filer”, “large accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer   _____                                                                Accelerated filer                       X     
Non-accelerated filer     ---------                                                               Smaller reporting company _____

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ____ No     X    

APPLICABLE ONLY TO CORPORATE ISSUERS

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

                           Title of class:                                                                                                                                                                As of March 31, 2008

Common stock, no par value                                                                                                                                                           6,451,733 *

 
*  Includes 373,289 shares held by the Rainier Pacific 401(k) Employee Stock Ownership Plan that have not been
    released, committed to be released, or allocated to participant accounts; and 80,328 restricted shares granted under
    the Rainier Pacific Financial Group, Inc. 2004 Management Recognition Plan that have not yet vested.

 
 

 

RAINIER PACIFIC FINANCIAL GROUP, INC. AND SUBSIDIARY

Table of Contents

PART I  -
FINANCIAL INFORMATION
Page
       
ITEM 1 -
Financial Statements.
 
       
 
Consolidated Statements of Financial Condition at
 
   
March 31, 2008 and December 31, 2007
2
 
Consolidated Statements of Income for the
 
   
Three Months Ended March 31, 2008 and 2007
3
 
Consolidated Statements of Shareholders’ Equity for the
 
   
Three Months Ended March 31, 2008 and
Twelve Months Ended December 31, 2007
 
4
 
Consolidated Statements of Cash Flows for the
 
   
Three Months Ended March 31, 2008 and 2007
5
 
Selected Notes to Unaudited Interim Consolidated Financial Statements
7
       
ITEM 2 -
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
 
       
 
Forward-Looking Statements
11
 
Comparison of Financial Condition at
    March 31, 2008 and December 31, 2007
11
 
Comparison of Operating Results for the
 
 
Three Months Ended March 31, 2008 and 2007
14
 
Liquidity and Capital Resources
17
       
ITEM 3 -
Quantitative and Qualitative Disclosures about Market Risk
18
     
ITEM 4 -
Controls and Procedures
18
       
PART II -
OTHER INFORMATION
 
       
ITEM 1 -
Legal Proceedings
19
ITEM 1A -
Risk Factors
19
ITEM 2 -
Unregistered Sales of Equity Securities and Use of Proceeds
19
ITEM 3 -
Defaults Upon Senior Securities
20
ITEM 4 -
Submission of Matters to a Vote of Security Holders
20
ITEM 5 -
Other Information
20
ITEM 6 -
Exhibits
21
       
SIGNATURES
22
   
EXHIBIT INDEX
 
Exhibit 31.1
24
Exhibit 31.2
25
Exhibit 32
26


 
1

 

RAINIER PACIFIC FINANCIAL GROUP, INC. AND SUBSIDIARY
Consolidated Statements of Financial Condition
(Dollars in Thousands)

ASSETS
       
At March 31, 
     
At December 31, 
 
       
2008 
      2007   
ASSETS: 
                 
     Cash and cash equivalents
  $   8,462     $ 8,724  
     Interest-bearing deposits with banks
      7,003       90  
Securities available-for-sale
      109,545       131,287  
Securities held-to-maturity (fair value at March 31, 2008: $40,744; at
          December 31, 2007: $45,541)
      40,557       45,756  
Federal Home Loan Bank of Seattle (“FHLB”) stock, at cost
      13,712       13,712  
                   
Loans
      655,624       637,000  
Less allowance for loan losses
      (7,979 )     (8,079 )
Loans, net
      647,645       628,921  
                   
Premises and equipment, net
      33,602       33,813  
Accrued interest receivable
      3,635       3,980  
Other assets
      14,761       12,581  
                   
TOTAL ASSETS
  $   878,922     $ 878,864  
                   
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
                   
LIABILITIES:
                 
Deposits
                 
Non-interest bearing
  $   37,145     $ 33,924  
Interest-bearing
      434,227       427,563  
                   
Total deposits
      471,372       461,487  
                   
Borrowed funds
      314,353       320,454  
Corporate drafts payable
      4,121       2,510  
Accrued compensation and benefits
      948       1,758  
Other liabilities
      4,085       5,835  
                   
TOTAL LIABILITIES
      794,879       792,044  
                   
SHAREHOLDERS’ EQUITY:
                 
Common stock, no par value: 49,000,000 shares authorized;
6,451,733 shares issued and 5,998,116 shares outstanding at
March 31, 2008; and 6,466,633 shares issued and 5,977,645 shares
           outstanding at December 31, 2007
     
50,668 
      50,458  
     Unearned Employee Stock Ownership Plan (“ESOP”) shares
     
                               (3,733
)     (3,903 )
Accumulated other comprehensive loss, net of tax
      (8,723 )     (4,575 )
Retained earnings
      45,831       44,840  
                   
TOTAL SHAREHOLDERS’ EQUITY
      84,043       86,820  
                   
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
  $   878,922     $ 878,864  
 

 
 
2

 
RAINIER PACIFIC FINANCIAL GROUP, INC. AND SUBSIDIARY
Consolidated Statements of Income
(Dollars in Thousands, except per share data)

   
Three Months Ended March 31,
 
   
2008
   
2007
 
INTEREST INCOME
           
Loans
  $ 11,277     $ 11,599  
Securities available-for-sale
    1,857       2,052  
Securities held-to-maturity
    451       565  
Interest-bearing deposits
    27       10  
FHLB dividends
    34       14  
Total interest income
    13,646       14,240  
                 
INTEREST EXPENSE
               
Deposits
    3,587       4,111  
Borrowed funds
    3,516       3,743  
Total interest expense
    7,103       7,854  
Net interest income
    6,543       6,386  
                 
PROVISION FOR LOAN LOSSES
    150       150  
Net interest income after provision for loan losses
    6,393       6,236  
                 
NON-INTEREST INCOME
               
Deposit service fees
    839       826  
Loan service fees
    315       292  
Insurance service fees
    550       543  
Investment service fees
    164       113  
Real estate lease income
    246       294  
Gain on sale of securities, net
    11       -  
Gain on sale of loans, net
    235       136  
Gain on sale of premises and equipment, net
    -       10  
Other operating income
    461       28  
Total non-interest income
    2,821       2,242  
                 
NON-INTEREST EXPENSE
               
Compensation and benefits
    4,060       3,993  
Office operations
    955       986  
Occupancy
    614       635  
Loan servicing
    109       110  
Outside and professional services
    448       432  
Marketing
    284       243  
Other operating expenses
    488       710  
Total non-interest expense
    6,958       7,109  
                 
INCOME BEFORE PROVISION FOR FEDERAL INCOME TAX
    2,256       1,369  
                 
PROVISION FOR FEDERAL INCOME TAX
    812       479  
                 
NET INCOME
  $ 1,444     $ 890  
                 
EARNINGS PER COMMON SHARE:
               
Basic
  $ 0.24     $ 0.15  
Diluted
  $ 0.24     $ 0.15  
Weighted average shares outstanding-Basic
    5,983,393 (1)     5,976,430 (2)
Weighted average shares outstanding-Diluted
    5,983,393       6,094,582  
                 
Dividends declared per share
  $ 0.070     $ 0.065  


(1)  
Weighted average shares outstanding – Basic includes 245,972 vested and ratably earned shares of the 326,300 restricted shares granted and issued under the 2004 Management Recognition Plan (“MRP”), net of forfeited shares.

(2)  
Weighted average shares outstanding – Basic includes 180,708 vested and ratably earned shares of the 321,300 restricted shares granted and issued under the MRP, net of forfeited shares.
 
3


RAINIER PACIFIC FINANCIAL GROUP, INC. AND SUBSIDIARY
Consolidated Statements of Shareholders’ Equity
(Dollars in Thousands)

   
Common Stock
   
Unearned
ESOP
   
Retained
   
Accumulated
Other
Comprehensive
       
   
Shares
   
Amount
   
Shares
   
Earnings
   
Loss
   
Total
 
                                     
Balance, December 31, 2006 (as restated)
    6,587,670     $ 50,531     $ (4,582 )   $ 42,687     $ (806 )   $ 87,830  
                                                 
Common stock repurchased
    (126,137
)
    (2,113 )                             (2,113 )
Common stock issued for Management
           Recognition Plan (“MRP”)
    10,000                                          
MRP forfeitures
    (5,900 )                                        
Earned ESOP shares released
                    679                       679  
ESOP activity - Change in value of
           shares committed to be released
            684                               684  
Dividends paid
                            (1,701 )             (1,701 )
Amortization of compensation related to MRP
            1,025                               1,025  
Amortization of compensation related to
           the Stock Option Plan (“SOP”)
            315                               315  
Exercise of stock options
    1,000       16                               16  
Comprehensive income:
                                               
Net income
                            3,854               3,854  
Unrealized loss on securities, net of tax
             benefit of $1,992
                                    (3,769 )     (3,769 )
Total comprehensive income
                                            85  
                                                 
Balance, December 31, 2007
    6,466,633       50,458       (3,903 )     44,840       (4,575 )     86,820  
                                                 
Common stock repurchased
    (14,300 )     (211 )                             (211 )
MRP forfeitures
    (600 )                                        
Earned ESOP shares released
                    170                       170  
ESOP activity - Change in value of
           shares committed to be released
            66                               66  
Dividends paid
                            (453 )             (453 )
Amortization of compensation related to
            MRP
            290                               290  
Amortization of compensation related to
            SOP
            65                               65  
Comprehensive income:
                                               
Net income
                            1,444               1,444  
Unrealized loss on securities, net of
                  tax benefit of $2,137
                                    (4,148 )     (4,148 )
Total comprehensive income
                                            (2,704 )
                                                 
Balance, March 31, 2008
    6,451,733     $ 50,668     $ (3,733 )   $ 45,831     $ (8,723 )   $ 84,043  


 
4

 

RAINIER PACIFIC FINANCIAL GROUP, INC. AND SUBSIDIARY
Consolidated Statements of Cash Flows
(Dollars in Thousands)
   
Three Months Ended March 31,
 
   
2008
   
2007
 
CASH FLOWS FROM OPERATING ACTIVITIES
           
Net income
  $ 1,444     $ 890  
Adjustments to reconcile net income to net cash from operating activities:
               
Depreciation
    599       573  
Provision for loan losses
    150       150  
Deferred income tax (benefit)
    50       (337 )
Gain on sale of securities, net
    (11 )     -  
Gain on sale of premises and equipment, net
    -       (10 )
Gain on sale of loans, net
    (235 )     (136 )
Amortization of premiums and discounts on securities
    104       166  
Amortization of intangible assets
    73       65  
Compensation for restricted stock awards
    290       251  
Compensation for stock options
    65       94  
Change in operating assets and liabilities, net:
               
Accrued interest receivable
    345       23  
Other assets
    (161 )     311  
Corporate drafts payable
    1,611       2,516  
Other liabilities
    (1,439 )     (1,666 )
                 
Net cash provided from operating activities
    2,885       2,890  
                 
CASH FLOWS FROM INVESTING ACTIVITIES
               
Increase in interest-bearing deposits with banks
    (6,913 )     (8,149 )
Activity in securities available-for-sale:
               
Sales
    14,294       -  
Maturities, prepayments, and calls
    1,025       1,861  
Activity in securities held-to-maturity:
               
Sales
    3,702       -  
Maturities, prepayments, and calls
    1,537       1,666  
Increase in loans, net
    (32,217 )     (5,962 )
Proceeds from sales of loans
    13,578       6,819  
Purchases of premises and equipment
    (388 )     (103 )
Proceeds from sales of premises and equipment
    -       10  
                 
Net cash used in investing activities
    (5,382 )     (3,858 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES
               
Net increase in deposits
    9,885       9,310  
Advances on borrowed funds
    52,239       77,253  
Repayments of borrowed funds
    (58,340 )     (83,363 )
Repayment of ESOP debt
    170       170  
Cash payments related to acquisition of insurance agencies
    (1,121 )     (1,150 )
Change in value of ESOP shares committed to be released
    66       121  
Proceeds from exercise of stock options
    -       3  
Dividends paid
    (453 )     (428 )
Common stock repurchased
    (211 )     (343 )
                 
Net cash provided from financing activities
    2,235       1,573  
                 
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    (262 )     605  
                 
CASH AND CASH EQUIVALENTS, at beginning of period
    8,724       11,847  
                 
CASH AND CASH EQUIVALENTS, at end of period
  $ 8,462     $ 12,452  
 

 
 
5

 

RAINIER PACIFIC FINANCIAL GROUP, INC. AND SUBSIDIARY
Consolidated Statements of Cash Flows (continued)
(Dollars in Thousands)

   
Three Months Ended March 31,
 
   
2008
   
2007
 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
           
Cash payments for:
           
Interest
  $ 7,047     $ 7,850  
                 
Income taxes
  $ 50     $ 150  
                 
SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING ACTIVITIES
               
Unrealized (losses)/gains on available-for-sale securities
  $ (6,285 )   $ 315  
                 










 
6

 
RAINIER PACIFIC FINANCIAL GROUP, INC. AND SUBSIDIARY
SELECTED NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2008

Note 1 – Organization and Basis of Presentation

Organization.  On October 20, 2003, Rainier Pacific Savings Bank (the “Bank”) converted from a Washington State chartered mutual savings bank to a Washington State chartered stock savings bank.  In connection with the Bank’s conversion, Rainier Pacific Financial Group, Inc. (the “Company”) was formed to be the bank holding company for the Bank.  The Company purchased 100% of the Bank’s common stock simultaneously with the Bank’s conversion to stock form and the Company’s offering and sale of its common stock to the public.

The Bank provides a full range of banking services to consumers and small to medium-sized businesses and professionals through 14 banking offices located in the Tacoma-Pierce County market and the City of Federal Way.  The Bank also provides insurance and investment services through operating units of the Bank doing business as Rainier Pacific Insurance Services and Rainier Pacific Financial Services, respectively.

Basis of Presentation.  The consolidated financial statements presented in this quarterly report include the accounts of the Company and the Bank.  The unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America for interim financial information and predominant practices followed by the financial services industry, and do not include all of the information and footnotes required for complete financial statements.  These consolidated financial statements should be read in conjunction with our December 31, 2007 audited consolidated financial statements and the accompanying notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2007 which were filed with the Securities and Exchange Commission (“SEC”) on March 12, 2008 (the “Company’s 2007 Form 10-K”).  All significant intercompany transactions and balances have been eliminated.  In the opinion of the Company’s management, all adjustments, including normal recurring accruals, necessary for a fair presentation of the financial condition and results of operations for the interim periods included herein have been made.  Operating results for the three months ended March 31, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008.

Reclassifications.  Certain amounts in the prior periods have been reclassified to conform to the March 31, 2008 presentation.  These reclassifications have no effect on net income, equity, or earnings per share.  Additionally, there was a restatement for years prior to 2007 in the Company’s 2007 Form 10-K which has no effect on the three month period ended March 31, 2008.

Note 2 – Summary of Significant Accounting Policies

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements.  Changes in these estimates and assumptions are considered reasonably possible and may have a material impact on the consolidated financial statements and thus actual results could differ from the amounts reported and disclosed herein.

Material estimates that are particularly susceptible to significant changes relate to the determination of the allowance for loan losses, the valuation of the deferred tax asset and liability accounts, and the valuation of real estate or other collateral acquired in connection with foreclosures or in satisfaction of loans.  In connection with the determination of the allowance for loan losses and the valuation of foreclosed or repossessed assets held-for-sale, management obtains independent appraisals for significant properties. There were no material changes in the Company’s significant accounting policies or critical accounting estimates from those disclosed in the Company’s 2007 Form 10-K.

Note 3 – Income Taxes

In June 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”). FIN 48 requires recognition and measurement of uncertain tax positions using a “more-likely-than-not” approach.  Our approach to adopting FIN 48 on January 1, 2007 consisted of an examination of our financial statements, our income tax provision, and our federal income tax returns.  We analyzed our tax positions including the permanent and temporary differences as well as the major components of income and expense.

Our permanent differences consist primarily of ESOP, MRP, and SOP adjustments, tax exempt investment income, meals and entertainment, and non-deductible dues.  These items are common within the banking industry and have not been subject to controversy.  We have supporting documentation for these differences and appropriately add back an allocable interest expense under Internal Revenue Code Sections 265 and 291 related to our tax exempt income.
 
 

 
7

 
        Our temporary differences consist primarily of loan loss adjustments, stock dividends from the FHLB of Seattle, differences in depreciation, certain adjustments for the ESOP, MRP and SOP, our charitable contributions from 2003 and 2004, and other timing differences that are common in the banking industry.  We have utilized cost segregation for a small percentage of our fixed assets, and this cost segregation study was performed by a third-party.

As disclosed in the Company’s 2007 Form 10-K, we have recorded a $550,000 valuation allowance in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes.  Management believes it is more likely than not that the Company will be unable to realize the full deduction for the charitable contributions made in 2003 and 2004 because of potentially insufficient future taxable income.  Management does not believe this is an issue regarding the deductibility of the charitable contribution (in accordance with FIN 48), but rather whether the entire deduction will be recognized.
 
        We do not believe that we have any uncertain tax positions as of March 31, 2008 that would rise to the level of having a material impact on our financial statements.  We have concluded, as of March 31, 2008, that no additional adjustments or valuation allowances are necessary.

Note 4 – Stock-Based Compensation

Accounting for Stock-Based Compensation.  On January 1, 2006 (the effective date), the Company adopted the fair value recognition provisions of SFAS 123(R), using the “modified prospective” method in which compensation cost is recognized for all share-based payments granted prior to the effective date of SFAS 123(R) that remained unvested on the effective date and for all awards granted to employees after the effective date.  See the Company’s 2007 Form 10-K for additional information regarding stock-based compensation.

On June 7, 2004, the Company granted 351,750 non-qualified stock options and 328,250 incentive stock options to certain directors and employees.  The fair market value of the Company’s common stock on the date of grant was $16.26 per share.  On August 17, 2005, the Company granted an additional 40,000 incentive stock options to certain employees.  The fair market value of the Company’s common stock on the August 17, 2005 grant date was $16.72 per share.  On June 1, 2007 the Company granted an additional 72,000 incentive stock options to certain employees.  The fair market value of the Company’s common stock on the June 1, 2007 grant date was $20.40 per share.  There were no grants during the first three months of 2008.

The following represents the stock option activity and option exercise price information for the three months ended March 31, 2008:
 
   
Number of
 Options
   
Weighted-
Average Price
Exercise Price
 
Aggregate
Intrinsic Value*
Balance at December 31, 2007
    718,600     $ 16.68    
                   
Granted
    -       -    
Exercised
    -       -    
Cancelled
    (12,200 )     16.64    
                   
Balance at March 31, 2008
    706,400     $ 16.68  
$                -

* Based on the March 31, 2008 closing stock price of $13.95, there was no intrinsic value at March 31, 2008.

The estimated fair value of options granted was determined as of the grant dates (June 7, 2004, August 17, 2005, and June 1, 2007) using a binomial pricing model with the following assumptions:

   
2007
   
2005
   
2004
 
                   
Option exercise price
  $ 20.40     $ 16.72     $ 16.26  
Stock price on grant date
  $ 20.40     $ 16.72     $ 16.26  
Annual dividend yield
    1.28 %     1.40 %     2.00 %
Expected volatility
    18.88 %     19.63 %     21.95 %
Risk-free interest rate
    4.92 %     3.99 %     4.39 %
Employee attrition rate
    7.50 %     5.00 %     3.00 %
Vesting period
 
5 years
   
5 years
   
5 years
 
Expected life
 
6 years
   
6 years
   
7 years
 
Contractual term
 
10 years
   
10 years
   
10 years
 
Estimated fair value of options
  $ 3.70     $ 3.92     $ 3.60  

 
 
8


 
Financial data pertaining to the stock options at March 31, 2008 is as follows:

Year of
Grant
 
Number of
Outstanding
Options
 
Weighted-
Average
Remaining
Contractual Life
in Years
 
Weighted-
Average
Exercise Price
of Outstanding
Options
 
Number
Exercisable
 
Weighted-
Average
Exercise Price
of Exercisable
Options
2004
 
618,600
 
6.25
 
$16.26
 
371,160
 
$16.26
2005
 
17,800
 
7.50
 
16.72
 
7,120
 
16.72
2007
 
70,000
 
9.25
 
20.40
 
-
 
20.40
   
706,400
 
6.58
 
$  16.68
 
378,280
 
$16.27

Stock-based compensation expense recognized by the Company in the Consolidated Statements of Income was $65,000 for the three months ended March 31, 2008 compared to $94,000 for the three months ended March 31, 2007.  On an after-tax basis, stock-based compensation expense was $42,000 for the three months ended March 31, 2008 compared to $61,000 for the same period in 2007.  The remaining unrecognized compensation expense for the fair value of outstanding stock options was approximately $372,000 and $449,000 at March 31, 2008 and December 31, 2007, respectively.

On June 24, 2004, the Company granted restricted stock awards of 336,800 shares of its common stock to its directors and certain employees under the MRP.  The fair market value of the restricted stock awards was $16.20 per share on June 24, 2004, and totaled $5.5 million.  These restricted stock awards vest over a five-year period, and therefore, the cost of these awards is accrued ratably over a five-year period as compensation expense.  On June 1, 2007, the Company granted restricted stock awards of 10,000 shares of its common stock to certain employees.  The fair market value of the restricted stock awards was $20.40 per share on June 1, 2007 and totaled $204,000.  These restricted stock awards will also vest over a five-year period and the cost is accrued ratably over a five-year period as compensation expense.  Compensation expense related to the MRP awards was $290,000 and $251,000 for the three months ended March 31, 2008 and 2007.  The remaining unrecognized compensation expense for MRP restricted stock was approximately $1.3 million and $1.6 million at March 31, 2008 and December 31, 2007, respectively.

Note 5 – Earnings Per Share
 
Earnings per share (“EPS”) is computed using the basic and diluted weighted average number of common shares outstanding during the periods presented.  Basic EPS is computed by dividing net income by the weighted average number of common shares outstanding during the period.  Unallocated shares related to the ESOP are deducted in the calculation of weighted average shares outstanding.  Diluted EPS is computed by dividing net income by diluted weighted average shares outstanding, which includes common stock equivalent shares outstanding using the treasury stock method, unless such shares are not dilutive.  Common stock equivalents include the stock options and restricted stock awards under the SOP and the MRP, respectively, that were approved by the Company’s shareholders in April 2004.
 
The following table presents the computation of basic and diluted earnings per share for the periods indicated (dollars in thousands, except the number shares and per share data):
 
   
Three Months Ended
March 31,
 
   
2008
   
2007
 
Numerator:
           
Net income
  $ 1,444     $ 890  
                 
Denominator:
               
Denominator for basic earnings per share:
               
Weighted average shares
    5,983,393       5,976,430  
Effect of dilutive common stock equivalents:
               
Stock options
    -       98,592  
MRP restricted stock
    -       19,560  
Denominator for diluted earnings per share:
               
Weighted average shares and assumed conversion of
                       dilutive stock options and restricted stock
    5,983,393       6,094,582  
                 
Basic earnings per share
  $ 0.24     $ 0.15  
Diluted earnings per share
  $ 0.24     $ 0.15  

 
 
9

Note 6 – Fair Value

Effective January 1, 2008, the Company began determining the fair market value of our financial instruments based on the fair value hierarchy established in SFAS No. 157, Fair Value Measurements (“SFAS 157”), which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  SFAS 157 describes three levels of inputs that can be used.  We carry our available-for-sale (“AFS”) securities at fair value and perform recurring valuations on our AFS securities.  We use observable inputs (i.e., Level 2 inputs under SFAS 157) to value our agency mortgage-backed securities and use unobservable inputs (i.e., Level 3 inputs under SFAS 157) to value our trust preferred securities, as obtained through an outside investment accounting service provider.  The following table presents the fair value of our AFS securities under the associated fair value hierarchy as established by SFAS 157 (dollars in thousands):

   
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
 
Significant Other
Observable Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
Assets at Fair
Value
                 
Available-for-sale securities
 
$            -
 
$    14,002
 
$   95,543
 
$   109,545


The following table reconciles the changes in the fair value of our AFS securities classified as Level 3 (i.e., trust preferred securities) (dollars in thousands):

   
Securities
Available for
 Sale
 
       
Beginning Balance at December 31, 2007
  $ 102,355  
   Total gains or losses (realized/unrealized)
    (6,645 )
   Purchases
    -  
   Paydowns and Maturities
    (167 )
   Transfers into Level 3
    -  
Ending Balance at March 31, 2008
  $ 95,543  
         
The amount of total gains (losses) for the three months ended March 31, 2008 included in earnings attributable to the change in unrealized gains (losses) relating to assets still held at March 31, 2008
  $ -  

 
Note 7 – Cash Dividends
 
On February 20, 2008 the Company announced a quarterly cash dividend of $0.07 per share payable on March 17, 2008 to shareholders of record on March 3, 2008.
 
Note 8 – Recently Issued Accounting Standards
 
In September 2006, the FASB issued SFAS 157.  This standard clarifies the principle that fair value should be based on the assumptions that market participants would use when pricing an asset or liability.  Additionally, it establishes a fair value hierarchy that prioritizes the information used to develop those assumptions.  SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and has not had a material impact on our consolidated financial statements.
 
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities – including an amendment of FASB Statement 115 (“SFAS 159”).  SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value.  Most of the provisions of this statement apply only to entities that elect the fair value option.  However, the amendment to FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, applies to all entities with available-for-sale and trading securities.  SFAS 159 is effective for fiscal years beginning after November 15, 2007, and has not had a material impact on our consolidated financial statements.  We did not elect the fair value option for any of our financial assets or liabilities.

 

 
10


In December 2007, the FASB issued SFAS No. 160, Non-controlling Interests in Consolidated Financial Statements – an amendment of ARB No. 51 (“SFAS 160”).  SFAS 160 establishes a single method of accounting for changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation.  This statement applies to all entities that prepare consolidated financial statements, except not-for-profit organizations, but will affect only those entities that have an outstanding non-controlling interest in one or more subsidiaries or that deconsolidate a subsidiary.  SFAS 160 is effective for fiscal years beginning on or after December 15, 2008, and is not expected to have a material impact on our consolidated financial statements.  We do not have an outstanding non-controlling interest in our subsidiary.

In December 2007, the FASB revised SFAS No. 141, Business Combinations (“SFAS 141(R)”).  SFAS 141(R) improves the completeness of the information reported about a business combination by changing the requirements for recognizing assets acquired and liabilities assumed arising from contingencies.  This statement requires an acquirer to recognize assets acquired and liabilities assumed arising from contractual contingencies as of the acquisition date.  SFAS No. 141, Business Combinations, permitted deferred recognition of pre-acquisition contingencies until the recognition criteria for SFAS No. 5, Accounting for Contingencies, was met.  SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008, and is not expected to have a material impact on our consolidated financial statements.
 
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities – an amendment of SFAS 133 (“SFAS 161”).  SFAS 161 changes the disclosure requirements for SFAS 133, Accounting for Derivative Instruments and Hedging Activities, to mention how and why an entity uses derivative instruments, as well as how derivative instruments and related hedged items are accounted for.  SFAS 161 is effective for fiscal years beginning on or after November 15, 2008, and is not expected to have a material impact on our consolidated financial statements.

ITEM 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

This Form 10-Q contains certain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements may be identified by the use of words such as "believe," "expect," "anticipate," "should," "planned," "estimated," and "potential." These forward-looking statements relate to, among other things, expectations of the business environment in which the Company operates, projections of future performance, perceived opportunities in the market, potential future credit experience, and statements regarding the Company’s mission and vision. These forward-looking statements are based upon current management expectations and may, therefore, involve risks and uncertainties. The Company’s actual results, performance, or achievements may differ materially from those suggested, expressed, or implied by forward-looking statements as a result of a wide variety or range of factors including, but not limited to: interest rate fluctuations; economic conditions in the Company’s primary market area; demand for residential, commercial real estate, consumer, and other types of loans; success of new products; competitive conditions between banks and non-bank financial service providers; regulatory and accounting changes; technological factors affecting operations; pricing of products and services; and other risks detailed in the Company’s reports filed with the Securities and Exchange Commission, including its Annual Report on Form 10-K for the fiscal year ended December 31, 2007. Accordingly, these factors should be considered in evaluating forward-looking statements, and undue reliance should not be placed on such statements.  The Company undertakes no responsibility to update or revise any forward-looking statements.

Comparison of Financial Condition at March 31, 2008 and December 31, 2007
 
The following table sets forth certain information concerning our consolidated financial condition at the dates indicated (dollars in thousands):
 
   
At March 31,
   
At December 31,
    $ Increase     % Increase  
   
2008
   
2007
   
(Decrease)
   
(Decrease)
 
                         
Total assets
  $ 878,922     $ 878,864     $ 58       - %
Investment securities (1)
    150,102       177,043       (26,941 )     (15.2 )
Interest-bearing deposits with banks
    7,003       90       6,913       7,681.1  
Loans, net
    647,645       628,921       18,724       3.0  
Deposits
    471,372       461,487       9,885       2.1  
Borrowed funds
    314,353       320,454       (6,101 )     (1.9 )
Total shareholders’ equity
    84,043       86,820       (2,777 )     (3.2 )
                                 
        (1) Includes mortgage-backed securities

 

 
11

 
 
Total assets were $878.9 million at March 31, 2008, relatively unchanged from the December 31, 2007 balance.  The $26.9 million decline in investment securities, resulting from investment securities sales, a market value decline in the value of our trust preferred securities, and principal payments on mortgage-backed securities, was nearly offset by an increase in the net loan portfolio as a result of strong loan growth and a $6.9 million increase in interest-bearing deposits with banks as a result of deposit growth.  Deposits increased $9.9 million to $471.4 million from $461.5 million at December 31, 2007, resulting primarily from increases in interest-bearing customer deposits.  Shareholders’ equity decreased $2.8 million to $84.0 million at March 31, 2008 from $86.8 million at December 31, 2007, primarily as a result of the decline in the market value of available-for-sale securities during the three months ended March 31, 2008.  

Loans.  The following table sets forth the composition of our loan portfolio by type of loan at the dates indicated (dollars in thousands):

 
At March 31, 2008
 
At December 31, 2007
 
$ Increase (Decrease)
 
% Increase
 (Decrease)
 
Amount
 
Percent
 
Amount
 
Percent
   
Real estate:
                     
One-to four-family residential
   $84,211
 
12.8%
 
$    76,882 
 
12.1% 
 
   $ 7,329 
 
9.5%
Five or more family residential
148,991
 
22.7   
 
149,080 
 
23.4     
 
(89)
 
(0.1)   
Commercial
223,076
 
34.0   
 
212,901 
 
33.4     
 
10,175 
 
4.8    
Total real estate
456,278
 
69.5   
     
438,863 
 
68.9     
 
17,415 
 
4.0    
                       
Real estate construction:
                     
One-to four-family residential
78,607
 
12.0  
 
73,114 
 
         11.5     
 
5,493 
 
7.5    
Five or more family residential
-
 
-  
 
1,839 
 
           0.3     
 
(1,839)
 
(100.0)   
Commercial
4,157
 
    0.6  
 
3,827 
 
           0.6     
 
330 
 
8.6    
Total real estate construction
82,764
 
12.6  
 
78,780 
 
         12.4     
 
3,984 
 
5.1    
                       
Consumer:
                     
Automobile
18,027
 
2.8  
 
20,798 
 
    3.3     
 
(2,771)
 
(13.3)  
Home equity
43,980
 
6.7  
 
45,293 
 
       7.1     
 
(1,313)
 
(2.9)  
Credit cards
22,120
 
3.4  
 
23,172 
 
           3.6     
 
(1,052)
 
(4.5)  
Other
7,812
 
1.2  
 
7,411 
 
           1.2     
 
401 
 
5.4   
Total consumer
91,939
 
14.1  
 
96,674 
 
         15.2     
 
(4,735)
 
(4.9)  
                       
Commercial/business
24,643
 
3.8  
 
22,683 
 
         3.5     
 
1,960 
 
8.6   
                       
Total loans
655,624
 
100.0%
 
637,000 
 
100.0% 
 
18,624 
 
2.9   
                       
Less allowance for loan losses
(7,979)
     
(8,079)
     
100 
 
(1.2)   
                       
Loans, net
$647,645
     
$  628,921 
     
$18,724 
 
3.0%


Our net loan portfolio increased $18.7 million, or 3.0%, to $647.6 million at March 31, 2008 from $628.9 million at December 31, 2007.  This increase was primarily attributable to increases in our real estate secured loans, which increased $20.1 million, or 3.6%, to $583.0 million at March 31, 2008 compared to $562.9 million at December 31, 2007.  The loan growth included a $10.2 million, or 4.8% increase in nonresidential commercial real estate loans, a $7.3 million, or 9.5% increase in the one-to four-family loan portfolio, and a $4.0 million, or 5.1% increase in real estate construction loans.  These increases were partially offset by a $1.3 million, or 2.9% decrease in home equity loans and an $89,000, or 0.1% decline in five or more family real estate loans.  Additionally, the commercial business loan portfolio increased $2.0 million, or 8.6%.  Partially offsetting these increases was a $3.4 million decrease in consumer loans (excluding home equity loans), including a $2.8 million decline in automobile loan balances primarily attributable to our decision to discontinue the origination of higher risk indirect auto loans on February 1, 2008.   During the balance of fiscal 2008, subject to market conditions, we plan to continue to grow our portfolio of real estate secured loans, primarily with loans secured by multi-family and commercial real estate.

Investments. The following table sets forth the composition of our investment securities at the dates indicated.  The available-for-sale investments are presented at net book value after a mark-to-market fair value adjustment, while the held-to-maturity securities are presented at amortized cost.  Our investment in the FHLB of Seattle’s common stock is presented at cost and for reference purposes only (dollars in thousands):

 
12


 

 
At March 31,
 
At December 31,
 
$ Increase
 (Decrease)
 
% Increase
 (Decrease)
 
2008
 
2007
   
Available-for-sale:
             
U. S. Government agencies
$             -
 
$                5,705
 
$   (5,705)
 
(100.0)%
Corporate securities
-
 
5,023
 
(5,023)
 
(100.0)   
Trust preferred securities
95,543
 
102,356
 
(6,813)
 
(6.7)   
Mortgage-backed securities
14,002
 
18,203
 
(4,201)
 
(23.1)   
Total available-for-sale portfolio
109,545
 
131,287
 
(21,742)
 
(16.6)   
               
Held-to-maturity:
             
Municipal obligations
12,785
 
12,784
 
 
                 -    
Mortgage-backed securities
27,772
 
32,972
 
(5,200)
 
(15.8)   
Total held-to-maturity portfolio
40,557
 
45,756
 
(5,199)
 
(11.4)   
               
Total Investment Securities
150,102
 
177,043
 
(26,941)
 
(15.2)   
     
  
       
Federal Home Loan Bank of Seattle stock
13,712
 
13,712
 
 
                 -     
                       
 Total
$ 163,814
 
$            190,755
 
$ (26,941)
 
(14.1)%

Our investment securities portfolio decreased by $26.9 million, or 15.2%, to $150.1 million at March 31, 2008 from $177.0 million at December 31, 2007.  The decrease in investments was primarily the result of $18.0 million of sales of investment securities during the quarter ended March 31, 2008, a $6.6 million market value decline in the Company’s portfolio of pooled trust preferred securities issued by FDIC-insured financial institutions and insurance companies, as well as $2.4 million in principal repayments on mortgage-backed securities.   Included in the $18.0 million of sales of investment securities during the current quarter was $3.7 million of held-to-maturity (“HTM”) securities.  These HTM securities were sold and classified as maturities in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities since they had remaining book values of less than 15% of original purchase price.

Deposits.  The following table sets forth the composition of our deposits at the dates indicated (dollars in thousands):

 
At March 31, 2008
 
At December 31, 2007
 
$ Increase (Decrease)
 
% Increase (Decrease)
 
Amount
 
Percent
 
Amount
 
Percent
   
                       
Non-interest-bearing checking
$  37,145
 
7.9%
 
$  33,924
 
7.4%
 
$    3,221 
 
9.5%
Interest-bearing checking
38,109
 
8.1    
 
41,083
 
8.9    
 
(2,974)
 
(7.2)   
Savings accounts
30,903
 
6.6    
 
28,397
 
6.1    
 
2,506 
 
8.8    
Money market accounts
117,582
 
24.9    
 
117,626
 
25.5    
 
(44)
 
             -    
IRA accounts
5,662
 
1.2    
    
5,713
 
1.2    
     
(51)
 
(0.9)  
Certificates of deposit
241,971
 
51.3    
 
234,744
 
50.9    
 
7,227 
 
3.1    
Total deposits
$471,372
 
100.0%
 
$461,487
 
100.0%
 
$    9,885 
 
2.1%
                       
Core deposits
$229,401
 
48.7%
 
$226,743
 
49.1%
 
$    2,658 
 
1.2%
Non-core deposits
241,971
 
51.3    
 
234,744
 
50.9    
 
7,227 
 
3.1    
Total deposits
$471,372
 
100.0%
 
$461,487
 
100.0%
 
$    9,885 
 
2.1%

Our deposits increased $9.9 million, or 2.1%, to $471.4 million at March 31, 2008 from $461.5 million at December 31, 2007. Interest-bearing deposits, primarily certificates of deposit, increased $6.7 million, or 1.6%, and non-interest bearing deposits, primarily checking accounts, increased $3.2 million.  Our deposit mix at the end of the first quarter included 48.7% of relatively low-cost checking, savings, money market, and individual retirement accounts (i.e., core deposits).  Certificates of deposit at March 31, 2008 included $61.3 million of brokered certificates of deposit, an increase of $345,000 from the $60.9 million of brokered certificates of deposit at December 31, 2007.



13

Borrowings.  Borrowed funds decreased $6.1 million, or 1.9%, to $314.4 million at March 31, 2008 from $320.5 million at December 31, 2007.  The decrease in borrowed funds during the quarter ended March 31, 2008 was primarily attributable to the increase in deposits, which decreased borrowings and increased the Company’s interest-bearing deposits with banks, as well as met other short-term liquidity needs.  We will continue to utilize borrowings from the FHLB of Seattle to fund attractive loan and investment opportunities and to enhance earnings in connection with leveraging the Company’s capital to increase our net interest income.

Capital.  Total shareholders’ equity decreased $2.8 million, or 3.2%, to $84.0 million at March 31, 2008 from $86.8 million at December 31, 2007.  The decrease in equity during the quarter was primarily attributable to a $4.1 million unrealized loss, net of taxes, on the available-for-sale securities portfolio.  Additionally, we paid out $453,000 in cash dividends to shareholders and purchased $211,000 in common stock.  Partially offsetting the decreases was $1.4 million in net income and $591,000 in positive equity adjustments related to stock compensation and benefits.  As a result of these factors, and relatively no change in the balance of our total assets, our capital-to-assets ratio under accounting principles generally accepted in the United States decreased 32 basis points to 9.56% at March 31, 2008, compared to 9.88% at December 31, 2007.

Comparison of Operating Results for the Three Months Ended March 31, 2008 and 2007

The following table sets forth certain information concerning our results of operations for the periods indicated (dollars in thousands):
 
 
Three Months Ended March 31,
 
$ Increase
 (Decrease)
 
% Increase
 (Decrease)
 
2008
 
2007
   
               
Net interest income
$    6,543
 
$       6,386
 
$         157 
    
2.5%
Non-interest income
2,821
 
2,242
 
579 
 
25.8   
Total revenue
     9,364
 
         8,628
 
736 
 
8.5   
Provision for loan losses
       150
 
            150
 
-  
 
 -   
Non-interest expense
      6,958
 
      7,109
 
(151)
 
(2.1)  
Net income
1,444
 
890
 
554 
 
62.2   

Net Interest Income.  The following table sets forth detailed information concerning our net interest income for the periods indicated (dollars in thousands):

 
Three Months Ended March 31,
 
$ Increase
 (Decrease)
 
% Increase
 (Decrease)
 
2008
 
2007
   
Interest income:
             
Loans
$   11,277
 
$     11,599
 
$          (322)
 
(2.8)%
Securities available-for-sale
1,857
 
2,052
 
(195)
 
(9.5)   
Securities held-to-maturity
451
 
565
 
(114)
 
(20.2)   
Interest-bearing deposits
27
 
10
 
17 
 
170.0    
Federal Home Loan Bank stock dividends
34
 
14
 
20 
 
142.9    
Total interest income
13,646
 
14,240
 
(594)
 
(4.2)   
               
Interest expense:
             
Deposits
3,587
 
4,111
 
(524)
 
(12.7)  
     Borrowed funds
3,516
 
3,743
 
(227)
  (6.1)  
Total interest expense
7,103
 
7,854
 
(751)
 
(9.6)  
Net interest income
$    6,543
 
$      6,386
 
$           157 
 
2.5%

Net interest income was $6.5 million for the three months ended March 31, 2008, compared to $6.4 million for the same period in 2007.  Our net interest margin increased 24 basis points to 3.20% for the three months ended March 31, 2008, from 2.96% for the same period in 2007, as the market decline in short-term interest rates allowed us to reprice deposits more rapidly than loans as a large portion of our loan portfolio consists of fixed-rate loans.

      Interest Income.  Our interest income decreased $594,000, or 4.2%, to $13.6 million for the three months ended March 31, 2008 from $14.2 million for the three months ended March 31, 2007. Interest earned on loans for the three months ended March 31, 2008 and 2007 was $11.3 million and $11.6 million, respectively.  The average yield on total loans was 7.12% for the three months ended March 31, 2008 compared to 7.24% for the same period in 2007 reflecting the decrease in interest rates.  The average balance of total
 
 
 
14

 
 
loans also decreased by $8.6 million to $635.2 million for the three months ended March 31, 2008 from $643.8 million for the same period in 2007.  A significant portion of the loan portfolio consists of real estate secured loans which do not immediately re-price when interest rates change.  Construction loans, home equity lines of credit, credit card loans, and our commercial/business loans, however, generally re-price when short-term interest rates change.  The yield decrease on our variable-rate loan products as a result of lower interest rates and a decrease in the average balance of loans, were the primary contributors to the decreased interest income on loans.

Interest income on investment securities (including mortgage-backed securities) decreased $309,000, or 11.5%, to $2.3 million for the three months ended March 31, 2008 from $2.6 million for the three months ended March 31, 2007 as a result of a lower average balance, partially offset by higher yields earned.  The average balances of investment securities for the three months ended March 31, 2008 and 2007 were $162.3 million and $196.6 million, respectively.  The average yield on investment securities increased to 5.68% for the three months ended March 31, 2008 from 5.32% for the three months ended March 31, 2007.  The average yield on investment securities increased as a result of our variable rate securities, which reprice quarterly and were last priced in December before the Federal Reserve cut the Federal Funds rate in January and March of 2008.

Interest Expense.  Our interest expense decreased $751,000, or 9.6%, to $7.1 million for the three months ended March 31, 2008 from $7.9 million for the three months ended March 31, 2007.  In addition to a decrease in the average balances of our deposits and borrowings, declining market rates helped decrease our deposit and borrowing costs as well.

       Interest expense on deposits decreased $524,000, or 12.7%, to $3.6 million for the three months ended March 31, 2008 from $4.1 million for the three months ended March 31, 2007.  The average cost of deposits decreased 41 basis points to 3.48% for the three months ended March 31, 2008 from 3.89% for the three months ended March 31, 2007 as a result of a decline in short-term interest rates.  This decrease in deposit costs for the three months ended March 31, 2008 was also lower as a result of an $8.3 million decrease in the average balance of higher cost certificates of deposit.

       Interest expense on borrowed funds decreased $227,000, or 6.1%, to $3.5 million for the three months ended March 31, 2008 from $3.7 million for the three months ended March 31, 2007 primarily attributable to a $21.8 million decline in the average balance of borrowed funds.  The average balances of borrowed funds were $320.4 million for the quarter ended March 31, 2008, compared to $342.3 million for the three months ended March 31, 2007.  The cost of borrowed funds decreased by only three basis points to 4.41% for the three months ended March 31, 2008 from 4.44% for the three months ended March 31, 2007, as $245.0 million of our borrowings are long-term and structured advances that do not reprice when short-term rates decline.

Provision for Loan Losses.   The following table sets forth an analysis of our allowance for loan losses at the dates and for the periods indicated (dollars in thousands):

 
Three Months Ended March 31,
 
$ Increase
 (Decrease)
 
% Increase
 (Decrease)
 
2008
 
2007
   
Allowance at beginning of period
$8,079
 
$8,283
 
$    (204)
 
(2.5)%
Provision for loan losses
150
 
150
 
                    -
 
             -     
Recoveries
72
 
61
 
                  11
 
18.0     
Charge-offs
(322)
 
(218)
 
              (104)
 
47.7     
Allowance at end of period
$7,979
 
$8,276
 
$    (297)
 
(3.6)%

Our provision for loan losses was unchanged at $150,000 for the three month periods ended March 31, 2008 and 2007.  The provision was recorded at a level considered appropriate to ensure that the allowance for loan losses was adequate to address the inherent credit risk in the loan portfolio.  At March 31, 2008, the $8.0 million allowance for loan losses was relatively unchanged from December 31, 2007 at $8.1 million; however, the allowance was $297,000 less than the March 31, 2007 balance of $8.3 million.  The allowance for loan losses as a percent of total loans at March 31, 2008 decreased five basis points to 1.22% compared to the 1.27% at December 31, 2007, and was eight basis points lower than the 1.30% at March 31, 2007.  The decrease in the allowance ratio over prior periods was deemed appropriate because of the reduced risk in the loan portfolio attributable to the growth in real estate secured loans, which have historically experienced a very low level of losses and a decrease in the balance of consumer loans (excluding home equity loans), which have historically experienced higher losses.  The credit quality of the loan portfolio remained stable as evidenced by net charge-offs only increasing to $250,000 during the three months ended March 31, 2008, compared to $157,000 for the three months ended March 31, 2007.

Management believes our allowance for loan losses as of March 31, 2008 was adequate to absorb the known and inherent risks of loss in the loan portfolio at that date. While management believes the estimates and assumptions used in its determination of the adequacy of the allowance are reasonable, there can be no assurance that such estimates and assumptions will not be proven incorrect in the future, or that the actual amount of future provisions will not exceed the amount of past provisions or that any increased provisions that may be required will not adversely impact our financial condition and results of operations.  In addition, the 
 
 
 
15

determination of the amount of our allowance for loan losses is subject to review by bank regulators, as part of the routine examination process, which may result in the establishment of additional reserves based upon their judgment of information available to them at the time of their examination.  We will continue to monitor the allowance and general credit quality of real estate loans in our primary market of the south Puget Sound.
 
 
Non-interest Income.  The following table sets forth information regarding our non-interest income for the periods indicated (dollars in thousands):

 
 
Three Months Ended March 31,
 
$ Increase
 (Decrease)
 
% Increase
 (Decrease)
 
2008
 
2007
   
Deposit service fees
$      839
 
$      826
 
$        13 
 
1.6%
Loan service fees
        315
 
        292
 
          23 
 
7.9    
Insurance service fees
    550
 
    543
 
    7 
 
1.3    
Investment service fees
    164
 
    113
 
    51 
 
45.1    
Real estate lease income
   246
 
   294
 
   (48)
 
(16.3)   
Gain on sale of securities, net
   11
 
   -
 
    11 
 
100.0    
Gain on sale of loans, net
   235
 
    136
 
   99 
    
72.8    
Gain on sale of premises and
equipment, net
   -
 
   10
 
   (10)
 
(100.0)   
Other operating income
         461
 
           28
 
         433 
 
1,546.4    
Total non-interest income
$   2,821
 
$   2,242
 
$      579 
 
25.8%

Our non-interest income for the three months ended March 31, 2008 increased $579,000, or 25.8%, to $2.8 million from $2.2 million for the three months ended March 31, 2007.  This increase was primarily a result of a $433,000 increase in other operating income and a $99,000 increase in the gain on sale of loans, net.  The increase in other operating income was primarily the result of a non-recurring $422,000 pre-tax gain from the redemption of VISA U.S.A., Inc. Class B common stock in connection with its initial public offering in March 2008.  The increase in gains on the sale of loans was attributable to an increase in the number of one- to four-family mortgages sold, including the recognition of the associated mortgage servicing asset of $71,000 during the first quarter of 2008.  All other categories of non-interest income reflected a net increase of $47,000.

Non-interest Expense.  The following table sets forth information regarding our non-interest expense for the periods indicated (dollars in thousands):

 
Three Months Ended March 31,
 
$ Increase
 (Decrease)
 
% Increase
 (Decrease)
 
2008
 
2007
   
Compensation and benefits
$4,060
 
$    3,993
 
$         67 
 
1.7% 
Office operations
955
 
        986
 
(31)
 
(3.1)   
Occupancy
614
 
635
 
(21)
 
(3.3)   
Loan servicing
109
 
             110
 
(1)
 
(0.9)   
Outside and professional services
448
 
           432
 
16 
 
3.7    
Marketing
284
 
           243
 
41 
  
16.9    
Other operating expenses
488
 
           710
 
(222)
 
(31.3)   
Total non-interest expense
$6,958
 
$    7,109
 
$     (151)
 
(2.1)%

Non-interest expense decreased $151,000, or 2.1%, to $7.0 million for the three months ended March 31, 2008 from $7.1 million for the three months ended March 31, 2007.  The decrease was primarily attributable to a $222,000 decrease in other operating expenses, partially offset by a $67,000 increase in compensation and benefits expense.

Other operating expenses decreased $222,000, or 31.3%, to $488,000 for the three months ended March 31, 2008 from $710,000 for the three months ended March 31, 2007.  The decrease was primarily a result of a $173,000 reversal in March 2008 of a pre-tax charge recognized in the fourth quarter of 2007 related to a reserve established for the Company’s share of the VISA U.S.A., Inc. litigation settlements.  We reversed the litigation settlement reserve as a result of VISA U.S.A., Inc. establishing an escrow account to satisfy this obligation as part of its initial public offering.  The 1.7% increase in compensation and benefits was primarily attributable to position value increases.  All other non-interest expenses increased by a combined $4,000.

 

 
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Average Balances, Interest and Average Yield/Costs.  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, resultant yields and costs, net interest income, interest rate spread, and net interest margin.  Average balances have been calculated using the average of daily balances during the period (amounts in thousands).

   
Three Months Ended
   
Three Months Ended
           
   
March 31, 2008
   
March 31, 2007
           
   
Average Balance
   
Average Yield/Cost
   
Average Balance
   
Average Yield/Cost
   
 $ Increase
   (Decrease)
      
 
% Increase 
(Decrease)
INTEREST-EARNING ASSETS:
                                 
    Total loans
  $ 635,217       7.12 %   $ 643,796       7.24 %   $ (8,579 )     (1.3 )%
    Mortgage-backed securities
    44,258       4.35       62,367       4.32       (18,109 )     (29.0 )
Investment securities
    118,047       6.19       134,221       5.79       (16,174 )     (12.1 )
Federal Home Loan Bank stock
    13,712       1.00       13,712       0.40       -       -  
Interest-bearing deposits in other banks
    3,781       2.85       793       5.17       2,988       376.8  
Total interest-earning assets
    815,015       6.71       854,889       6.69       (39,874 )     (4.7 )
                                                   
Non-interest-earning assets
    54,713               49,913               4,800       9.6  
                                                   
Total assets
  $ 869,728             $ 904,802             $ (35,074 )     (3.9 )%
                                                   
                                                   
INTEREST-BEARING LIABILITIES: