S-1 1 ds1.htm FORM S-1 FORM S-1
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As filed with the Securities and Exchange Commission on May 6, 2011

Registration No. 333-            

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

HOMESTREET, INC.

(Exact Name of Registrant as Specified in its Charter)

 

 

 

Washington   6036   91-0186600

(State or other jurisdiction of

incorporation or organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification No.)

601 Union Street, Suite 2000

Seattle, WA 98101

(206) 623-3050

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

 

 

Mark K. Mason

Chief Executive Officer

HomeStreet, Inc.

601 Union Street, Suite 2000

Seattle, WA 98101

(206) 623-3050

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

 

Copy to:

 

Marcus J. Williams

Donna M. Cochener

Davis Wright Tremaine LLP

1201 Third Avenue, Suite 2200

Seattle, WA 98101

(206) 622-3150

(206) 757-7700 – Facsimile

 

Godfrey B. Evans

HomeStreet, Inc.

601 Union Street, Suite 2000

Seattle, WA 98101

(206) 623-3050

(206) 389-7703 – Facsimile

 

John C. Grosvenor

James J. Vieceli

Manatt, Phelps & Phillips, LLP

695 Town Center Drive, 14th Floor

Costa Mesa, CA 92626

(714) 371-2500

(714) 371-2550 – Facsimile

As soon as practicable after the effective date of this Registration Statement.

(Approximate date of commencement of proposed sale to the public)

 

 

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933 check the following box.    ¨

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.    ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.    ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.    ¨

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

 

Large accelerated filer

 

¨

     Accelerated filer   ¨

Non-accelerated filer

 

x

     Smaller reporting company   ¨

 

 

CALCULATION OF REGISTRATION FEE

 

 

Title of Each Class of

Securities to be Registered

 

Proposed Maximum

Aggregate Offering
Price(1)

  Amount of
Registration Fee

Common Stock, no par value per share

  $210,000,000.00   $24,381
 
 
(1) Estimated solely for the purpose of determining the amount of the registration fee in accordance with Rule 457(o) promulgated under the Securities Act of 1933, as amended. Includes offering price of additional shares that the underwriters have the option to purchase to cover over-allotments, if any. See “Underwriting.”

 

 

THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF THE SECURITIES ACT OF 1933, AS AMENDED, OR UNTIL THIS REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(a), MAY DETERMINE.

 

 

 


Table of Contents

The information in this preliminary prospectus is not complete and may be changed. We may not sell these securities or accept any offer to buy these securities until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell these securities and we are not soliciting an offer to buy these securities in any state where the offer or sale is not permitted.

 

PROSPECTUS (SUBJECT TO COMPLETION) DATED                     , 2011

[] Shares of Common Stock

LOGO

 

 

This is our initial public offering. Prior to this offering, there has been no public market for our common stock. We currently expect the initial public offering price to be between $[] and $[] per share. See “Underwriting” for a discussion of the factors to be considered in determining the initial public offering price. The market price of the shares after the offering may be higher or lower than the initial offering price.

We have applied to have our common stock listed on the Nasdaq Global Market under the symbol “HMST.”

We and the Bank are currently operating under orders to cease and desist issued by the Office of Thrift Supervision, or the OTS, and by the Federal Deposit Insurance Corporation, or the FDIC, and the Washington State Department of Financial Institutions, Division of Banks, or the DFI, respectively. As a result of these orders, we and the Bank are required to augment regulatory capital and reduce problem assets, and are subject to certain restrictions on our operations.

 

 

Investing in our common stock is speculative and involves a significant degree of risk. You should consider carefully the risks and uncertainties in the section entitled “Risk Factors” beginning on page 18 of this prospectus before investing in our common stock.

The shares of our common stock are not deposits, bank accounts or obligations of any bank, are not insured by the FDIC or any other governmental agency and are subject to investment risks, including possible loss of the entire amount invested.

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

 

 

 

     Per Share      Total  

Initial public offering price

   $                    $                

Underwriting discounts and commission

   $         $     

Proceeds to us, before expenses

   $         $     

We have granted an over-allotment option which will allow the underwriters to purchase up to an additional [] shares of our common stock from us at the initial offering price within 30 days following the date of this prospectus solely to cover over-allotments, if any.

The underwriters expect to deliver our common stock in book entry form only, through the facilities of The Depository Trust Company, against payment therefor on or about [], 2011.

FBR CAPITAL MARKETS & CO.

The date of this prospectus is                     , 2011


Table of Contents

TABLE OF CONTENTS

 

     Page  

Summary

     1   

Risk Factors

     18   

Use of Proceeds

     46   

Capitalization

     47   

Dilution

     48   

Dividend Policy

     49   

Selected Historical Consolidated Financial and Other Data

     50   

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     53   

Business

     107   

Regulation and Supervision

     125   

Management

     149   

Executive Compensation

     163   

Certain Relationships and Related Transactions

     176   

Principal Shareholders

     177   

Description of Capital Stock

     181   

Shares Available for Future Sale

     186   

Material United States Federal Income Tax Considerations

     188   

Underwriting

     193   

Validity of Common Stock

     196   

Experts

     196   

Where You Can Find More Information

     196   

Index of Consolidated Financial Statements

     F-1   

Notes to Consolidated Financial Statements

     F-10   

 

 

You should rely only on the information contained in this prospectus. Neither we nor the underwriters have authorized any other person to provide you with different information. We and the underwriters are offering to sell, and seeking offers to buy, shares of our common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date on the front cover of this prospectus or such other date stated in this prospectus. You should assume that the information appearing in this prospectus is accurate only as of that date. Our business, financial condition, results of operations and prospects may have changed since that date.

Unless we state otherwise or the context otherwise requires, references in this prospectus to “HomeStreet” “we,” “our,” “us” and the “Company” refer to HomeStreet, Inc., a Washington corporation, HomeStreet Bank (“Bank”), HomeStreet Capital Corporation (“HomeStreet Capital”) and HomeStreet Inc.’s other direct and indirect subsidiaries.

 

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SUMMARY

The following summary highlights information contained elsewhere in this prospectus. This summary is not intended to be complete and does not contain all the information you should consider before investing in our common stock. We encourage you to read carefully this entire prospectus, including the section entitled “Risk Factors” and our financial statements and related notes appearing elsewhere in this prospectus, before deciding to invest in our common stock.

Our Company

We are a 90-year-old diversified financial services company headquartered in Seattle, Washington, that has grown from a small mortgage bank to a full-service community bank serving consumers and businesses in the Pacific Northwest and Hawaii. In 1986 we established the Bank to fund our lending activities and to offer a broader range of products and services. Our banking strategy has allowed us to expand our lending activities while building stable core deposits and a more diversified core customer base that offers better cross-selling opportunities. The Bank has the oldest continuous relationship of all Fannie Mae seller servicers in the nation, having been the second company approved by Fannie Mae at its founding in 1938.

Our primary subsidiaries are HomeStreet Bank and HomeStreet Capital Corporation. HomeStreet Bank is a Washington state-chartered savings bank that provides deposit and investment products and cash management services. The Bank also provides loans for single family homes, commercial real estate, construction, land development and commercial businesses. HomeStreet Capital Corporation, a Washington corporation, originates, sells and services multifamily mortgage loans under the Fannie Mae Delegated Underwriting and Servicing Program (“DUS”) in conjunction with HomeStreet Bank. We also provide insurance products and services for consumers and businesses as HomeStreet Insurance and loans for single family homes through a joint venture, Windermere Mortgage Services Series LLC (“WMS”). At December 31, 2010, we had total assets of $2.49 billion, net loans held for investment of $1.54 billion, deposits of $2.13 billion and shareholders’ equity of $58.8 million.

We have a network of 20 bank branches and nine stand-alone lending centers located in the Puget Sound, Olympia, Vancouver and Spokane regions of Washington, the Portland and Salem regions of Oregon, and the Hawaiian Islands of Oahu, Maui and Hawaii. Our bank branches have average deposits per branch of $106.5 million as of December 31, 2010. WMS provides point-of-sale loan origination services through 44 Windermere Real Estate offices in Washington and Oregon.

We operate four primary lines of business: Community Banking, Single Family Lending, Income Property Lending and Residential Construction Lending.

Community Banking. We provide diversified financial products and services to our consumer and business customers, including deposit products, investment products, insurance products, cash management services and consumer and business loans.

Single Family Lending. We originate, sell and service residential mortgage loans both directly and through our relationship with WMS. We also originate and service loans for our portfolio on a selective basis.

Income Property Lending. We originate commercial real estate loans with a focus on multifamily lending through Fannie Mae’s DUS program. These loans are sold to or securitized by Fannie Mae, and we generally retain the right to service them. We also originate commercial real estate construction, land, bridge and permanent loans for our own portfolio.

 

 

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Residential Construction Lending. We originate residential construction and land development loans primarily for our own portfolio.

Recent Developments

As the economic downturn began in late 2007 and continued into mid-2009, our business experienced a series of interrelated negative events, the combination of which led to significant operating losses that diminished our capital and weakened our financial condition. During this period, home prices and the volume of home sales decreased significantly along with occupancy and rental rates on commercial real estate. Related declines in the value of residential and commercial real estate, especially residential land and finished lots, significantly impacted the economic viability of many of our borrowers’ construction projects and investments and reduced the value of our collateral. Our classified assets increased from $114.8 million at December 31, 2007 to a peak of $759.7 million at June 30, 2009 and nonperforming assets increased from $35.7 million at December 31, 2007 to their peak of $482.0 million at December 31, 2009.

As a result of the deterioration in our asset quality, operating performance and capital adequacy, on May 8, 2009, we entered into an agreement with HomeStreet Bank’s primary banking regulators, the Federal Deposit Insurance Corporation, or FDIC, and the Washington State Department of Financial Institutions, or DFI, pursuant to which we consented to the entry of an Order to Cease & Desist from certain allegedly unsafe and unsound banking practices. On May 18, 2009, we entered into a similar agreement with HomeStreet, Inc.’s primary regulator, the Office of Thrift Supervision, or OTS. We refer to the Order to Cease & Desist with the FDIC and DFI as the Bank Order, the Order to Cease & Desist with the OTS as the Company Order, and to the Bank Order and Company Order collectively as the Orders. Among other things, the Orders required us to increase our capital to certain specified levels, improve management, reduce classified assets and improve earnings. The Orders are described in more detail under “Regulation and Supervision — Cease and Desist Orders.”

Management Changes

In light of the then-prevailing economic conditions confronting our organization and to develop and implement a bank turnaround strategy, the boards of directors of the Company and the Bank recruited and retained a new executive management team. Starting in August of 2009, we added the following executives:

Mark K. Mason, Director, Chief Executive Officer and President of HomeStreet, Inc.; Director, Chairman of the Board, Chief Executive Officer and President of HomeStreet Bank. Mr. Mason has over 25 years of experience in credit, lending, operations and finance. A substantial portion of Mr. Mason’s career has been spent resolving or recapitalizing troubled institutions, restructuring operations and upgrading troubled loan portfolios. Since joining the Company in late 2009, Mr. Mason has led the Company’s significant turnaround. Prior to that, Mr. Mason has served as an executive officer, director and consultant to banks and mortgage companies, most significantly as the chairman of the board, chief executive officer and chief lending officer of Fidelity Federal Bank.

David E. Hooston, Executive Vice President and Chief Financial Officer of HomeStreet, Inc. and HomeStreet Bank. Mr. Hooston has over 30 years of experience in the financial services industry. He has extensive experience in turning around troubled institutions, raising public and private capital and negotiating and executing mergers and acquisitions. Mr. Hooston has served as president and chief operating officer, chief financial officer and as a director of banks and bank holding companies including Placer Sierra Bancshares, Belvedere Capital Partners, LLC and ValliCorp Holdings, Inc.

Jay C. Iseman, Executive Vice President and Chief Credit Officer of HomeStreet, Inc. and HomeStreet Bank. Mr. Iseman has 20 years of credit management experience at major national banks in commercial and real estate lending. This includes significant experience in troubled loan workouts, special assets and credit administration.

 

 

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Prior to joining the Bank, Mr. Iseman served as a senior vice president and senior portfolio manager of commercial special assets with Bank of America.

Godfrey B. Evans, Executive Vice President, General Counsel, Chief Administrative Officer and Corporate Secretary of HomeStreet, Inc. and HomeStreet Bank. Mr. Evans has 29 years of experience in banking and corporate securities law, including significant roles in the recapitalization and restructuring of financial institutions. Mr. Evans is an experienced public company general counsel. Prior to joining the Company, Mr. Evans served as the general counsel, chief administrative officer and corporate secretary to Fidelity Federal Bank and prior to that was a corporate lawyer for Gibson, Dunn & Crutcher, LLP in Los Angeles.

Turnaround Plan

Under the leadership of our new management team, we have implemented a plan to stabilize and turn around the institution. The principal elements of this plan are to improve asset quality and upgrade our credit culture, restructure the balance sheet and improve core earnings, control noninterest expense and maintain satisfactory regulatory relations.

Improve Asset Quality and Upgrade Credit Culture

We have addressed the risks that contributed to the deterioration in our asset quality and earnings, including reducing and limiting loan concentrations in higher risk loan types and market segments where we have continuing concerns about deterioration in collateral values. Since 2007, we have dramatically curtailed most types of lending in response to deteriorating economic conditions and in order to preserve regulatory capital ratios. We have also implemented or are implementing a number of additional measures aimed at improving our asset quality, including:

 

   

Aggressively managing troubled loans. Where appropriate, we have restructured loans to improve our position, including negotiated principal reductions and additional collateral, aggressively collected on loans and guaranties, and obtained and enforced writs of attachment on bank accounts and personal property when necessary. Where restructuring has proven impossible or impracticable, we have negotiated deeds in lieu of foreclosure or have foreclosed on real property.

 

   

Actively marketing and selling other real estate owned (“OREO”). We have actively marketed and sold OREO to end users, such as developers and investors, who make direct and immediate use of such properties. We have generally avoided selling to financial buyers or other intermediaries who typically hold properties for a limited period of time and who do not usually improve or add value to the properties.

 

   

Restructuring our credit administration and approval infrastructure. We restructured our credit administration infrastructure to create more oversight at the board level and to better manage our loan approval process and credit exposure. We hired a Chief Credit Officer and centralized all credit approval, administration and portfolio monitoring functions under his authority. We also established a special assets department of our credit administration group to manage troubled loans and OREO.

 

   

Upgrading our underwriting policies and procedures. We revised our lending policies and procedures to reflect more conservative underwriting standards, such as lower loan-to-value ratios, increased cash equity requirements and debt service coverage, lower maximum loan sizes, more restrictive financial covenants, including total debt, leverage and minimum cash flow, minimum net worth, liquidity and experience requirements, lower loan-to-one borrower limits, global financial reviews of borrowers and their credit histories and use of inter-creditor agreements when appropriate.

 

 

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Balance Sheet Restructuring and Core Earnings Improvement

We are restructuring our balance sheet by increasing loan yields, extending the duration of our investment securities and diversifying our credit risk by reducing the relative size and concentration of our loan portfolio in residential construction and land loans. In addition, because our net interest margin had been negatively affected by variable rate loans originated without interest rate floors, management has instituted interest rate floors upon the renewal, restructuring or origination of new loans. Between September 30, 2009, and December 31, 2010, loans without interest rate floors have decreased by $568.1 million, or 56.3%.

We have also focused on reducing our noncore funding and improving our core deposit base. As the banking system began to stabilize in 2009, we began moving to a more normalized liquidity management and investment strategy, reducing noncore deposits and wholesale funding while retaining and increasing core deposit balances and customers. Between September 30, 2009 and December 31, 2010, advances from the Federal Home Loan Bank of Seattle, or FHLB, and brokered deposits have decreased from $1.01 billion to $175.9 million. This funding has been generally replaced with retail deposits or retired with proceeds from the sales of investment securities. The composition of our deposit portfolio continues to improve. We have initiated marketing strategies to attract and retain relationship-based customers and eliminate rate-sensitive time deposit customers, which has the dual effect of creating a more stable funding base representative of a relationship-based institution and helping us return to a more normalized liquidity profile. Between September 30, 2009, and December 31, 2010, core deposits consisting of checking, savings and certificates of deposits with balances less than $250,000 have increased from 72.0% of total deposits to 81.8% of total deposits.

Improving our deposit mix and increasing loan yields have significantly improved our net interest margin. Our net interest margin has increased from 0.85% for the quarter ended September 30, 2009 to 2.34% for the quarter ended December 31, 2010.

Controlling Noninterest Expense

We have experienced, and we expect in the near term to continue to experience, higher than normal noninterest expense associated with loan resolution activities, dispositions of OREO, increased deposit insurance costs and efforts associated with compliance with the Orders. However, during this time we have reduced other core banking compensation and general and administrative expenses by streamlining operations and reducing unnecessary staff, freezing salaries, temporarily suspending our 401(k) match and reducing travel and entertainment budgets. Going forward, we plan to manage future changes in all noninterest expense categories based on changes in revenue growth, reductions in problem assets and removal of the Orders. Upon satisfaction and removal of the Orders, we anticipate lower regulatory-related expenses, deposit insurance assessments, professional fees, and time devoted by management and staff to the compliance with the Orders.

Maintain Satisfactory Regulatory Relations

Maintaining the confidence of our regulators is an integral part of our turnaround plan. Beginning in the fourth quarter of 2009, management initiated monthly conference calls with our regulators to present and discuss progress on management changes, problem asset reduction, capital adequacy, interest rate risk, liquidity maintenance, funding restructuring and earnings. These meetings have produced transparency in our relationship with our regulators and have facilitated current reporting of the status of management’s turnaround plan.

This offering reflects one of management’s primary initiatives to strengthen our regulatory capital. We expect to be able to satisfy the requirements of the Orders if this offering and our continuing efforts to reduce our problem loans are successful. We have reviewed with our regulators the parameters of this offering, including the pro forma

 

 

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capital ratios and asset quality measures. Based on those discussions, absent material deterioration in other parts of our business, we believe the completion of this offering will qualify us for termination of the Orders.

Selected Turnaround Results

As illustrated below, we believe we have made significant progress on our turnaround plan, dramatically reducing our credit risk and improving our financial condition and results of operations.

 

     Quarter Ended  
     $ Thousands  
     31-Dec-10     30-Sep-09  

Total Construction Loans

   $ 285,131      $ 733,394   

Provision for Loan Losses

     8,200        35,555   

Classified Assets

     363,947        737,925   

Nonperforming Loans

     113,209        388,663   

OREO

     170,455        63,321   

Nonperforming Assets

     283,664        451,984   

Total Delinquencies and Nonaccruing Loans

     178,287        495,168   

Total Assets

     2,485,697        3,224,464   

Nonperforming Assets/Total Assets

     11.4     14.0

Nonperforming Loans/Loans

     7.06     17.7

Total Delinquencies and Nonaccruing Loans/Loans

     11.1     22.6

Net Interest Margin

     2.34     0.85

Operating Efficiency Ratio*

     73.56     78.42

 

* We include an operating efficiency ratio which is not calculated based on accounting principles generally accepted in the United States (“GAAP”), but that we believe provides important information regarding our result of operations. Our calculation of the operating efficiency ratio is computed by dividing noninterest expense less costs related to OREO (gains (losses) on sales, valuation allowance adjustments, and maintenance and taxes) by total revenue (net interest income and noninterest income). Management uses this non-GAAP measurement as part of its assessment of performance in managing noninterest expense. We believe that costs related to OREO are more appropriately considered as credit-related costs rather than as an indication of the operating efficiency of the Company.

Our Growth Strategy

Our growth strategy is comprised of the following:

Integrated Consumer and Business Financial Services Delivery Strategy

Our Community Banking strategy involves the development of an integrated consumer and business financial services delivery platform. We seek to meet the financial services needs of our customers by providing consumer and business banking products, investment advice and products, and insurance products through our bank branches and our dedicated investment advisors, insurance agents and business banking officers. We have historically offered a limited line of investment, cash management and insurance products, however, we are currently in the process of significantly enhancing and expanding our products and services by:

 

   

expanding our investment product offerings through a third-party broker dealer, building a staff of dedicated investment advisors and sales representatives and licensing additional qualified branch personnel for annuity sales;

 

   

enhancing our business cash management service offerings and building a team of business cash management sales and support personnel; and

 

   

expanding our insurance product offerings and further integrating sales of these products into our consumer and business financial advisory activities.

 

 

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Expand Core Deposit Base

We plan to grow our consumer core deposit base through limited media advertising, effective deposit product design, account cash incentives, cash referral bonuses and relationship incentives. To attract new business customers, we offer money market and business savings accounts as well as a competitive array of cash management products and services.

Our growth strategy will be limited by our regulatory status, which generally would preclude us from obtaining the required consent from the FDIC and the DFI in order to open new bank branches. However, once the Orders are lifted, we intend to expand our bank branch network to support core deposit growth, expand our consumer and business financial services customer base and increase access to our services and products for our current customers. We may also open additional stand-alone loan production offices to support growth in our single family lending and income property lending businesses.

Business Banking Growth

During our turnaround, we have focused on retaining our existing customers and developing new deposit-oriented customer relationships. As the economy improves, we believe we will be well positioned to attract new middle-market business customers requiring commercial business and owner-occupied real estate loans. The number of competitors for middle-market business customers has decreased since the economic downturn as a result of bank failures and market consolidation. In recent years, national banks have focused on larger customers in order to achieve economies of scale in lending and depository relationships and have also consolidated business banking operations and support and reduced service levels in the Pacific Northwest. Additionally, high levels of problem loans at many local banks combined with low levels of capital have significantly impaired competitors’ capacity to make new loans.

New loan demand is generally weak because of the economic downturn and has resulted in increased competition for good customers in spite of industry consolidation. However, as the economy improves and new loan demand increases, we believe our community banking focus will distinguish us from our competitors because we are able to offer quicker, local decision making and to provide customers with direct access to our senior managers. At the same time, our larger capital base and broader offering of products and services will enable us to compete effectively against smaller banks. As a result, we believe we have a substantial opportunity to attract additional borrowers and depositors and expand our presence and market share, especially in the high-growth Puget Sound area.

Single Family Mortgage Origination and Servicing Portfolio Growth

During the real estate boom of 2004 through 2007, we maintained our historical focus on originating conforming conventional and FHA and VA loans for sale in the secondary market while supplementing those products with some portfolio lending. Our adherence to traditional credit standards limited our loan originations during the peak of the expansion of the subprime and option adjustable rate mortgage lending boom, and we lost market share to competitors during this time. However, our conventional conforming mortgage banking expertise positioned us to expand our originations when market conditions changed as a result of the tightening of lending standards and the market’s reliance on government sponsored entities and agencies for secondary market liquidity. As a result, we have grown our single family origination and servicing business substantially since 2007. We originated $1.43 billion, $1.53 billion, $1.45 billion and $1.57 billion in home loans in 2004, 2005, 2006 and 2007, respectively, followed by $1.74 billion, $2.73 billion and $2.07 billion in 2008, 2009 and 2010, respectively. Because we retain servicing rights on substantially all of the single family residential mortgages that we sell into the secondary markets, our portfolio of single family loans serviced for others has grown significantly during this period and stood at $6.34 billion at December 31, 2010.

 

 

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We intend to grow our market share and continue to focus on conventional conforming single family mortgage banking and use portfolio lending to complement, but not replace, secondary market lending, particularly for well qualified borrowers with loan sizes greater than the conventional conforming limits. In addition, we plan to open a correspondent lending channel and to increase our Internet-based lending.

Multifamily Mortgage Banking Growth

As market conditions improve we plan to grow our multifamily mortgage banking business, particularly through our DUS license. We expect to expand beyond our current markets by forming strategic alliances with producers and underwriters in the Western Region of the United States.

We intend to expand our multifamily residential mortgage lending business by targeting strong apartment markets and experienced borrowers with whom we have had prior working relationships. We expect to continue to benefit from being one of approximately 25 companies nationally that has a Fannie Mae DUS license. The Fannie Mae DUS program has become a key multifamily funding source nationally due to the turmoil in the financial services industry and the resulting loss of other financing sources. We have historically supported our DUS program by providing short-term bridge loans to experienced borrowers who purchase apartment buildings for renovation, which we would then seek to replace with permanent takeout financing through the Fannie Mae DUS program upon completion of the renovations. As market conditions warrant, we will also originate for our portfolio permanent loans and construction loans.

Strategic Acquisitions

The economic downturn and related banking crisis have led to increased regulatory and compliance burdens, management fatigue and limited access to capital. As a result, we anticipate there will be opportunities to acquire smaller institutions in the Pacific Northwest that would enhance our franchise and complement our branch network. Following this recapitalization, we may consider such strategic opportunities to acquire other institutions or branches. We may need to raise more equity or additional capital to implement this strategy.

Competitive Strengths

The Bank has a number of competitive strengths and advantages that position the institution for continued growth.

Established and Well-respected Seattle-based Franchise

We have developed a footprint in the Pacific Northwest, including the highly attractive Puget Sound region in Washington and the greater Portland region in Oregon, as well as selected markets in Hawaii. Through our 90-year history, we have developed a highly skilled and dedicated workforce who understand our business and have long-standing relationships with our customers. Furthermore, we have a strong tradition of involvement in our communities, and promote management participation in charitable, civic and social organizations that we believe enhance the visibility and reputation of the HomeStreet brand in our target markets. We are a leading single family mortgage originator in the markets we serve. For example, according to MortgageDataWeb, www.mortgagedataweb.com, in the Seattle area we had market share rankings of #8 and #6 among originators of conventional and government-sponsored loan programs, respectively, in 2010.

 

 

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Experienced and Talented Management Team

We have assembled an executive management team that possesses significant depth of knowledge and expertise in bank turnaround situations and in operating and growing community banks. Additionally, the Bank has significant depth and experience in its senior management ranks. The five senior managers in our lending units average 33 years of industry experience and average 25 years with the Bank. In our mortgage banking units, each of the managers has built strong working relationships with our investor partners, particularly Fannie Mae. Three managers currently serve on four of Fannie Mae’s primary advisory boards and councils. Our Retail Banking Director has 32 years of industry experience, including 26 years with the Bank. Our Chief Credit Officer, Risk & Regulatory Oversight Director and Treasurer have an average of 24 years of industry experience and 11 years on average with the Bank.

Disciplined Underwriting and Credit Culture

Since 2008, we have made significant modifications to our credit policies and procedures designed to foster disciplined underwriting practices and create a strong credit culture. Our CEO has significant credit management experience, and we have bolstered our credit and underwriting expertise at the board and management levels. We have restructured our credit administration infrastructure to create more oversight at the board level and better manage our loan approval process and credit exposure and have centralized all credit approval, administration and portfolio monitoring functions under the authority of our Chief Credit Officer. We have also revised our lending policies and procedures to reflect more conservative underwriting standards, such as lower loan-to-value ratios and increased cash equity and debt service coverage requirements.

Significant Sources of Noninterest Income

Our noninterest income is substantially higher than traditional banks.

 

   

Highly Profitable Single Family Mortgage Origination and Servicing Business. Throughout the economic downturn, our mortgage origination and servicing business has provided us with a continuing source of profitability and internal capital generation. In 2009, we generated higher relative retail origination revenue per loan (338 basis points) compared to a peer group of regional banks and exceeded the average for independent and large lenders participating in a study conducted by MBA/STRATMOR. Additionally, the study also shows our retail net origination income per loan (161 basis points) was the highest among our peer group and significantly exceeded the average for all independent and large lenders. Our mortgage banking expertise has positioned us well to take advantage of current market conditions. HomeStreet has been primarily a conventional conforming loan originator, making mortgage loans conforming to Fannie Mae, Freddie Mac, and FHA and VA guidelines, supplemented by a small menu of portfolio products. As noted earlier, the Bank has the oldest continuous relationship of all Fannie Mae seller-servicers in the nation. We have been an FHA-approved lender continuously since 1937 and a VA approved lender continuously since its founding in 1944. We possess the product expertise and servicing infrastructure to originate and service government guaranteed loans and specialized products such as 203(k) rehabilitation loans and Department of Hawaiian Home Lands (“DHHL”) loans that require specific product knowledge and servicing expertise. The Bank derives significant competitive benefits from the scale and longevity of WMS, its joint venture with Windermere Real Estate (“Windermere”), the largest real estate brokerage company in the Pacific Northwest by sales volume. A primary benefit is the diversification of loan origination capabilities through mortgage consultants located in Windermere real estate offices, who can reach potential purchase customers and referral sources early in the home-buying process. We also benefit from increased loan production, which improves the efficiency and profitability of our

 

 

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mortgage origination infrastructure and helps us achieve better pricing and terms with Fannie Mae, Freddie Mac and other correspondent lenders. Windermere’s focus on the purchase market adds significantly to volume, loan quality and profits during strong purchase markets.

 

   

Multifamily Mortgage Origination and Servicing Expertise. Fannie Mae granted the Company one of the first DUS licenses and we remain one of only 25 licensees nationally. We are the only organization headquartered in the Pacific Northwest with a DUS license.

 

   

Growth Opportunity in Fee-Generating Banking Services. We are currently expanding our cash management, investment and insurance product and service offerings. We believe our integrated approach to the delivery of these products and services will enhance customers’ sales experience and enable growth in our customer base and fee revenues.

Robust Capital Position

Upon completion of this offering and after contributing $[] million of the net proceeds of this offering to the Bank, we believe we will have the capital necessary to address remaining asset quality issues and will be positioned to capitalize on business opportunities in our target markets. Our pro forma capital ratios will be in excess of the minimum levels to be considered “well capitalized” by our regulators. The table below presents the Bank’s Tier 1 leverage and total risk-based capital ratios, as of December 31, 2010, both actual and on a pro forma basis giving effect to this offering as well as our consolidated pro forma capital ratios reflecting the condition of both the Bank and the Company after giving effect to the proposed offering. It also depicts the median ratio of peer banks in the Pacific Northwest with assets greater than or equal to $1.0 billion.

 

      Pro Forma
Consolidated
     Pro Forma
Bank
     Bank
Actual
     Peer
Median
     Well
Capitalized
 

Tier 1 Leverage Capital Ratio

     10.6%         10.0%         4.5%         10.5%         5.0%   

Total Risk-Based Capital Ratio

     19.8%         17.4%         8.2%         16.6%         10.0%   

Compliance Culture

Historically, we have emphasized compliance in all of our activities. In addition to general banking regulations, our single family lending and loan servicing businesses and our investment advisory and product sales businesses are subject to complex regulations. In particular, our single family mortgage and multifamily origination and servicing businesses are highly dependent upon successful compliance with underwriting and servicing guidelines of Fannie Mae, Freddie Mac and Ginnie Mae as well as a myriad of federal and state consumer compliance regulations. Additionally, our significant volume of lending to low- and moderate-income areas and direct community investment contribute to our uninterrupted record of “outstanding” CRA ratings since the inception of the Bank in 1986. The financial services industry generally, and the single family mortgage banking industry in particular, is experiencing consolidation caused, in part, by the ever-increasing operational and cost burden of compliance. We believe our ability to maintain our historically strong regulatory compliance culture and our track record of compliance with regulations and guidelines are significant competitive advantages.

 

 

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Our Structure

HomeStreet, Inc. was established in 1921 as Continental Mortgage and Loan Company, initially offering financing for commercial real estate and home mortgages. Continental Savings Bank was established in 1986 and changed its name to HomeStreet Bank in 2000. Our activities are conducted through the following consolidated subsidiaries:

LOGO

 

   

HomeStreet, Inc. operates a personal lines insurance agency offering home, auto, life, umbrella, boat, motorcycle, recreational vehicle, earthquake, difference in conditions and notary bond insurance products. It is licensed to do business in Washington and Oregon under the name “HomeStreet Insurance” and is licensed to do business in Hawaii for life insurance only.

   

HomeStreet Bank, a regional state-chartered savings bank headquartered in Seattle, Washington.

   

We hold common securities in four statutory business trusts, which have, in turn, issued trust preferred securities. We have previously commenced tender offers for all of the outstanding trust preferred securities issued by these trusts; however, we recently terminated those tender offers. See “Dividend Policy” below for a further description of the trust preferred securities.

   

HomeStreet Capital Corporation has been selling and servicing multifamily residential loans made through the Fannie Mae DUS program since 2000.

   

Union Street Holdings LLC, a Washington limited liability company holds title to, markets and disposes of real estate acquired through foreclosure.

   

HomeStreet Reinsurance, Ltd. was established in 2000 as a limited-purpose reinsurance company. It is incorporated in the Turks and Caicos Islands and reinsures private mortgage insurance solely with respect to mortgage loans originated by the Bank. We discontinued all new reinsurance business at the end of 2008 and we are monitoring market conditions to determine if and when we will begin writing new reinsurance risk.

   

Continental Escrow Company provides reconveyance services solely for the Bank in connection with deeds of trust on one-to-four family residential loans, or single family residential loans, originated by the Bank.

   

HomeStreet/WMS, Inc. holds a joint venture interest in Windermere Mortgage Services Series LLC, or WMS. The remaining equity interest in WMS is held by certain franchisees of Windermere Real Estate Services Company, the largest real estate brokerage companies in the Pacific Northwest by sales volume. Through WMS, we provide point-of-sale loan origination services in 44 Windermere Real Estate offices in Washington and Oregon.

 

 

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Risk Factors

An investment in our common stock involves certain risks. You should carefully consider the risks described under “Risk Factors” beginning on page 18 of this prospectus as well as other information included in this prospectus, including our financial statements and the notes thereto, before making an investment decision.

Corporate Information

Our principal executive offices are located at 601 Union Street, Suite 2000, Seattle, WA 98101. Our telephone number is (206) 623-3050. Our Internet address is www.homestreet.com. The information on our website does not constitute a part of this prospectus.

 

 

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The Offering

 

Common stock offered

[] shares of our common stock(1)

 

Common stock to be outstanding after this offering

[] shares of our common stock(2)

 

Price per share of our common stock

$[]

 

Use of Proceeds

We estimate that we will receive net proceeds from this offering of approximately $[], assuming no exercise of the over-allotment option and after deducting the underwriters’ discounts and commission and estimated offering expenses payable by us. We intend to contribute $[] million of the net proceeds of this offering to the Bank for increased capital, balance sheet growth, expanding operations through new branch offices and the Bank’s general corporate purposes, and to use the remainder for the Company’s general corporate purposes. See “Use of Proceeds.”

 

Dividends

We do not intend to pay cash dividends on our common stock in the near future and the Orders prohibit the payment of dividends. Any determination to pay dividends in the future will be at the discretion of our board of directors and will depend upon our earnings, financial condition, results of operations, capital requirements, regulatory restrictions, contractual restriction and other factors that our board of directors may deem relevant. Any dividends paid by us would be subject to various federal and state regulatory limitations as well as the ability of the Bank to pay dividends to us. See “Dividend Policy.”

 

Ownership Restrictions

The acquisition of 10.0% or more of the voting stock of a savings association or its holding company may, under certain circumstances, constitute the acquisition of control under OTS guidelines. An investor wishing to acquire and hold more than 10.0% of our common stock after this offering may be required to file a change of control application with the OTS that would need to be approved before such investor could acquire more than 10.0% of our common stock. See “Description of Capital Stock.”

 

Proposed Nasdaq symbol

We have applied for listing of our common stock on the Nasdaq Global Market under the symbol “HMST.”

 

Risk Factors

Investment in our common stock involves risk. See “Risk Factors” beginning on page 18 and other information included in this prospectus for a discussion of factors you should consider carefully before deciding whether to invest in shares of our common stock.

 

(1) Assumes the underwriter’s option to purchase up to an additional [] shares of our common stock to cover over-allotments is not exercised.

 

(2) The number of shares of our common stock to be outstanding after this offering excludes (a) a number of shares equal to 10.0% of the number of our issued and outstanding shares of common stock following the closing of this offering on a fully diluted basis, which shares will be issuable upon exercise of options not yet granted under our 2010 stock option plan, and (b) [] shares of our common stock issuable to our non-employee directors under a director equity compensation plan to be implemented following the closing of this offering.

 

 

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FORWARD-LOOKING STATEMENTS

This prospectus, including statements under “Summary,” “Risk Factors,” “Dividend Policy,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business” and elsewhere, contains forward-looking statements concerning the Company, the Bank, and their respective subsidiaries, operations, performance, financial conditions and likelihood of success. Forward-looking statements are based on many beliefs, assumptions, estimates and expectations of our future performance, taking into account information currently available to us, and include statements about the competitiveness of the banking industry. When used in this prospectus, the words “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “should,” “will” and “would” and similar expressions (or the negative of these terms) generally identify forward-looking statements. Statements regarding the following subjects, among others, are forward-looking by their nature:

 

   

our business strategy and projected operating results;

 

   

our ability to effectively implement and manage our turnaround plan;

 

   

the removal of the Orders, including the date by which the Orders will be removed, if at all;

 

   

our ability to effectively use the proceeds of this offering;

 

   

our ability to grow, including managing that growth;

 

   

the quality of our loan and investment portfolios;

 

   

our ability to compete in the marketplace;

 

   

market trends; and

 

   

projected capital and operating expenditures.

Our beliefs, assumptions and expectations can change as a result of many possible events or factors, not all of which are known to us or within our control. If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements. You should carefully consider these risks before you make an investment decision with respect to our common stock, along with, among others, the following factors that could cause actual results to vary from our forward-looking statements:

 

   

the factors referenced in this prospectus, including those set forth under the sections captioned “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business”;

 

   

our ability to manage the credit risks of our lending activities, including potential increases in loan delinquencies, nonperforming assets and write offs, decreased collateral values, inadequate loan reserve amounts and the effectiveness of our hedging strategies;

 

   

general economic conditions, either nationally or in our market area, including a continuation or worsening of the housing market, employment trends, business contraction, consumer confidence, real estate values and other recessionary pressures;

 

 

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changes in the levels of general interest rates, deposit interest rates, our net interest margin and funding sources;

 

   

potential changes in interest rates which may affect demand for our products as well as the success of our interest rate risk management strategies;

 

   

compliance with regulatory requirements, including new laws and regulations such as the Dodd-Frank Act as well as restrictions that may be imposed by the OTS, the FDIC, the DFI, the Federal Reserve Board or other regulatory authorities pursuant to the cease and desist orders or other discretionary enhanced supervision which could adversely affect our capital, liquidity and earnings;

 

   

our ability to control costs while meeting operational needs and retaining key members of our senior management team and other key managers and business producers;

 

   

the possibility of a significant reduction in our mortgage banking profitability if we are not able to or are limited in our ability to resell mortgages; and

 

   

increased competition in our industry due in part to consolidation.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this prospectus. We are not obligated to update any forward-looking statements, whether as a result of new information, future events or otherwise.

In addition, this prospectus contains market and industry data that we have obtained from independent industry sources and publications, as well as from research and third-party and governmental reports and publications prepared for other purposes. Although we believe that these sources are reliable, we have not independently verified the data obtained from these sources, and neither we nor the underwriter can assure you of the accuracy or completeness of the data. Forecasts and other forward-looking information obtained from these sources are subject to the same qualifications and the additional uncertainties regarding the other forward-looking statements in this prospectus.

Nothing contained in this prospectus is, or should be relied upon as, a promise, a guaranty or representation as to our future performance. You may lose some or all of your investment if you invest in our common stock.

NON-GAAP FINANCIAL MEASURES

In this prospectus, we sometimes use certain non-GAAP financial measures as a supplemental measure of our performance that is not required by, or presented in accordance with, accounting principles generally accepted in the United States (“GAAP”). Examples of non-GAAP measures used in this prospectus include certain profitability, performance and asset quality ratios.

These are not a measurement of our financial performance or condition under GAAP and should not be considered in isolation or as an alternative to net income or any other performance measure derived in accordance with GAAP or as an alternative to cash flows from operating activities as a measure of our liquidity.

 

 

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Summary Selected Historical Consolidated Financial and Other Data

The following table sets forth selected historical consolidated financial and other data for us at and for each of the periods ended as described below. The selected historical consolidated financial data as of December 31, 2010 and 2009 and for each of the years ended December 31, 2010, 2009 and 2008 have been derived from, and should be read together with, our audited consolidated financial statements and related notes included elsewhere in this prospectus. The selected historical consolidated financial data as of December 31, 2008, 2007 and 2006 for each of the years ended December 31, 2007 and 2006 have been derived from our audited consolidated financial statements for those years, which are not included in this prospectus.

You should read the summary selected historical consolidated financial and other data presented below in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and the notes thereto, which are included elsewhere in this prospectus.

Our historical consolidated financial results may not be indicative of our future performance.

 

 

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     December 31,  
     2010 (1)     2009     2008     2007     2006  
(in thousands, except share data)                               

Income Statement Data (for the period ended):

          

Net interest income

   $ 39,034      $ 31,502      $ 75,885      $ 90,037      $ 86,779   

Provision for loan losses

     37,300        153,515        34,411        10,955        6,471   

Noninterest income

     96,931        59,230        40,345        23,298        19,313   

Noninterest expense

     132,215        94,448        70,189        71,253        68,131   
                                        

Net (loss) income before taxes

     (33,550     (157,231     11,631        31,127        31,490   

Income taxes

     697        (46,955     3,202        10,663        10,173   
                                        

Net (loss) income

   $ (34,247   $ (110,276   $ 8,429      $ 20,464      $ 21,317   
                                        

Basic (loss) earnings per common share

   $ (10.14   $ (32.65   $ 2.50      $ 6.06      $ 6.30   

Diluted (loss) earnings per common share

   $ (10.14   $ (32.65   $ 2.50      $ 6.04      $ 6.24   

Shareholders’ equity per share

   $ 17.41      $ 27.21      $ 61.03      $ 58.80      $ 53.36   

Dividends per share

   $      $      $ 0.90      $ 0.90      $ 0.85   

Financial position (at year end):

          

Cash and cash equivalents

   $ 72,639      $ 217,103      $ 270,577      $ 43,635      $ 53,972   

Investment securities available for sale

     313,513        657,840        56,337        111,621        115,327   

Loans held for sale

     212,602        57,046        48,636        77,969        67,914   

Loans held for investment, net

     1,538,521        1,964,994        2,425,887        2,428,214        2,067,247   

Mortgage servicing rights

     87,232        78,372        57,699        53,422        50,270   

Other real estate owned

     170,455        107,782        20,905        1,974        1   

Total assets

     2,485,697        3,209,536        2,958,911        2,793,935        2,428,054   

Deposits

     2,129,742        2,332,333        1,923,616        1,717,681        1,536,768   

FHLB advances

     165,869        677,840        705,764        746,386        575,063   

Shareholder Equity

     58,789        91,895        206,103        198,052        180,322   

Financial position (averages):

          

Investment securities available for sale

     457,930        372,320        119,720        113,333        133,424   

Loans held for investment

     1,868,039        2,307,215        2,519,811        2,239,639        1,901,996   

Total interest earning assets

     2,642,693        3,056,755        2,762,723        2,435,145        2,103,862   

Total interest bearing deposits

     2,071,237        2,012,971        1,557,533        1,452,742        1,255,402   

FHLB advances

     382,083        685,715        734,989        617,225        520,881   

Total interest bearing liabilities

   $ 2,522,767      $ 2,776,163      $ 2,485,786      $ 2,170,807      $ 1,863,969   

Financial performance:

          

Return on average common shareholder equity (2)

     (38.00 %)      (68.90 )%      4.14     10.74     12.54

Return on average assets

     (1.19 %)      (3.47 )%      0.29     0.79     0.96

Net interest margin (3)

     1.49     1.04     2.78     3.68     4.16

Efficiency ratio (4)

     97.24     104.10     60.39     62.87     64.22

Operating efficiency ratio (5)

     73.56     92.55     59.06     62.82     64.17

Credit quality:

          

Allowance for loan losses

   $ 64,177      $ 109,472      $ 58,587      $ 38,804      $ 27,834   

Allowance/Total loans

     4.00     5.28     2.36     1.57     1.33

Total classified assets

   $ 363,945      $ 570,010      $ 376,424      $ 114,797      $ 34,418   

Classified assets/total assets

     14.64     17.76     12.72     4.11     1.42

Total nonaccrual loans (6)

   $ 113,210      $ 374,219      $ 75,385      $ 33,757      $ 3,361   

Nonaccrual loans/Total loans

     7.06     18.03     3.03     1.37     0.06

Total nonperforming assets

   $ 283,665      $ 482,000      $ 96,291      $ 35,732      $ 3,362   

Nonperforming assets/total assets

     11.41     15.00     3.25     1.28     0.05

Net charge-offs

   $ 83,156      $ 101,680      $ 14,628      $ (15   $ 117   

Regulatory capital ratios for the bank:

          

Tier 1 capital to total assets (leverage)

     4.5     4.5     8.7     9.0     9.9

Tier 1 risk-based capital

     6.9     7.2     10.5     9.9     11.0

Total risk-based capital

     8.2     8.5     11.8     11.2     12.3

SUPPLEMENTAL DATA:

          

Loans serviced for others:

          

Single family

   $ 6,343,158      $ 5,820,946      $ 4,695,804      $ 3,775,362      $ 3,389,050   

Multifamily

     776,671        810,910        822,512        715,946        729,715   

Other

     58,765        69,839        74,230        77,329        53,682   
                                        

Total loans serviced for others

   $ 7,178,594      $ 6,701,695      $ 5,592,546      $ 4,568,637      $ 4,172,447   
                                        

Loan origination activity:

          

Single family

   $ 2,069,144      $ 2,727,457      $ 1,735,897      $ 1,568,834      $ 1,445,218   

Other

     120,058        124,433        817,438        1,332,147        1,650,072   
                                        

Total loan origination activity

   $ 2,189,202      $ 2,851,890      $ 2,553,335      $ 2,900,981      $ 3,095,290   
                                        

 

 

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(1) On January 1, 2010, we elected to carry mortgage servicing rights related to single family loans at fair value, and elected to carry single family mortgage loans held for sale using the fair value option.

 

(2) Net earnings (loss) available to common shareholders divided by average common shareholders’ equity.

 

(3) Net interest income divided by total average earning assets on a tax equivalent basis.

 

(4) The efficiency ratio is noninterest expense divided by total revenue (net interest income and noninterest income).

 

(5) We include an operating efficiency ratio which is not calculated based on accounting principles generally accepted in the United States (“GAAP”), but that we believe provides important information regarding our result of operations. Our calculation of the operating efficiency ratio is computed by dividing noninterest expense less costs related to OREO (gains (losses) on sales, valuation allowance adjustments, and maintenance and taxes) by total revenue (net interest income and noninterest income). Management uses this non-GAAP measurement as part of its assessment of performance in managing noninterest expense. We believe that costs related to OREO are more appropriately considered as credit-related costs rather than as an indication of the operating efficiency of the Company.

 

(6) Generally, loans are placed on nonaccrual status when they are 90 or more days past due.

 

 

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RISK FACTORS

An investment in our common stock is speculative and involves a high degree of risk. The risks described below represent some of the material risks you should carefully consider before making an investment decision. If any of these risks occur, our business, capital, liquidity, financial condition and results of operations could be materially and adversely affected, in which case the price of our common stock could decline significantly and you could lose all or a part of your investment. The risk factors described below are not the only risks that may affect us. Additional risks and uncertainties not presently known to us, or that we currently deem immaterial, may also become important factors that materially adversely affect our business, capital, liquidity, financial condition and results of operations. You should carefully consider the following risk factors, together with the other information contained in this prospectus, before purchasing our common stock.

Risks Related to our Business

We are operating under cease and desist orders from the OTS, the FDIC and the DFI that prohibit us, among other things, from paying dividends without the consent of our regulators and that place other limitations and obligations on the Company and Bank. We are not in full compliance with the Bank Order, and noncompliance may subject us to additional enforcement action.

On May 8, 2009, the Bank consented to the issuance by the FDIC and the DFI of a supervisory order, which we refer to as the Bank Order, following a review of the Bank’s financial and lending data. The Bank Order alleges that the Bank had engaged in certain unsafe or unsound banking practices and had violated federal and state law and/or regulations, and orders the Bank to cease and desist from certain practices relating to poor management, inadequate board oversight, inadequate liquidity and capital for our assets, excessive poor quality loans, operating losses and failure to comply with certain laws or regulations.

The Bank Order places certain restrictions on the Bank, including, but not limited to, prohibiting cash dividends and limiting our ability to solicit or renew brokered deposits and to extend additional credit to borrowers who have outstanding, uncollected loans or credit agreements that have been charged off or classified as a “Loss.” Additionally, the Bank cannot extend additional credit to any borrower with outstanding, uncollected loans or credit agreements that have been classified as “Substandard” or “Doubtful” without prior approval of a majority of the Bank’s board of directors or the credit committee of the board. Moreover, the Bank Order requires the Bank to adopt and adhere to certain policies relating to, among other things, reduction of classified assets and reliance on noncore funding sources.

The Bank Order also requires the Bank to take certain affirmative actions, including, but not limited to, increasing the Bank’s Tier 1 and risk-based capital ratios to specified levels, improving lending and collection policies, reducing outstanding commercial real estate and acquisition, development and construction loans, reducing the level of classified assets, and retaining qualified management. At December 31, 2010, the Bank was not in compliance with the Bank Order in two areas. The first is the requirement to achieve and thereafter maintain a Tier I capital ratio of at least 10.0% and a risk-based capital ratio of at least 12.0%. Second, while we met the terms of the Bank Order by submitting a plan for the reduction of adversely classified loans on the Bank’s books as of December 31, 2008, we did not meet the Bank Order’s requirement to fully comply with the plan. The plan contained a target reduction of the specified adversely classified assets to 40.0% of risk based capital by February 28, 2010, which was not achieved. At February 28, 2010, the level of adversely classified assets to risk-based capital was 91.6%. At December 31, 2010, this ratio was 77.9%.

While we have complied with the additional requirement of the Bank Order to develop and submit a plan for reducing our commercial real estate and land acquisition and development and construction loans, we did not achieve our internally established targets of 355.0% of risk-based capital and 178.0% of risk-based capital, respectively, as of December 31, 2010.

 

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We are also operating under an order to cease and desist issued by the OTS on May 18, 2009, which we refer to as the Company Order (and together with the Bank Order, the Orders), which requires the Company to refrain from engaging in all unsafe and unsound practices that have resulted in the operation of HomeStreet, Inc. with low earnings and inadequate capital. The Company Order requires the consent of the OTS for the Company to pay dividends, make capital distributions, incur, issue, renew, repurchase, make payments on or roll over any debt (including our trust preferred securities, or “TruPS”), increase any current lines of credit, guarantee the debt of any entity, make certain severance or indemnification payments and make any change in directors or senior executive officers without the prior approval of the OTS.

Pursuant to the Company Order, we have developed a plan to manage our liquidity, capital and risk profile, and to address our financial obligations, including interest payments on the TruPS, without relying on dividends from the Bank for 2009 through 2011. The Company Order will remain in effect until terminated, modified or suspended by the OTS. We believe we are currently in compliance with the Company Order.

Because of the restrictions contained in Orders, we may be limited in our ability to take certain actions and pursue certain operating strategies that might otherwise have resulted in greater benefits to our earnings and results of operations. Moreover, both the pendency of the Orders and the circumstances that gave rise to their issuance may place other limitations on our business, such as making it more difficult to attract and retain depositors, increasing the burdens required to satisfy our contractual obligations and increasing our operating and general and administrative expenses. In addition, failure to comply with these regulatory actions or any future actions could result in further regulatory actions or restrictions, including monetary penalties and the potential closure of the Bank. The Orders are described in more detail in this prospectus under “Regulation and Supervision — Cease and Desist Orders.” For a summary of additional restrictions that may be placed on the Bank, see “Regulation and Supervision — Regulation of HomeStreet Bank — Capital and Prompt Corrective Action Requirements.”

Our auditor’s opinions on our 2009 and 2010 financial statements include a “going concern” emphasis paragraph.

Our consolidated financial statements have been prepared assuming that the Company will continue as a going concern. Accordingly, our consolidated financial statements do not include any adjustments to reflect the possible future effects that may result from the outcome of various uncertainties as discussed below.

The effects of the severe economic contraction caused HomeStreet to incur net losses for the years ended December 31, 2010 and 2009. HomeStreet and the Bank are operating under significant regulatory restrictions including a requirement to achieve certain capital requirements, enhance liquidity and improve assets. In response, management is conducting this offering in order to raise capital to meet the requirements of the Orders.

Based upon its plans and expectations, management believes HomeStreet has sufficient capital and liquidity to achieve realization of assets and the discharge of liabilities in the normal course of business. However, uncertainties exist as to future economic conditions, regulatory actions and the successful implementation of plans to improve our financial condition and meet the requirements of the Orders. These circumstances raise substantial doubt about our ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might result from the lack of success in implementing our plans or the occurrence of other events that could adversely affect its condition or operations.

We may be subject to continuing enhanced supervision by our regulators even if we achieve compliance with the cease and desist orders.

Following the completion of this offering and our contribution of capital to the Bank of a substantial portion of the net proceeds, we expect that the Bank will achieve capital ratios that exceed the minimum ratios required

 

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under the Bank Order. However, we cannot guarantee that we will continue to meet our capital requirements under the Bank Order or that we will not suffer additional increases in classified assets or other adverse developments in the foreseeable future. If we do not meet the capital requirements of the Bank Order, due to continued adverse consequences from the downturn in real estate and the capital markets or otherwise, our regulators may continue to monitor our business more closely and may keep in effect all or some of the existing restrictions or adopt new or additional restrictions on our operations. Such restrictions could limit our ability to grow our earning assets, increase our operating expenses and make it more difficult to raise additional capital if needed in the future. Any such measures, if taken, may have an adverse effect upon the value of our common stock. Even if we are able to restore our capital ratios to the level required by the Bank Order, we may be subject to additional supervision and restrictions imposed by the regulatory authorities. Other banks that have had cease and desist orders similar to ours often have subsequently been required to enter into informal supervisory agreements with the FDIC and the DFI. These arrangements have included increased capital requirements and asset quality targets, restrictions on payment of dividends and indebtedness, limits on appointment and compensation of directors and senior executive officers and other limitations on operations. As a result, we may face continuing restrictions on our operations and increased compliance costs even if we are successful in getting the Orders lifted.

We expect to maintain capital levels higher than many of our peers did before the financial crisis which may cause us to be less profitable.

The Orders require us to maintain capital levels in excess of what would normally be required for an adequately capitalized or well capitalized bank, and significantly above the levels maintained by many of our peers prior to the financial crisis. If the Orders are lifted, we expect to maintain capital levels higher than those that may be required of some of our peers, in part because we expect to be subject to continued enhanced regulatory oversight that may mandate such increased capital levels. While decreasing our leverage by maintaining higher capital levels will cause us to be less sensitive to adverse economic changes in our markets, it will also result in lower profits for the Company as we will not be able to grow our lending as quickly as we might otherwise be able to do if we were to maintain lower capital levels.

We have incurred substantial losses and cannot assure you that we will become profitable.

Our profitability depends primarily on our ability to originate loans and either sell them into the secondary market or hold them in our loan portfolio and collect interest and principal as they come due. When loans become nonperforming or their ultimate collection is in doubt, our income is adversely affected. Our provisions for loan losses of $34.4 million in the year ended December 31, 2009, $153.6 million in the year ended December 31, 2009 and $37.3 million in the year ended December 31, 2010, and our net interest income has declined, reflecting the significant increase in our nonaccrual loans. This resulted in net income of $8.4 million in 2008 and net losses of $110.3 million and $34.2 million being reported for the years ended December 31, 2009 and 2010, respectively. Our ability to return to profitability will significantly depend on the successful resolution of nonperforming assets and the subsequent stabilization of our loan portfolio, the timing and certainty of which cannot be predicted. No assurance can be given that we will be successful in such efforts.

HomeStreet, Inc. primarily relies on dividends from the Bank and payment of dividends by the Bank is restricted under the Orders.

HomeStreet, Inc. is a separate legal entity from the Bank, and although we do receive some dividends from HomeStreet Capital, the primary source of our funds from which we service our debt, pay dividends and otherwise satisfy our obligations is the receipt of dividends from the Bank. The availability of dividends from the Bank is limited by various statutes and regulations. Depending upon the financial condition of the Bank and other factors, the applicable regulatory authorities could assert that payment of dividends or other payments, including payments to us, is an unsafe or unsound practice. In this regard, the Bank Order

 

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currently prohibits the Bank from paying dividends to us without the prior written approval of the FDIC and the DFI. If the Bank’s ability to pay dividends continues to be restricted or is restricted in the future, we may be limited in our ability to service our debts and fund operations.

Our turnaround plan has been designed and is being implemented by our new executive management team in a period of unpredictable market conditions, and there can be no assurance that the turnaround plan can be implemented with positive or the anticipated results or on the schedule forecasted by management.

In 2009, the Company recruited and retained a new executive management team who designed and are implementing a turnaround plan for the Company to address its weakened financial condition. The success of this turnaround plan depends in part on the ability of our new management team to implement the plan and on economic conditions in our markets, which in recent years have been and continue to be unpredictable. A worsening of current economic indicators, such as real estate property values and continued high unemployment, will slow, limit or otherwise negatively affect the success of the turnaround plan. In addition, the executive management team responsible for implementing the turnaround plan is relatively new to the Company and may not have anticipated all of the issues that may face the Company and its geographic marketplace with regard to the plan. As a result, there can be no assurance that the turnaround plan can be implemented with positive or the anticipated results or on the schedule forecasted by management.

Difficult market conditions have adversely affected and may continue to have an adverse effect on our business.

Since late 2008, the capital and credit markets have experienced difficulty stemming in part from dramatic declines in the housing market, increasing foreclosures and rising unemployment. These difficulties have negatively impacted residential and commercial real estate values and the performance of mortgage, residential construction and other loans and required significant write-downs of asset values by financial institutions. As a result, many financial institutions, including the Company and the Bank, have been faced with the choice of seeking additional capital, merging with stronger institutions or failing. Many lenders and institutional investors have curtailed lending due to concern for the stability of the market, including lending to other financial institutions. This market turmoil and tightening of credit have led to an increased level of loan defaults and delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally, all of which has adversely affected our business, financial condition and results of operations. We expect that these difficult conditions in the financial markets will improve, if at all, slowly, and that a worsening of these conditions may prolong or exacerbate the adverse effects already felt by us and the rest of the financial institutions industry. In particular, we may face risks related to market conditions that may negatively impact our business opportunities and plans, such as:

 

   

uncertainty related to increased regulation and enforcement in the financial sector, including increased costs of compliance;

 

   

the models we use to assess the creditworthiness of our customers may become less reliable in predicting future behaviors which may impair our ability to effectively make underwriting decisions;

 

   

challenges in accurately estimating the ability of our borrowers to repay their loans if our forecasts of economic conditions and other economic predictions are not accurate;

 

   

further increases in FDIC insurance premiums due to additional depletion of that agency’s insurance funds;

 

   

restrictions in our ability to engage in routine funding transactions due to the commercial soundness of other financial institutions and government sponsored entities; and

 

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increased competition from further consolidation in the financial services industry.

If recovery from the economic recession slows or if we experience another recessionary dip, our ability to access capital and our business, financial condition and results of operations may be adversely impacted.

Adverse economic conditions in the Pacific Northwest and other regions where we have operations have caused and could continue to cause us to incur losses.

Our mortgage banking and retail and commercial banking operations are currently concentrated in the Puget Sound area of Washington, and to a lesser extent, the Vancouver, Washington and Portland, Oregon regions and Hawaii. We also have lending offices in Spokane and Aberdeen, Washington, and Salem, Oregon. As a result of this geographic concentration, our results of operations currently depend largely upon economic conditions in these areas. Deterioration in economic conditions in these markets, including decreasing real estate values and sales and increasing unemployment and commercial real estate vacancy rates, are having and may continue to have a material adverse impact on the quality of our loan portfolio and the demand for retail and commercial banking products and services. In particular, the economic slowdown in our markets has resulted in many of the following conditions, which have had, and may continue to have, an adverse impact on the Bank’s business:

 

   

an increase in loan delinquencies, problem assets and foreclosures;

 

   

a decline in the demand for products and services, including a material reduction in the volume of our single family purchase loan transactions and commercial real estate loan transactions;

 

   

a decline in the value of loan collateral, especially real estate, which in turn may reduce customers’ borrowing power;

 

   

a decline in the demand for loans; and

 

   

a decline in the origination of loans, especially residential construction, income property and business banking loans.

Each of these conditions has had and may continue to have a material adverse effect on our results of operations, including but not limited to a decrease in fee income and net interest income.

In addition, as a result of the significant deterioration in economic conditions in our markets, our loan portfolio suffered substantial deterioration during 2008, 2009 and 2010. During 2010, we experienced continuing high provisions for loan losses and charge-offs but at a declining rate in comparison to 2009. Total “classified assets,” which comprise the outstanding balance of all loans classified as substandard or doubtful and the carrying value of all other real estate owned (“OREO”), totaled $363.9 million, or 14.6% of total assets, as of December 31, 2010. We had an additional $156.5 million, or 6.3% of total assets, of “special mention” assets. At December 31, 2010, our nonaccrual loans totaled $113.2 million, or 7.0% of gross loans. No assurance can be given that additional loans will not be added to “classified” or “special mention” status or that existing classified or special mention loans will not migrate into lower classifications and that additional provisions for loan losses may not be required. Additionally, we cannot assure you that we can foreclose on and sell real estate collateral without incurring additional losses.

A substantial portion of our revenue is derived from residential mortgage and residential construction and land lending which are market sectors that have experienced significant volatility.

Approximately 66.0% and 58.1% of our consolidated revenues (interest income plus noninterest income) in 2010 and 2009, respectively, were derived from originating, selling and servicing residential mortgages, and

 

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approximately 28.5% and 24.9% of our consolidated total assets as of the end of each of those years, respectively, represented residential mortgage loans held for investment. An additional 3.4% and 8.2% of our revenues in 2010 and 2009, respectively, were derived from residential construction and land lending, and as of December 31, 2010, residential construction loans represented 5.7% of our consolidated total assets. Residential mortgage lending in general, and residential construction and land lending in particular, has experienced substantial volatility in recent years, and each of our primary geographic market areas has recorded more significant declines in real estate values and higher levels of foreclosures and mortgage defaults than the national averages for those statistical categories. Were these trends to be protracted or exacerbated, our financial condition and result of operations may be affected materially and adversely.

The significant concentration in our portfolio of real estate secured loans has had and may continue to have a negative impact on our asset quality and profitability as a result of continued or worsening conditions on the real estate market and higher than normal delinquency and default rates.

Substantially all of our loans are secured by real property. As of December 31, 2010, 94.8% of all of our outstanding loans, totaling $1.52 billion, were secured by real estate, including $526.5 million in single family residential loans, $426.9 million in commercial real estate loans (including $133.7 million in owner-occupied loans underwritten based on the cash flows of the business), $104.5 million in multifamily residential loans, $285.1 million in construction and land development loans and $181.5 million in home equity loans.

Our real estate secured lending is generally sensitive to regional and local economic conditions, making loss levels difficult to predict. Declines in real estate sales and prices, as well as the adverse impacts of the economic slowdown and recession and an associated increase in unemployment, have resulted in higher than expected loan delinquencies and foreclosures, problem loans and OREO, net charge-offs and provisions for credit and OREO losses. We may continue to incur losses and may suffer additional adverse impacts to our capital ratios and our business. If the significant decline in market values continues, the collateral for our loans will provide less security and our ability to recover the principal, interest and costs due on defaulted loans by selling the underlying real estate will be diminished, leaving us more likely to suffer additional losses on defaulted loans. Such declines may have a greater effect on our earnings and capital than on the earnings and capital of financial institutions whose loan portfolios are more diversified.

Continued or worsening conditions in the real estate market and higher than normal delinquency and default rates on loans could cause other adverse consequences for us, including:

 

   

the reduction of cash flows and capital resources, as we are required to make cash advances to meet contractual obligations to investors, process foreclosures, and maintain, repair and market foreclosed properties;

 

   

declining mortgage servicing fee revenues because we recognize these revenues only upon collection;

 

   

increasing loan servicing costs;

 

   

declining fair value on our mortgage servicing rights; and

 

   

declining fair values and liquidity of securities held in our investment portfolio that are collateralized by mortgage obligations.

 

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Our loans held for investment have historically been concentrated in construction and residential land acquisition, development and construction loans which have a higher risk of loss than residential mortgage loans and we have experienced increased delinquencies and loan losses related to those loans.

Construction and residential land acquisition, development and construction loans (“ADC loans”) represented 17.8% and 30.4% of our total loan portfolio at December 31, 2010 and 2009. Such loans represented 58.3% and 79.1% of our non performing loans at those dates. In 2010 and 2009, 82.5% and 80.7% of our charge-offs came from construction and ADC loans. If current downward trends in the housing and real estate markets continue, we expect that we will continue to experience increased delinquencies and credit losses from these loans. An increase in our delinquencies and credit losses would adversely affect our financial condition and results of operations, perhaps materially.

Our allowance for loan losses may prove inadequate or we may be negatively affected by credit risk exposures. Future additions to our allowance for loan losses will reduce our earnings.

Our business depends on the creditworthiness of our customers. As with most lending institutions, we maintain an allowance for loan losses to provide for defaults and nonperformance, which is a reserve established through a provision for loan losses charged to expense that represents management’s best estimate of probable incurred losses inherent in the loan portfolio. Such allowance may not be adequate to cover actual losses, and future provisions for losses could adversely affect our financial condition, results of operations and cash flows.

The level of the allowance for loan losses reflects management’s continuing evaluation of specific credit risks and loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions, industry concentrations and other unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and judgment and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Generally, our nonperforming loans and OREO reflect operating difficulties of individual borrowers and weaknesses in the economies of the markets we serve.

If the credit quality of our customer base materially decreases, if the risk profile of a market, industry or group of customers changes materially or if our allowance for loan losses is not adequate, our business, financial condition, including our liquidity and capital, and results of operations could be materially adversely affected. A significant source of risk arises from the possibility that we could sustain losses caused by the failure of borrowers, guarantors and related parties to perform in accordance with the terms of their respective loans. The underlying credit monitoring polices and procedures that we have adopted to address this risk may not prevent unexpected losses that could have a significant adverse effect on our financial condition, results of operations and cash flows. Unexpected losses may arise from a variety of specific systematic factors, many of which are beyond our ability to predict, influence or control.

Subsequent evaluations of our loan portfolios may reveal that estimated levels of loss frequency and or severity used in determining the allowance for loan losses differed significantly from actual experience, and in such circumstances we may have to record an increased provision for loan losses in subsequent periods, thereby reducing earnings in those periods. As an integral part of the examination process, our independent accountants, federal and state regulatory agencies all review our loans, loan-related commitments and allowance for loan loss methodology. While we believe that our allowance for loan losses is adequate to cover losses inherent in the Bank’s loan portfolios, we cannot guarantee that we will not need to increase further the allowance for loan losses or that regulators will not require such an increase. An increase in the level of loan loss allowance, whether voluntary or compelled by regulators, may have a material adverse effect on our financial condition, results of operations and cash flows.

 

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Nonperforming assets take significant time to resolve and adversely affect our financial condition and results of operations.

At December 31, 2010, nonperforming loans totaled $113.2 million, or 7.0% of our total loan portfolio. At December 31, 2010, our nonperforming assets (which include OREO) were $283.7 million, or 11.4% of our total assets. In addition, we had approximately $43.5 million in loans that were 90 or more days past due and still accruing and $21.6 million in loans 30 to 89 days delinquent. Until economic and market conditions improve, we may continue to incur additional losses relating to an increase in nonperforming assets. We do not record interest income on nonaccrual loans, which adversely affects our income. Additionally, higher levels of nonperforming assets increase our loan administration and legal expenses.

In addition, when we take possession of collateral through foreclosure or other similar proceedings, we are required to record the related collateral at the then fair value of the collateral less selling costs, which may result in a loss. Nonperforming assets increase our risk profile and the level of capital we and our regulators believe is adequate in light of such risks. Impairment of the value of these assets, the value of the underlying collateral, the liquidity and net worth of guarantors, or our borrowers’ performance or financial conditions, whether or not due to economic and market conditions beyond our control, have adversely affected, and may continue to adversely affect, our business, results of operations and financial condition. See discussion below regarding additional risks associated with other real estate owned.

Our OREO may be subject to additional impairment and expense associated with ownership, and such properties may ultimately be sold at below appraised values.

Real estate owned by the Bank and not used in the ordinary course of its operations is referred to as other real estate owned, or OREO. We foreclose on and take title to the real estate collateral for defaulted loans as part of our business. We obtain appraisals on these assets prior to taking title to the properties and periodically thereafter. However, due to the rapid and severe deterioration in our markets, there can be no assurance that such valuations will reflect the amount which may be paid by a willing purchaser in an arms-length transaction at the time of the final sale. Moreover, we cannot assure investors that the losses associated with OREO will not exceed the estimated amounts, which would adversely affect future results of our operations. The calculation for the adequacy of write-downs of our OREO is based on several factors, including the appraised value of the real property, economic conditions in the property’s sub-market, comparable sales, current buyer demand, availability of financing, entitlement and development obligations and costs and historic loss experience. All of these factors have caused further write-downs in recent periods and can change without notice based on market and economic conditions.

In addition, our earnings may be affected by various expenses associated with OREO, including personnel costs, insurance, taxes, completion and repair costs and other costs associated with property ownership, as well as by the funding costs associated with assets that are tied up in OREO. Moreover, our ability to sell OREO properties is affected by public perception that banks are inclined to accept large discounts from market value in order to quickly liquidate properties. Any decrease in market prices may lead to OREO write-downs, with a corresponding expense in our statement of operations. Further write-downs on OREO or an inability to sell OREO properties could have a material adverse effect on our results of operations and financial conditions. Furthermore, the management and resolution of nonperforming assets, which include OREO, increases our costs and requires significant commitments of time from our management and directors, which can be detrimental to the performance of their other responsibilities. There can be no assurance that we will not experience further increases in nonperforming assets in the future.

 

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Our underwriting practices may not have adequately captured the risk inherent in our loan portfolio and our past underwriting practices may result in loans that expose us to a greater risk of loss.

We seek to mitigate the risks inherent in our loan portfolio by adhering to specific underwriting practices. These practices will often include analysis of a borrower’s prior credit history, financial statements, tax returns and cash flow projections; valuation of collateral; obtaining personal guarantees of loans to businesses; and verification of liquid assets. If our underwriting process fails to capture accurate information or proves to be inadequate, we may incur losses on loans that meet our underwriting criteria, and those losses may exceed the amounts set aside as reserves in the allowance for loan losses.

Prior to the revision of our lending policies in September 2008, which are further described in “Business—Credit Risk Management,” we granted exceptions to our loan-to-value limits, and our current aggregate loan-to-value exceptions exceed regulatory guidelines. As a result, some of our single family residential loans are secured by liens on mortgage properties in which the borrowers have little or no equity. During 2008 we began originating up to 100.0% loan-to-value loans to qualifying consumers to purchase select properties on which we hold a construction lien and also converted some of our construction loans to permanent investor rental property loans, many of which are in excess of 85.0% loan-to-value. We also originated first mortgage loans of up to an 80.0% loan-to-value ratio and a concurrent purchase money second mortgage with a combined loan-to-value ratio of up to 100.0% for purchase borrowers select properties. In addition, certain of our home equity lines of credit may have, when added to existing senior lien balances, a post-funding combined loan-to-value ratio of greater than 100.0% of the value of the property securing the loan. We do not consider the level of these high loan-to-value loans to be material to the Bank’s operations. Residential loans with high combined loan-to-value ratios are more sensitive to declining property values than those with lower combined loan-to-value ratios and, therefore, may experience a higher incidence of default and severity of losses. In addition, if the borrowers sell their homes, such borrowers may be unable to repay their loans in full from the sale.

A substantial amount of our residential mortgage loans and home equity lines of credit also have adjustable interest rates, and these loans may experience a higher rate of default in a rising interest rate environment. In addition, loans with combined loan-to-values in excess of 90.0% for owner-occupied property loans and 85.0% for investor rental property loans may experience higher rates of delinquencies, defaults and losses. In declining real estate or rental markets, investor property borrowers may not have the incentive to carry the burden of negative cash flow and thus may have higher default rates. We are actively working to reduce our concentrations of those loans with a higher risk of default; however, we are still subject to an increased exposure of loss due to those loans.

We may incur significant losses as a result of ineffective hedging of interest rate risk related to our single family loans held for sale and single family mortgage servicing rights.

A substantial portion of our single family loan originations are sold into the secondary market. We generally retain the right to service these loans. We are exposed to the risk of decreases in the fair value of our single family loans held for sale and our single family mortgage servicing rights as a result of changes in interest rates. We use derivative financial instruments to hedge these risks, however our hedging strategies, techniques and judgments may not be effective and may not anticipate every event that would affect the fair value of our single family loans held for sale and single family servicing rights. Our inability to effectively reduce the risk of fluctuations in the fair value of our single family loans and single family mortgage servicing rights could negatively affect our results of operations due to decreases in the fair value of these assets.

 

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Our real estate lending also exposes us to the risk of environmental liabilities.

In the course of our business, it is necessary to foreclose and take title to real estate, which could subject us to environmental liabilities with respect to these properties. Hazardous substances or waste, contaminants, pollutants or sources thereof may be discovered on properties during our ownership or after a sale to a third party. We could be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances or chemical releases at such properties. The costs associated with investigation or remediation activities could be substantial and could substantially exceed the value of the real property. In addition, as the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. We may be unable to recover costs from any third party. These occurrences may materially reduce the value of the affected property, and we may find it difficult or impossible to use or sell the property prior to or following any environmental remediation. If we ever become subject to significant environmental liabilities, our business, financial condition and results of operations could be materially and adversely affected.

If we sell mortgage loans or mortgage loan servicing rights and a default occurs on the underlying mortgage loan, we may be liable to the purchaser for unpaid principal and interest on the loan.

When we sell mortgage loans in the ordinary course of business, we are required to make certain representations and warranties to the purchaser about the mortgage loans and the manner in which they were originated. Our loan sale agreements require us to repurchase mortgage loans if we have breached any of these representations or warranties, in which case we may be required to repurchase such loan and/or bear any subsequent loss on the loan. We may not have any remedies available to us against an originating broker or other third party for such losses, or the remedies available to us may not be as broad as the remedies available to the purchaser of the mortgage loan against us. In addition, if there are remedies against a third party available to us, we face further risk that such third party may not have the financial capacity to perform remedies that otherwise may be available to us. Therefore, if a purchaser enforces remedies against us, we may not be able to recover our losses from a third party and may be required to bear the full amount of the related loss. If repurchase and indemnity demands increase, our liquidity, results of operations and financial condition will be adversely affected.

We may face risk of loss if we purchase loans from a seller that fails to satisfy its indemnification obligations.

We generally receive representations and warranties from the originators and sellers from whom we purchase loans and servicing rights such that if a loan defaults and there has been a breach of such representations and warranties, we may be able to pursue a remedy against the seller of the loan for the unpaid principal and interest on the defaulted loan. However, if the originator and/or seller breach such representations and warranties and does not have the financial capacity to pay the related damages, we may be subject to the risk of loss for such loan as the originator or seller may not be able to pay such damages or repurchase loans when called upon by us to do so. Currently, we only purchase loans from Windermere Mortgage Services Series LLC, a joint venture with certain Windermere real estate brokerage franchise owners.

We are subject to losses due to fraudulent and negligent acts on the part of loan applicants, brokers, other vendors and our employees. We are also subject to similar losses from existing customers and other third parties.

When we originate loans, we rely heavily upon information supplied by third parties, including the information contained in the loan application, appraisal, title information and employment and income

 

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documentation. If any of this information is intentionally or negligently misrepresented and such misrepresentation is not detected prior to the loan funding, the value of the loan may be significantly lower than expected, and we may be subject to repurchase or indemnification obligations under loan sales agreements. Whether a misrepresentation is made by the loan applicant, the broker, another third party or one of our own employees, we generally bear the risk of loss associated with the misrepresentation. A loan subject to a material misrepresentation is not typically saleable or is subject to repurchase if it is sold prior to detection of the misrepresentation. Even though we may have rights against persons and entities who made or knew about the misrepresentation, such persons and entities are often difficult to locate and it is often difficult to collect any monetary losses that we have suffered as a result of their actions.

Although we have controls and processes designed to help us identify misrepresented information in our loan origination operations, we give no assurance that we have detected or will detect all misrepresented information in our loan originations.

We are also subject to losses due to fraudulent and negligent acts in the on-going management of our loan portfolios and in other parts of our operations including, but not limited to, ACH fraud and wire transfer fraud. If we experience or detect a significant number of such fraudulent or negligent acts, our business, financial condition, liquidity and results of operations would be significantly harmed.

We may be subject to claims relating to documentation and procedures under various foreclosure laws.

In 2010, concerns surfaced among state attorneys general, federal regulators and government-sponsored entities that some mortgage loan servicers have commenced foreclosure proceedings in reliance on affidavits and other documents that were not signed or completed by persons with personal knowledge of the facts asserted in the documents (a practice commonly referred to as “robo-signing”). Similarly, some loan servicers have not been able to establish their legal standing to foreclose under applicable state law because they have not been able to demonstrate possession of the note evidencing the underlying debt or that they are the legal owner of the lien that is in default and the subject of a foreclosure action (problems commonly referred to as “chain of title” defects). Loan servicers that initiate foreclosures where there are chain of title defects or that are based on faulty affidavits may be exposed to litigation and regulatory risk for violating state and federal consumer protection laws, for breach of contract under servicing agreements and/or repurchase or indemnification obligations if the servicer was also the originator of the mortgage loans. In addition, these servicers then incur a loss because of an inability to foreclose on the collateral due to non-compliance with foreclosure statutes. Because of our substantial mortgage servicing activities and the current regulatory and economic environment related to the housing markets, it is possible that the Bank may be subject to future complaints, lawsuits or regulatory or investor challenges relating to foreclosure laws.

The proposed restructuring of Fannie Mae and Freddie Mac and changes in existing government-sponsored and federal mortgage programs could negatively affect our business.

We originate and purchase, sell and thereafter service single family and multifamily mortgages under the Fannie Mae, and to a lesser extent the Freddie Mac, single family purchase programs and the Fannie Mae multifamily Delegated Underwriting and Servicing, or DUS, program. These activities represented 67.5% and 59.9% of our consolidated revenues (interest income plus noninterest income) in 2010 and 2009, respectively. Since the nationwide downturn in residential mortgage lending that began in 2008 and the placement of Fannie Mae and Freddie Mac into conservatorship, Congress and various executive branch agencies have offered a wide range of proposals aimed at restructuring these agencies. None of these proposals have yet been defined with any specificity, and so we cannot predict how any such initiative would impact our business. However, any restructuring of Fannie Mae and Freddie Mac that restricts their loan repurchase programs may have a material adverse effect on our business and results of operations. Moreover, we have recorded on our balance sheet an intangible asset relating to our right to service single and multifamily loans sold to Fannie Mae and Freddie Mac.

 

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That asset was valued at $87.2 million at December 31, 2010. Changes in Fannie Mae’s and Freddie Mac’s policies and operations that adversely affect our single family residential loan and DUS mortgage servicing assets may require us to record impairment charges to the value of these assets, and significant impairment charges could be material and adversely affect our business.

Through our wholly owned subsidiary Home Street Capital Corporation, we participate as a lender in the Fannie Mae Delegated Underwriting and Servicing program, or DUS. Fannie Mae delegates responsibility for originating, underwriting and servicing mortgages, and we assume a limited portion of the risk of loss during the remaining term on each commercial mortgage loan that we sell to Fannie Mae. In the year ended December 31, 2010, we originated $55.8 million in loans through the DUS program.

Fannie Mae and Freddie Mac are under conservatorship with the Federal Housing Finance Agency. On February 11, 2011, the Obama administration presented Congress with a report titled “Reforming America’s Housing Finance Market, A Report to Congress,” outlining its proposals for reforming America’s housing finance market with the goal of scaling back the role of the U.S. government in, and promoting the return of private capital to, the mortgage markets and ultimately winding down Fannie Mae and Freddie Mac. Without mentioning a specific time frame, the report calls for the reduction of the role of Fannie Mae and Freddie Mac in the mortgage markets by, among other things, reducing conforming loan limits, increasing guarantee fees and requiring larger down payments by borrowers. The report presents three options for the long-term structure of housing finance, all of which call for the unwinding of Fannie Mae and Freddie Mac and a reduced role of the government in the mortgage market. We cannot be certain if or when Fannie Mae and Freddie Mac will be wound down, if or when reform of the housing finance market will be implemented or what the future role of the U.S. government will be in the mortgage market, and, accordingly, we will not be able to determine the impact that any such reform may have on us until a definitive reform plan is adopted.

In addition, our ability to generate income through mortgage sales to institutional investors depends in part on programs sponsored by Fannie Mae, Freddie Mac and the FHA, which facilitate the issuance of mortgage-backed securities in the secondary market. These programs have been reduced in recent periods due to current economic conditions. Any discontinuation of, or significant reduction in, the operation of those programs could have a material adverse effect on our loan origination and mortgage sales as well as our results of operations. Also, any significant adverse change in the level of activity in the secondary market or the underwriting criteria of these entities could negatively impact our results of business, operations and cash flows.

The lending qualification and limits of FHA and VA may also be subject to changes that may limit our origination of loans guaranteed or insured by the agencies in the future.

We originate and sell FHA and VA loans. The origination of FHA and VA loans represented 29.3% and 28.4% of the dollar value of loans originated in 2010 and 2009, respectively. The housing finance reform contemplated by the current presidential administration may impact the lending qualification and limits of these programs. The details of the changes outlined in the Obama administration report to Congress in February 2011 are not yet known; however, resulting legislation may adversely impact the Bank’s volume of FHA and VA loan originations in the future and may increase in the price of our mortgage insurance premiums or otherwise ultimately negatively affect the Bank’s business and results of operations.

Fluctuations in interest rates could adversely affect the value of our assets and reduce our net interest income and noninterest income thereby adversely affecting our earnings and profitability.

Our earnings are highly dependent on the difference between the interest earned on loans and investments and the interest paid on deposits and borrowings. Changes in market interest rates impact the rates earned on loans and investment securities and the rates paid on deposits and borrowings. In addition, changes to market interest rates may impact the level of loans, deposits and investments and the credit quality of existing loans.

 

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Changes in interest rates also affect demand for our residential loan products and the revenue realized on the sale of loans. A decrease in the volume of loans sold can decrease our revenues and net income. These rates may be affected by many factors beyond our control, including general and economic conditions and the monetary and fiscal policies of various governmental and regulatory authorities. Changes in interest rates may negatively impact our ability to attract deposits, make loans and achieve satisfactory interest rate spreads, which could adversely affect our financial condition or results of operations. Changes in interest rates may reduce our mortgage revenues, which would negatively impact our noninterest income.

Our net interest margin, which represents the effective yield on interest earning assets, declined steadily from 4.2% for the year 2006 to 1.0% for the year 2009 before improving to 1.5% for the year 2010. We have taken certain actions that have improved our net interest margin, and our business plan contains certain additional business initiatives intended to further improve our net interest margin. These actions may not prove to be successful.

Our securities portfolio includes securities that are insured or guaranteed by U.S. government agencies or government-sponsored enterprises and other securities that are sensitive to interest rate fluctuations. The unrealized gains or losses in our available-for-sale portfolio are reported as a separate component of shareholders’ equity until realized upon sale. As a result, future interest rate fluctuations may impact shareholders’ equity, causing material fluctuations from quarter to quarter. Failure to hold our securities until maturity or until market conditions are favorable for a sale could adversely affect our financial condition.

A significant portion of our noninterest income is derived from originating residential mortgage loans and selling them into the secondary market. That business has benefited from a long period of historically low interest rates. To the extent interest rates rise, particularly if they rise substantially or quickly, we may experience a reduction in mortgage refinancing and financing of new home purchases. These factors may negatively affect our mortgage loan origination volume and adversely affect our noninterest income.

Our mortgage servicing rights carry interest rate risk because the total amount of servicing fees earned, as well as the amortization of the investment in the servicing rights, fluctuates based on loan prepayments (affecting the expected average life of a portfolio of residential mortgage servicing rights). At December 31, 2010, we were servicing over $6.34 billion of residential loans for third parties. The rate of prepayment of residential mortgage loans may be influenced by changing national and regional economic trends, such as recessions or depressed real estate markets, as well as the difference between interest rates on existing residential mortgage loans relative to prevailing residential mortgage rates. Changes in prepayment rates are therefore difficult for us to predict. An increase in the general level of interest rates may adversely affect the ability of some borrowers to pay the interest and principal of their obligations. During periods of declining interest rates, many residential borrowers refinance their mortgage loans. The loan administration fee income related to the residential mortgage loan servicing rights corresponding to a mortgage loan ceases as mortgage loans are prepaid. Consequently, the fair value of portfolios of residential mortgage loan servicing rights tend to decrease during periods of declining interest rates, because greater prepayments can be expected and, as a result, the amount of loan administration income received also decreases.

We may be required, in the future, to recognize impairment with respect to investment securities, including the FHLB stock we hold.

Our securities portfolio currently includes securities with unrecognized losses. We may continue to observe declines in the fair market value of these securities. We evaluate the securities portfolio for any other than temporary impairment each reporting period, as required by generally accepted accounting principles in the United States, and as of December 31, 2010, we did not recognize any securities as other-than-temporarily impaired. There can be no assurance, however, that future evaluations of the securities portfolio will not require us to recognize an impairment charge with respect to these and other holdings.

 

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In addition, as a condition of membership in the FHLB, we are required to purchase and hold a certain amount of FHLB stock. Our stock purchase requirement is based, in part, upon the outstanding principal balance of advances from the FHLB. At December 31, 2010, we had stock in the FHLB totaling $37.0 million. The FHLB stock held by us is carried at cost and is subject to recoverability testing under applicable accounting standards. The FHLB has discontinued the repurchase of their stock and discontinued the distribution of dividends. As of December 31, 2010, we have not recognized an impairment charge related to our FHLB stock holdings. There can be no assurance, however, that future negative changes to the financial condition of the FHLB may not require us to recognize an impairment charge with respect to such holdings.

Inability to access and maintain liquidity could impair our ability to fund operations and jeopardize our financial condition.

Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a material adverse effect on our liquidity that would negatively impact our ability to fund continued loan growth and may negatively affect asset growth and, therefore, our earnings capability.

The termination or restructuring of Fannie Mae or Freddie Mac may have an adverse impact on our ability to fund and sell loans and to generate loan fees and gains on sales and create servicing income.

Our main sources of liquidity are loan sales, deposits, payments of principal and interest received on loans and investment securities. In addition, we also rely on borrowing lines with the FHLB and the Federal Reserve Bank of San Francisco, or FRBSF. However, the FHLB has discontinued the repurchase of its stock and discontinued the distribution of dividends. Based on the foregoing, there can be no assurance the FHLB will have sufficient resources to continue to fund our borrowings at their current levels. In the event of a deterioration in our financial conditions or a further downturn in the economy, particularly in the housing market, our ability to access these funding resources could be negatively affected, which could limit the funds available to us and make it difficult for us to maintain adequate funding for loan growth. In addition, our customers’ ability to raise capital and refinance maturing obligations could be adversely affected, resulting in a further unfavorable impact on our business, financial condition and results of operations.

In addition, if we were to suffer a significant drop in our capital levels due to a decrease in our business activity or other factors such that we were no longer considered “adequately capitalized,” we would no longer be eligible to borrow from the FRBSF. Interest rate competition, negative views and expectations about the prospects for the financial services industry as a whole, continued turmoil in the domestic and worldwide credit markets or a severe disruption of the financial markets may also impact the ability to access capital markets and maintain necessary liquidity levels. Our business is also impacted by the fiscal and monetary policies of the U.S. federal government and its agencies, including the Federal Reserve Board.

At present, under the Bank Order, we may not solicit, retain or rollover any brokered deposits without the approval of the FDIC. At December 31, 2010 we held $10.0 million in brokered deposits, and in the past we have used brokered deposits. If we need brokered deposits in the future for liquidity purposes, we may be unable to accept such brokered deposits, which may materially and adversely affect our liquidity position. In addition, as a result of the Bank and Company Orders, we have been designated as a “less than well capitalized” institution under applicable regulations. As a result of being designated “less than well capitalized,” effective January 1, 2010, we were required to price our deposit interest rates based on national average rates. If local competitors are able to offer higher rates, our ability to attract deposits as a source of liquidity may also be adversely impacted.

 

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We have relied heavily in the past, and may continue to rely, on wholesale borrowing and brokered deposits to fund our lending activities.

We have historically relied on a high level of wholesale borrowings and brokered deposits to fund our lending activities. We borrow on a collateralized basis from the FHLB, and, as back-up, the FRBSF. In the past, we have also used brokered deposits; however, pursuant to the Bank Order we are not presently permitted to solicit, retain or rollover brokered deposits, which has required us to run off that portfolio. Our liquidity has been negatively affected because of limitations on our access to these funds. The FHLB and the FRBSF are not contractually bound to continue to offer credit to us, and our access to credit from either or both of these agencies for future borrowings may be discontinued at any time. There can be no assurance that actions by the FHLB or the FRBSF, limitations on our available collateral or adverse regulatory action against us would not reduce or eliminate our borrowing capacity or that we would be able to continue to attract nonbrokered deposits at competitive rates. To this end, the FHLB recently changed its collateral requirements for the Bank, moving away from blanket custody towards physical custody and eliminating loans held for sale as eligible collateral. These changes in policy have constrained our additional borrowing capacity from the FHLB. We also may not be in compliance with certain covenants in our borrowing agreement with the FHLB relating to safe and sound banking practices, and without a waiver of such convenants, we may not be able to obtain future advances from the FHLB, or we may be required to satisfy additional conditions or may face limitations as to the timing or amounts of such advances, until the Bank Order is lifted. Such events have and could continue to have a material adverse impact on our results of operations and financial condition.

Adverse operating results or changes in industry conditions could lead to difficulty or an inability to access additional funding sources. Our financial flexibility will be severely constrained if we are unable to maintain our access to funding or if adequate financing is not available to accommodate future growth at acceptable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs. In this case, our operating margins and profitability would be adversely affected.

We may have reduced access to wholesale funding sources, which may adversely affect our liquidity and cost of funds.

As part of liquidity management, we use a number of funding sources in addition to core deposit growth and repayments and maturities of loans and investments. We generally select funding sources based on decisions regarding cost and liquidity. If we lose access to one or more wholesale funding sources, our liquidity may be impaired and our cost of borrowing may increase. If we are required to rely more heavily on costlier funding sources, our revenues may not increase proportionately to cover our costs, and our earnings and profitability would be adversely affected. Changes in accounting standards could materially impact our consolidated financial statements.

Clients may pursue alternatives to bank deposits or otherwise seek to minimize their bank deposit risk, causing us to lose a relatively inexpensive source of funding.

Checking and savings account balances and other forms of client deposits could decrease if clients perceive alternative investments as providing better returns, or a weakness in our financial stability. Deposit customers may also seek to distribute their deposits over several banks to maximize FDIC insurance coverage. Similarly, technology and other changes are allowing parties to complete financial transactions that historically have involved banks at one or both ends of the transaction. For example, consumers can now pay bills and transfer funds directly without banks. The process of eliminating banks as intermediaries, known as disintermediation, could result in the loss of fee income, as well as the loss of customer deposits and income generated from those deposits. If, as a result of general economic conditions, market interest rates, competitive pressures or other factors, clients move money out of bank deposits in favor of alternative investments and our level of deposits

 

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decreases relative to our overall banking activities, we can lose a relatively inexpensive source of funds, increasing our funding costs.

Changes in accounting principles or standards may affect our reported results of operations and financial condition.

The regulatory bodies that establish accounting standards, including the Financial Accounting Standards Board, the SEC and other regulatory bodies, from time to time may change the financial accounting and reporting standards that govern the preparation of our consolidated financial statements. These changes can be difficult to predict and can materially impact how we record and report our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retroactively, resulting in changes to previously reported financial results or a cumulative charge to retained earnings.

Emergency measures designed to stabilize the U.S. financial markets are beginning to wind down.

Since mid-2008, a host of government actions have been implemented in response to the financial crisis and the recession. Some of the programs are beginning to expire and the impact of the wind-down of these programs on the financial sector and on the economic recovery is unknown. As government support programs are cancelled, changed or withdrawn, there is a possibility that we, as well as other financial institutions, may have insufficient access to, or incur higher costs associated with, deposit or other funding alternatives, which could have a material adverse effect on our business, financial condition, results of operations and prospects. In particular, although the Dodd-Frank Act provides a full FDIC guarantee for certain non-interest bearing transaction accounts for an unlimited amount of coverage through the end of 2012, some accounts previously covered under the voluntary Transaction Account Guarantee (“TAG”) program, such as Negotiable Order of Withdrawal, or NOW, checking accounts, did not benefit from the coverage extension that took effect upon the TAG program’s expiration on December 31, 2010. This change could adversely affect us, especially in light of the concerns about our financial viability. In addition, a stall in the economic recovery or continuation or worsening of current financial market conditions could exacerbate these effects.

The FDIC has increased insurance premiums to restore and maintain the federal deposit insurance fund, which has increased our costs and could adversely affect our business.

In 2009, the FDIC imposed a special deposit insurance assessment of five basis points on all insured institutions and also required insured institutions to prepay estimated quarterly risk-based assessments through 2012. While the Bank paid the 2009 special assessment, the FDIC exempted the Bank from prepaying its quarterly risk-based assessments for the fourth quarter of 2009 and all of 2010, 2011 and 2012, under the discretionary authority granted by regulation if such prepayment would adversely impact the safety and soundness of the Bank. The Bank has continued to pay its quarterly assessments on the payment due dates.

The Dodd-Frank Act established 1.35% as the minimum deposit insurance fund reserve ratio. The FDIC has determined that the fund reserve ratio should be 2.0% and has adopted a plan under which it will meet the statutory minimum fund reserve ratio of 1.35% by the statutory deadline of September 30, 2020. The Dodd-Frank Act requires the FDIC to offset the effect on institutions with assets less than $10.0 billion of the increase in the statutory minimum fund reserve ratio to 1.35% from the former statutory minimum of 1.15%. The FDIC has not announced how it will implement this offset or how larger institutions will be affected by it.

Despite the FDIC’s actions to restore the deposit insurance fund, the fund will suffer additional losses in the future due to failures of insured institutions. There can be no assurance that there will not be additional significant deposit insurance premium increases, special assessments or prepayments in order to restore the insurance fund’s reserve ratio. Any significant premium increases or special assessments could have a material adverse effect on the Company’s financial condition and results of operations.

 

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We are subject to extensive regulation that has restricted and could further restrict our activities, including capital distributions, and impose financial requirements or limitations on the conduct of our business.

Our operations are subject to extensive regulation by federal, state and local governmental authorities, including the FDIC, the DFI and the OTS, and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of our operations. Because our business is highly regulated, the laws, rules and regulations to which we are subject are evolving and change frequently. Changes to those laws, rules and regulations are also sometimes retroactively applied. Furthermore, the on-site examination cycle for an institution in our circumstances is frequent and extensive. Examination findings by the regulatory agencies may result in adverse consequences to the Company. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the authority to restrict our operations, adversely reclassify our assets, determine the level of deposit premiums assessed and require us to increase our allowance for loan losses.

Legislative action regarding foreclosures or bankruptcy laws may negatively impact our business.

Legislation and regulations have been proposed which, among other things, could allow judges to modify the terms of residential mortgages in bankruptcy proceedings and could hinder our ability to foreclose promptly on defaulted mortgage loans or expand assignee liability for certain violations in the mortgage loan origination process, any or all of which could adversely affect our business or result in our being held responsible for violations in the mortgage loan origination process. These legislative and regulatory proposals generally have focused primarily, if not exclusively, on residential mortgage origination, but we cannot offer assurances as to what, if any, of these initiatives may be adopted or, if adopted, to what extent they would affect our business. Such legislation may limit our ability to take actions that may be essential to preserve the value of the mortgage loans we service or hold for investment. Any restriction on our ability to foreclose on a loan, any requirement that we forego a portion of the amount otherwise due on a loan or any requirement that we modify any original loan terms may require us to advance principal, interest, tax and insurance payments, which would negatively impact our business, financial condition, liquidity and results of operations. Given the relatively high percentage of our business that derives from originating residential mortgages, any such actions are likely to have a significant impact on our business, and the effects we experience will likely be disproportionately high in comparison to financial institutions whose residential mortgage lending is more attenuated.

We are unable to predict whether U.S. federal, state or local authorities, or other pertinent bodies, will enact legislation, laws, rules, regulations, handbooks, guidelines or similar provisions that will affect our business or require changes in our practices in the future, and any such changes could adversely affect our cost of doing business and profitability. See “Regulation and Supervision — Regulation and Supervision of HomeStreet Bank.”

The Dodd-Frank Act is expected to increase our costs of operations and may have a material negative effect on us.

The Dodd-Frank Act significantly changes the laws as they apply to financial institutions and revises and expands the rulemaking, supervisory and enforcement authority of federal banking regulators. It is also expected to have a material impact on our relationships with current and future customers. Although the statute will have a greater impact on larger institutions than regional bank holding companies such as the Company, many of its provisions will apply to us. Among other things, the Dodd-Frank Act:

 

   

transfers supervision of HomeStreet, Inc. from the OTS to the FRB, which has higher capital requirements for bank holding companies, potentially limiting our ability to deploy our capital into earning assets, which would serve to limit our own earnings;

 

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grants the FDIC back-up supervisory authority with respect to depository institution holding companies that engage in conduct that poses a foreseeable and material risk to the Deposit Insurance Fund and heightens the Federal Reserve’s authority to examine, prescribe regulations and take action with respect to all subsidiaries of a bank holding company;

 

   

prohibits insured state-chartered banks such as ours from engaging in certain derivatives transactions unless the chartering state’s lending limit laws take into consideration credit exposure to derivatives transactions;

 

   

subjects both large and small financial institutions to data and information gathering by a newly created Office of Financial Research;

 

   

creates a new Consumer Bureau given rulemaking, examination and enforcement authority over consumer protection matters and contains provisions on mortgage-related matters such as steering incentives, determinations as to a borrowers’ ability to repay and prepayment penalties; and

 

   

imposes certain corporate governance and executive compensation standards that may increase costs of operation and adversely affect our ability to attract and retain management.

Some of these changes are effective immediately, though most will be phased in gradually. In addition, the statute in many instances calls for future rulemaking to implement its provisions, so the precise contours of the law and its effects on us cannot yet be fully understood. The provisions of the Dodd-Frank Act and the subsequent exercise by regulators of their revised and expanded powers thereunder could materially and negatively impact the profitability of our business, the value of assets we hold or the collateral available for our loans, require changes to business practices or force us to discontinue businesses and expose us to additional costs, taxes, liabilities, enforcement actions and reputational risk.

The short-term and long-term impacts of the new Basel III capital standards and the forthcoming new capital rules to be proposed for non-Basel III U.S. banks is uncertain.

The Basel Committee on Banking Supervision (Basel Committee) recently announced new standards that, if adopted, could lead to significantly higher capital requirements, higher capital charges, a cap on the level of mortgage servicing rights that can be included in capital, and more restrictive leverage and liquidity ratios. These new Basel III capital standards will be phased in from January 1, 2013 until January 1, 2019, and it is not yet known how these standards will be implemented by U.S. regulators or applied to community banks of our size. Implementation of these standards, or any other new regulations, might adversely affect our ability to pay dividends or require us to reduce business levels or raise capital, including in ways that may adversely affect our results of operations or financial condition.

We could be materially adversely affected if we or any of our officers or directors fail to comply with holding company, bank and other laws and regulations.

As a bank holding company, we are subject to extensive regulation by U.S. federal and state regulatory agencies and face risks associated with investigations and proceedings by regulatory agencies, including those that we may believe to be immaterial. Like any corporation, we are also subject to risk arising from potential employee misconduct, including noncompliance with our policies. Any interventions by authorities may result in adverse judgments, settlements, fines, penalties, injunctions, suspension or expulsion of our officers or directors from the banking industry or other relief. In addition to the monetary consequences, these measures could, for example, impact our ability to engage in, or impose limitations on, certain of our businesses. The number of these investigations and proceedings, as well as the amount of penalties and fines sought, has increased substantially in recent years with regard to many firms in the industry. Significant regulatory action against us or our officers or

 

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directors could materially adversely affect our business, financial condition or results of operations or cause us significant reputational harm, which could seriously harm our business.

We face strong competition which could limit our growth and profitability.

We operate in a highly competitive environment and expect competition to continue as financial services companies combine to produce larger companies that are able to offer a wide array of financial products and services at competitive prices with attractive terms. In addition, customer convenience and service capabilities, such as product lines offered and the accessibility of services, are significant competitive factors.

Our most direct competition for loans comes from commercial banks, other savings institutions, investment banking firms and regional and national mortgage banking companies. Many of these entities have greater capital and other resources than we do. With respect to deposits, our most direct competition comes from commercial banks, other savings institutions and credit unions doing business in our markets. As with all banking organizations, we also experience competition from non-banking sources, including mutual funds, corporate and government debt securities and other investment alternatives offered within and outside of our primary markets. In addition, technology advances and the growth of e-commerce have made it possible for non-depository institutions to offer products and services that were traditionally offered only by banks. Many of these competitors have fewer regulatory constraints and some have lower cost structures.

The loss of our key management or the inability to attract and retain key employees could result in a material adverse effect on our business.

We depend on our executive officers and key personnel to continue the implementation of our business strategy and could be harmed by the loss of their services. We believe that our growth and future success will depend in large part upon the skills of our management team. Additionally, our future success and growth will depend upon our ability to recruit and retain highly skilled employees with strong community relationships and specialized knowledge in the financial services industry. The competition for qualified personnel in the financial services industry is intense, and the loss of our key personnel or an inability to continue to attract, retain and motivate key personnel could adversely affect our business. We cannot assure you that we will be able to retain our existing key personnel or attract additional qualified personnel.

Our ability to attract and retain customers, investors and employees could be adversely affected to the extent our reputation is harmed.

Threats to our reputation can come from many sources, including adverse sentiment about financial institutions generally, unethical practices, employee misconduct, failure to deliver minimum standards of service or quality, compliance deficiencies and questionable or fraudulent activities of our customers. We have policies and procedures in place to protect our reputation and promote ethical conduct, but these policies and procedures may not be fully effective. Negative publicity regarding, among other things, regulatory actions against us, our business or our employees, with or without merit, may result in the loss of customers, investors and employees, costly litigation, a decline in revenues and increased governmental regulation.

The strength and stability of other financial institutions may adversely affect our business.

Our counterparty risk exposure is affected by the actions and creditworthiness of other financial institutions with which we do business. Negative impacts to our counterparty financial institutions could affect our ability to engage in routine funding transactions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. Many of these types of transactions can expose us to credit risk in the event of default by a direct or indirect counterparty or client.

 

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If other financial institutions in our markets dispose of real estate collateral at below-market or distressed prices, such actions may increase our losses and have a material adverse effect our financial condition and results of operations.

Our accounting policies and methods are fundamental to how we report our financial condition and results of operations, and we use estimates in determining the fair value of certain of our assets, which estimates may prove to be imprecise and result in significant changes in valuation.

A portion of our assets are carried on the balance sheet at fair value, including investment securities available for sale, mortgage servicing rights related to single family loans and single family loans held for sale. Generally, for assets that are reported at fair value, we use quoted market prices or internal valuation models that utilize observable market data inputs to estimate their fair value. In certain cases, observable market prices and data may not be readily available or their availability may be diminished due to market conditions. We use financial models to value certain of these assets. These models are complex and use asset-specific collateral data and market inputs for interest rates. Although we have processes and procedures in place governing internal valuation models and their testing and calibration, such assumptions are complex as we must make judgments about the effect of matters that are inherently uncertain. Different assumptions could result in significant changes in valuation, which in turn could affect earnings or result in significant changes in the dollar amount of assets reported on the balance sheet.

The cost of additional finance and accounting systems, procedures and controls in order to satisfy our new public company reporting requirements will increase our expenses.

As a result of the completion of this offering, we will become a public reporting company. We expect that the obligations of being a public company, including the substantial public reporting obligations and compliance with related regulations, will require significant expenditures and place additional demands on our management team. Compliance with these rules will, among other things, require us to assess our internal controls and procedures and evaluate our accounting systems. We have made, and will continue to make, changes to our internal controls and procedures for financial reporting and accounting systems to meet our reporting obligations as a public company. However, the measures we take may not be sufficient to satisfy these obligations. In addition, we have hired, and may need to hire further additional compliance, accounting and financial staff with appropriate public company experience and technical knowledge, and we may not be able to do so in a timely fashion. As a result, we may need to rely on outside consultants to provide these services for us until qualified personnel are hired. These obligations will increase our operating expenses, although we cannot predict or estimate the amount of additional costs we may incur in order to comply with these requirements, and could divert our management’s attention from our operations.

We are subject to examinations and challenges by tax authorities.

In the normal course of business, we are routinely subject to examinations and challenges from federal and state tax authorities regarding the amount of taxes due in connection with investments we have made and the businesses in which we have engaged. Recently, federal and state taxing authorities have become increasingly aggressive in challenging tax positions taken by financial institutions. These tax positions may relate to tax compliance, sales and use, franchise, gross receipts, payroll, property and income tax issues, including tax base, apportionment and tax credit planning. The challenges made by tax authorities may result in adjustments to the timing or amount of taxable income or deductions or the allocation of income among tax jurisdictions. If any such challenges are made and are not resolved in our favor, they could have a material adverse effect on our financial condition and results of operations.

 

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Our internal controls and procedures may not be effective.

We regularly review and update our internal controls, disclosure controls and procedures and corporate governance policies and procedures. As a result, we may incur increased costs to maintain and improve our controls and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls or procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations or financial condition.

Our independent public accounting firm has identified certain significant deficiencies in our internal controls. If we fail to remediate these internal control deficiencies, address the potential for future deficiencies and maintain an effective system of internal controls over financial reporting, we may not be able to accurately report our financial results.

During their audit of our financial statements for the year ended December 31, 2010, our independent registered public accounting firm, identified certain deficiencies in our internal controls, including deficiencies considered to be significant deficiencies. A significant deficiency is a deficiency, or a combination of deficiencies, in internal controls over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the registrant’s financial reporting.

Specifically, our independent auditors identified a significant deficiency relating to a monitoring control over the adoption of new accounting policies. They also identified a significant deficiency relating to a monitoring control over the identification and ongoing evaluation of our non-GAAP accounting methods for materiality.

Management has taken steps to address these identified deficiencies through implementation of additional internal control procedures. However, it is possible that these deficiencies may not be fully remediated by these actions, or that we or our independent auditors may identify significant deficiencies in our internal control over financial reporting in the future. Any failure or difficulties in implementing and maintaining these controls could cause us to fail to meet the periodic reporting obligations that we will be subject to after this offering or result in material misstatements in our financial statements.

Our enterprise risk management framework may not be effective in identifying risks.

Our framework for managing risks may not be effective in mitigating risk and loss to us. Our risk management framework seeks to mitigate risk and loss to us. We have established processes and procedures intended to identify, measure, monitor, report and analyze the types of risk to which we are subject. In the fall of 2010, we conducted an enterprise-wide risk assessment using a framework espoused by the Office of the Comptroller of the Currency, which includes liquidity risk, credit risk, market risk, interest rate risk, operational risk, legal, compliance/regulatory risk and reputation risk, among others. However, as with any risk management framework, there are inherent limitations to our risk management strategies as there may exist, or develop in the future, risks that we have not appropriately anticipated or identified. If our risk management framework proves ineffective, we could suffer unexpected losses and could be materially adversely affected.

We are subject to operational risks, which may cause us to incur financial losses.

We are exposed to many types of operational risk, including the risk of fraud by employees or outsiders, the risk of operational errors, including clerical or recordkeeping errors or those resulting from faulty or disabled computer or telecommunications systems. Certain errors may be repeated or compounded before they are discovered and successfully corrected. Our dependence upon automated systems to record and process

 

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transactions may further increase the risk that technical system flaws or an employee tampering with or manipulating those systems will result in losses that are difficult to detect.

We may be subject to disruptions of our systems arising from events that are wholly or partially beyond our control (including, for example, computer viruses, electrical or telecommunications outages, natural disasters or similar catastrophic events), which may give rise to losses in service to customers and to financial loss or liability. We are further exposed to the risk that our external vendors may be unable to fulfill their contractual obligations (or will be subject to the same risk of fraud or operational errors by their respective employees as we are) and to the risk that our (or our vendors’) business continuity and data security systems prove to be inadequate.

Our operations could be interrupted if our third-party service providers experience difficulty, terminate their services or fail to comply with banking regulations.

We depend, and will continue to depend, to a significant extent, on a number of relationships with third-party service providers. Specifically, we receive core systems processing, essential web hosting and other Internet systems and deposit and other processing services from third-party service providers. If these third-party service providers experience difficulties or terminate their services and we are unable to replace them with other service providers, our operations could be interrupted. If an interruption were to continue for a significant period of time, our business financial condition and results of operations could be materially adversely affected.

We continually encounter technological change, and we may have fewer resources than many of our competitors to continue to invest in technological improvements.

The financial services industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success will depend, in part, upon our ability to address the needs of our clients by using technology to provide products and services that will satisfy client demands for convenience, as well as to create additional efficiencies in our operations. Many national vendors provide turn-key services to community banks, such as internet banking and remote deposit capture that allow smaller banks to compete with institutions that have substantially greater resources to invest in technological improvements. We may not be able, however, to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers.

In addition, because of the demand for technology-driven products, banks are increasingly contracting with outside vendors to provide data processing and core banking functions. The use of technology-related products, services, delivery channels and processes exposes a bank to various risks, particularly transaction, strategic, reputation and compliance risks. There can be no assurance that we will be able to successfully manage the risks associated with our increased dependency on technology.

The network and computer systems on which we depend could fail or experience a security breach.

Our computer systems could be vulnerable to unforeseen problems. Because we conduct a part of our business over the Internet and outsource several critical functions to third parties, operations will depend on our ability, as well as the ability of third-party service providers, to protect computer systems and network infrastructure against damage from fire, power loss, telecommunications failure, physical break-ins or similar catastrophic events. Any damage or failure that causes interruptions in operations could have a material adverse effect on our business, financial condition and results of operations.

In addition, a significant barrier to online financial transactions is the secure transmission of confidential information over public networks. Our Internet banking system relies on encryption and authentication

 

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technology to provide the security and authentication necessary to effect secure transmission of confidential information. Advances in computer capabilities, new discoveries in the field of cryptography or other developments could result in a compromise or breach of the algorithms our third-party service providers use to protect customer transaction date. If any such compromise of security were to occur, it could have a material adverse effect on our business, financial condition and results of operations.

An interruption in or breach of our information systems could impair our ability to originate loans on a timely basis and may result in lost business.

We rely heavily upon communications and information systems to conduct our lending business. Any failure or interruption or breach in security of our information systems or the third-party information systems that we rely on could cause delays in our operations. We cannot assure you that no failures or interruptions will occur or, if they do occur, that we or the third parties on which we rely will adequately address them. The occurrence of any failures or interruptions could significantly harm our business, financial condition and results of operations.

Our growth or future losses may require us to raise additional capital in the future, but that capital may not be available when it is needed and that capital may be dilutive to shareholders.

We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. We believe the net proceeds of this offering will be sufficient to permit us to attain regulatory capital compliance, but we cannot guarantee that we will continue to meet our capital requirements. We may need to raise additional capital, and our ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside our control, and on our financial condition and performance. Accordingly, we may not be able to raise additional capital on terms that are acceptable to us, if at all. If we cannot raise additional capital when needed, our operations could be materially impaired and our financial condition and liquidity could be materially and adversely affected. In addition, if we are unable to raise additional capital when required by the FDIC and the DFI, we may be subject to additional adverse regulatory action. We may be subject to more severe future regulatory enforcement actions if our financial condition or performance weakens further.

Hedging strategies that we use to manage various risks may be ineffective in mitigating those risks.

We typically use derivatives and other instruments to hedge against certain financial risks. Hedging is a complex process, requiring our managers to be highly qualified to design and manage sophisticated models that require constant monitoring. We use a variety of derivative financial instruments including futures, options, forward sales and interest rate swaps, among others. Our models and the related instruments may not fully correlate with the risks being hedged. If we fail to appropriately manage our hedging, our financial results may be adversely affected.

Federal, state and local consumer lending laws may restrict our ability to originate or increase our risk of liability with respect to certain mortgage loans and could increase our cost of doing business.

Federal, state and local laws have been adopted that are intended to eliminate certain lending practices considered “predatory.” These laws prohibit practices such as steering borrowers away from more affordable products, selling unnecessary insurance to borrowers, repeatedly refinancing loans, and making loans without a reasonable expectation that the borrowers will be able to repay the loans irrespective of the value of the underlying property. It is our policy not to make predatory loans, but these laws create the potential for liability with respect to our lending, servicing and loan investment activities. They increase our cost of doing business, and ultimately may prevent us from making certain loans and cause us to reduce the average percentage rate or the points and fees on loans that we do make.

 

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Risks Associated with our Securities

There has been no trading market for our common stock and an active market may not be developed or maintained, and the market price of our common stock may be volatile.

Before this offering, there has been no public market for our common stock. Although we have applied for listing of our common stock on the Nasdaq Global Market, an active trading market for our common stock may never develop or be sustained. In addition, you will pay a price for our common stock in this offering that was not established in a competitive market. Instead, you will pay a price that we negotiated with the underwriter. See “Underwriting” for factors considered in determining the initial public offering price. The initial public offering price does not necessarily bear any relationship to our book value or the fair market value of our assets and may be higher than the market price of our common stock after this offering. In particular, we cannot assure you as to:

 

   

the likelihood that an active public trading market for the shares of our common stock will develop after this offering, or, if developed, that a public trading market can be sustained;

 

   

the liquidity of any such market;

 

   

the ability of our shareholders to sell their shares of our common stock; or

 

   

the price that our shareholders may obtain for their shares of our common stock.

If no public market develops, it may be difficult or impossible to resell our common stock if you should desire to do so. Even if an active trading market develops, the market price for shares of our common stock may be highly volatile and could be subject to wide fluctuations after this offering. We cannot predict how the shares of our common stock will trade in the future. Some of the factors that could negatively affect our share price include:

 

   

actual or anticipated variations in our quarterly operating results and, in particular, further deterioration of asset quality;

 

   

changes in revenue or financial estimates or publication of research reports and recommendations by financial analysts;

 

   

publication of research reports about us or the commercial and residential real estate industry;

 

   

our ability to continue as a going concern;

 

   

fluctuations in the stock price and operating results of our competitors;

 

   

our ability to execute our business plan and forecasted growth;

 

   

additions or departures of key management personnel;

 

   

proposed or adopted regulatory changes or developments;

 

   

speculation in the press or investment community;

 

   

issuances of new equity pursuant to future offerings; and

 

   

general market and economic conditions.

 

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The stock market and, in particular, the market for financial institution stocks, has experienced significant volatility recently. As a result, the market price of our common stock may be volatile. The trading price of our common stock will depend on many factors, which may change from time to time, including, without limitation, our financial condition, performance, creditworthiness and prospects, future sales of our equity or equity related securities and other factors identified in the Summary above under the heading “Forward-Looking Statements.” Accordingly, the shares of our common stock that an investor purchases, whether in this offering or in the secondary market, may trade at a price lower than that at which they were purchased. In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers without regard to those issuers’ underlying financial strength.

A significant decline in our stock price could result in substantial losses for individual stockholders and could lead to costly and disruptive securities litigation.

Your interest in us may be diluted if we issue additional shares.

Existing shareholders and potential investors in this offering do not have preemptive rights to purchase or subscribe for any common stock issued by us in the future. Subject to market conditions, we may take further capital raising actions in addition to the issuance of our common stock offered by this prospectus. Such actions could include, among other things, the issuance of additional shares of our common stock in public or private transactions. In addition, we face significant regulatory and other governmental risk as a financial institution, and it is possible that capital requirements and directives could in the future require us to change the amount or composition of our current capital, including common equity.

Therefore, investors purchasing shares in this offering may experience dilution of their equity investment if we sell additional common stock in the future, sell securities that are convertible into common stock or issue options or warrants exercisable for shares of common stock. In addition, we could sell securities at a price less than the then-current net asset value per share.

Shortly after this offering, we intend to file a registration statement on Form S-8 to register shares of our common stock issuable under our 2010 Equity Incentive Plan as well as shares to be issued as awards under a director equity compensation plan, and a registration statement to register the resale of shares held in our Employee Stock Ownership Plan. All of these shares of our common stock will be freely tradable without restriction or further registration under the federal securities laws except to the extent purchased by one of our affiliates. See “Shares Eligible for Future Sale.”

If the proceeds from this offering are not sufficient to satisfy our capital and liquidity needs or to satisfy changing regulatory requirements, we may need even more capital and could be subject to further regulatory restrictions, either of which could significantly adversely affect us and the trading price of our stock.

We must maintain certain minimum regulatory capital ratios. While we believe that the capital expected to be raised through this offering should be sufficient capital for our operations, including satisfaction of the capital requirements set forth in the Bank Order, if we are unable to meet our minimum capital ratios, we may be forced to raise additional capital. In addition, we may elect to raise additional capital to support our business or to finance potential acquisitions, if any, or we may otherwise elect to raise additional capital. No assurance can be given that sufficient additional capital would be available on acceptable terms or at all. Factors affecting whether we would need to raise additional capital include, among others, changing requirements of regulators, additional provisions for loan losses and loan charge-offs and other risks discussed in this “Risk Factors” section.

Our ability to raise additional capital will depend on conditions in the capital markets at such time that are outside our control, as well as on our financial performance. If sufficient capital were not available, we would consider a variety of alternatives, including the sale of assets. Under such forced-sale conditions, we may not be

 

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able to realize the fair value of the assets sold. Other alternatives would include changing our business practices or entering into additional equity transactions. Even if capital is available, the terms and pricing of such securities may be dilutive to existing shareholders and cause the price of our outstanding securities to decline.

The issuance of preferred shares could adversely affect holders of our common stock, which may negatively impact your investment in our common stock.

Our board of directors is authorized to issue classes or series of preferred stock without any action on the part of our shareholders. Our board of directors also has the power, without shareholder approval, to set the terms of any such classes or series of preferred stock that may be issued, including voting rights, dividend rights and preferences over our common stock with respect to dividends or upon the liquidation, dissolution or winding up of our business and other terms. If we issue preferred shares in the future that have a preference over our common stock with respect to the payment of dividends or upon liquidation, dissolution or winding up, or if we issue preferred shares with voting rights that dilute the voting power of our common stock, the rights of holders of our common stock or the market price of our common stock could be adversely affected.

Future sales of shares of our common stock could depress the market price of our shares.

We cannot predict the effect, if any, of future sales of our common stock, or the availability of shares for future sales, on the value of our common stock. Sales of these shares by our existing shareholders, or the perception that such sales could occur, may cause the trading price of our common stock to decrease or be lower than it might be in the absence of those sales or perceptions.

Some provisions of our articles of incorporation and bylaws and certain provisions of Washington law may deter takeover attempts, which may limit the opportunity of our shareholders to sell their shares at a favorable price.

Some provisions of our articles of incorporation and bylaws may have the effect of deterring or delaying attempts by our shareholders to remove or replace management, to commence proxy contests, or to effect changes in control. These provisions include:

 

   

a classified board of directors so that only approximately one third of our board of directors is elected each year;

 

   

elimination of cumulative voting in the election of directors;

 

   

procedures for advance notification of shareholder nominations and proposals;

 

   

the ability of our board of directors to amend our bylaws without shareholder approval; and

 

   

the ability of our board of directors to issue shares of preferred stock without shareholder approval upon the terms and conditions and with the rights, privileges and preferences as the board of directors may determine.

In addition, as a Washington corporation, we are subject to Washington law which imposes restrictions on some transactions between a corporation and certain significant shareholders. These provisions, alone or together, could have the effect of deterring or delaying changes in incumbent management, proxy contests or changes in control.

 

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There are substantial regulatory limitations on ownership of our common stock and changes of control.

Federal regulations place limitations on the level of ownership of our common stock. Under the Federal Change in Bank Control Act and the Savings and Loan Holding Company Act, a notice must be submitted to the OTS if any person (including a company), or group acting in concert, seeks to acquire “control” of a savings and loan holding company or savings association. An acquisition of “control” can occur upon the acquisition of 10.0% or more of any class of the voting stock of a savings and loan holding company or savings institution or as otherwise defined by the OTS. Under the Change in Bank Control Act, the OTS has 60 days from the filing of a complete notice to act, taking into consideration certain factors, including the financial and managerial resources of the acquirer and the antitrust effects of the acquisition. Any company that so acquires control would then be subject to regulation as a savings and loan holding company.

Our common stock is equity and therefore is subordinate to our indebtedness.

The shares of our common stock are equity interests and do not constitute indebtedness. As such, our common stock will rank junior to all current and future indebtedness, other non-equity and senior claims and preferred stock with a liquidation preference with respect to assets available to satisfy such indebtedness, claims or liquidation preference. In addition, our common stock will effectively rank junior to all existing and future liabilities of the Bank and any other subsidiaries. In the event of our bankruptcy, liquidation or winding up, we will pay all of our indebtedness, other liabilities and other senior claims and any liquidation preference on preferred stock before any distributions are made to holders of our common stock. In such an event, there may not be sufficient assets remaining, after paying our liabilities, our subsidiaries’ liabilities and any preferred shareholders, to make any distributions to holders of our common stock.

We may, and the Bank may also, incur additional indebtedness from time to time and may increase our aggregate level of outstanding indebtedness. Additionally, holders of our common stock are subject to the prior dividend and liquidation rights of any holders of our preferred stock. Our board of directors is authorized to cause us to issue additional classes or series of preferred stock without any action on the part of our shareholders. If we issue preferred shares in the future that have a preference over or are on parity with our common stock with respect to the payment of dividends or upon liquidation, or if we issue preferred shares with voting rights that dilute the voting power of our common stock, then the rights of holders of our common stock and the market price of our common stock could be adversely affected.

We have deferred payment of the interest on our outstanding TruPS for each quarter since December 15, 2008 and, accordingly, we are prohibited from declaring or paying dividends or distributions on, and from making liquidation payments with respect to, our common stock.

There are currently four separate series of the TruPS outstanding, each issued under a separate indenture and with a separate guarantee. Each of these indentures, together with the related guarantee, prohibits us, subject to limited exceptions, from declaring or paying any dividends or distributions on, or redeeming, repurchasing, acquiring or making any liquidation payments with respect to, any of our capital stock at any time when (a) there is an event of default under such indenture (including a default that will occur solely with passage of time); (b) we are in default with respect to payment of any obligations under such guarantee; or (c) we have deferred payment of interest on the debentures outstanding under that indenture. We are entitled, at our option but subject to certain conditions, to defer payments of interest on each series of debentures from time to time for up to five years.

Events of default under each indenture generally consist of our failure to pay interest on the TruPS (except in certain circumstances, including a deferral of interest described in (c) above), our failure to pay any principal of, or premium, if any, on, such TruPS when due, our failure to comply with certain covenants under such indenture, and certain events of bankruptcy, insolvency or liquidation relating to us or, in some cases certain of our significant subsidiaries.

 

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Because we have deferred payments of interest on each series of the TruPS, we are prohibited by the indentures from declaring or paying any dividends on our common stock, repurchasing or otherwise acquiring our common stock and making any payments to holders of our common stock in the event of our liquidation. These restrictions, which will continue until we are current on interest payments with respect to these indentures, may have a material adverse effect on the market value of our common stock. This will cause us to incur increasing interest expense as deferred interest payments are capitalized to principal, and may limit our ability to raise additional capital.

The proceeds of this offering are intended to be used, in part, to pay deferred interest payments and to provide liquidity at HomeStreet, Inc. for the payment of future interest on TruPS in the event that HomeStreet Bank is unable to make sufficient dividend distributions to HomeStreet, Inc. to make future interest payments. No assurance can be given that the proceeds from the successful completion of this offering will be sufficient for these purposes.

Moreover, without notice to or consent from the holders of our common stock, we may issue additional series of TruPS in the future with terms similar to those of the existing debentures, or enter into other financing agreements that limit our ability to purchase or to pay dividends or distributions on our capital stock, including our common stock.

Management and the board of directors have significant discretion over the investment of the offering proceeds and may not be able to achieve acceptable returns on the proceeds from the offering.

We will have significant flexibility in determining how to apply the net proceeds of this offering, and you will not be able to influence how we deploy this capital in the near term. If we do not apply these funds effectively, we may lose significant business opportunities. Our management may use the proceeds from this offering for corporate purposes that may not increase our market value or make us profitable. Our failure to utilize these funds effectively could reduce our profitability and our stock price could decline if the market does not view our use of the net proceeds from this offering favorably. We have not established a timetable for the effective deployment of the proceeds, and we cannot predict how long it will take to deploy the proceeds. Investing the offering proceeds in securities until we are able to deploy the proceeds will provide lower margins than we generally earn on loans, potentially adversely affecting shareholder returns, including earnings per share, return on assets and return on equity.

An investment in our common stock is not an insured deposit.

Our common stock is not a bank savings account or deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or any other public or private entity. As a result, if you acquire our common stock, you could lose some or all of your investment.

 

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USE OF PROCEEDS

We estimate that the net proceeds that we will receive in this offering will be approximately $[], based upon the expected sale of [] shares of our common stock by us in this offering at an assumed offering price of $[] per share and after deducting the underwriter’s discounts and commissions and estimated offering expenses payable by us. This estimated amount of net proceeds assumes that the underwriters’ over allotment option is not exercised. If the over allotment option is exercised in full, our net proceeds are expected to be approximately $[].

We intend to contribute $[] million of net proceeds from this offering to the Bank as equity capital in order to help us comply with the terms of the Orders by meeting the minimum capital requirements and the remaining proceeds will be used for our general corporate purposes.

The amount and timing of the actual use of proceeds described above may vary significantly and depend on a number of factors, including those factors described in this prospectus under the heading “Risk Factors.”

 

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CAPITALIZATION

The following table sets forth, among other things, our cash and cash equivalents, liabilities, capitalization and regulatory capital ratios as of December 31, 2010:

 

   

on an actual basis; and

 

   

on a pro forma basis to give effect to, and show the impact of, the issuance of our common stock in this offering at $[] per share, net of the underwriters’ discounts and commissions and other offering expenses paid by us in connection with this offering, and the repurchase of $5.0 million par value of our outstanding senior notes as if each occurred on December 31, 2010.

This table should be read in conjunction with the more detailed information contained elsewhere in this prospectus, including “Use of Proceeds,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Selected Historical Consolidated Pro Forma and Separate Financial and Other Data” and the audited annual and unaudited interim financial statements and other financial information and related notes included elsewhere in this prospectus.

 

    As reported     Adjustments  
      Offering of the
Common Stock
Pursuant to this
Prospectus
    Pro Forma  

Liabilities

     

Deposits

  $ 2,129,742       

FHLB Advances

  $ 165,869       

Securities sold under agreements to repurchase

  $         

Senior debentures

  $ 66,857       

Accrued expenses and other liabilities

  $ 64,440       
                       

Total liabilities

  $ 2,426,908       
                       

Shareholders’ Equity

     

Preferred stock, no par value; 10,000 shares authorized; no shares issued and outstanding

     

Common stock, no par value; 100,000,000 shares authorized; 3,377,186 shares issued and outstanding, actual; and             shares issued and outstanding, pro forma

  $ 511       

Additional paid in capital

  $ 16       

Retained earnings

  $ 65,627       

Treasury stock

     

Accumulated other comprehensive loss, net of taxes

  $ (7,365    
                       

Total shareholders’ equity

  $ 58,789       
                       

Per Common Share

     

Common book value per share

  $ 17.41       

Tangible common book value per share

  $ 17.28       
                       

Regulatory Capital Ratios for the Bank:

     

Tier 1 Core Capital Ratio

    4.5    

Tier 1 Risk-Based Capital Ratio

    6.9    

Total Risk-Based Capital Ratio

    8.2    

 

 

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DILUTION

If you invest in our common stock, your interest will be diluted to the extent of the difference between the price per share you pay and our net tangible book value per share immediately after this offering.

Our net tangible book value per share represents the amount of our total tangible assets reduced by the amount of our total liabilities and divided by the total number of shares of common stock outstanding. Dilution in net tangible book value per share represents the difference between the amount per share paid by purchasers of shares of our common stock in this offering and the pro forma net tangible book value per share of our common stock as adjusted for the expected sale of [] shares of our common stock by us in this offering at an assumed offering price of $[] per share and for our receipt of the estimated net proceeds of that sale after deducting the estimated underwriter’s discounts and commissions and estimated offering expenses payable by us.

Our net tangible book value as of December 31, 2010 was approximately $58.4 million, or $17.28 per share of our common stock. Based on the foregoing, our pro forma, net tangible book value as adjusted and as of the completion of this offering would be approximately $[], or $[] per share of our common stock. This amount represents an immediate increase in net tangible book value of $[] per share to our shareholders as of December 31, 2010, and an immediate dilution in net tangible book value of $[] per share of our common stock to purchasers in this offering. The following table illustrates this per share dilution:

 

Assumed initial public offering price before any transaction costs

      $                

Pro forma net tangible book value of each share of our common stock as of [], 2011

   $                   

Increase in net tangible book value of each share of our common stock attributable to new investors

   $        

Pro forma, as adjusted net tangible book value of each share of our common stock assuming the completion of this offering

      $     

Dilution in pro forma net tangible book value of each share of our common stock to new investors

      $     

If the underwriters exercise in full their over-allotment option, dilution per share to new investors would be approximately $[] based on the assumptions set forth above.

The following table summarizes, as of [], 2011, on the pro forma basis, as adjusted, described above, the differences between existing shareholders and new investors with respect to the number of shares of our common stock purchased from us, the total consideration paid and the average price per share paid before deducting the underwriter’s discounts and commissions and our estimated offering expenses.

 

     Shares Purchased      Total Consideration      Average Price
Per Share
 
     Number      Percentage      Amount      Percentage     

Existing shareholders

              

New investors in this offering

              

Total

              

As of December 31, 2010, and after giving effect to retention grants in 2010, there were options outstanding to purchase an aggregate of 279,000 shares of our common stock with exercise prices ranging from $0.90 to $1.20 per share. Following the closing of this offering, we will also have available for issuance as awards under our 2010 Equity Incentive Plan an additional number of shares of common stock equal to 10.0% of the number of issued and outstanding shares of our common stock following the closing of this offering calculated on a fully diluted basis. We will also have available for issuance [] shares of common stock that will be issuable to our non-employee directors as part of their annual compensation under a director equity compensation plan to be implemented following the closing of this offering.

 

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DIVIDEND POLICY

The board of directors of HomeStreet, Inc. has in the past authorized an annual cash dividend. The most recent dividend it declared was paid on April 15, 2008 to shareholders of record as of April 1, 2008 at a rate of $0.90 per share, which equated to $3.0 million, or 14.8% of our net income for the year ended December 31, 2007.

The amount and timing of any future dividends has not been determined. The payment of dividends will depend upon a number of factors, including capital requirements, the Company’s and the Bank’s financial condition and results of operations, tax considerations, statutory and regulatory limitations, general economic conditions and certain restrictions described below.

We are currently subject to a cease and desist order issued by the OTS that prohibits us from declaring, making or paying any dividends on our common stock without the prior written consent of the OTS. See “Regulation and Supervision — Cease and Desist Orders” for information on that regulatory restriction.

Our outstanding trust preferred securities, or TruPS, also restrict the payment of dividends under the terms of their indentures. We have issued $61.9 million in junior subordinated debentures in connection with the sale of TruPS by the HomeStreet Statutory Trusts. The related indenture agreements, guarantees and declarations of trust for each statutory trust prohibit us, subject to limited exceptions, from declaring or paying any dividends or distributions on, or redeeming, repurchasing, acquiring or making any liquidation payments with respect to, any of our capital stock at any time when (1) an event of default has occurred or is occurring under such debentures (2) we are in default with respect to payment of any obligations under such guarantee or (3) we have deferred payment of interest on the outstanding junior subordinated debentures, which deferral of interest is permitted by the terms of the indentures from time to time for up to five years. We have deferred payment of interest on all of the junior subordinated debentures for each quarter since December 15, 2008. Accordingly, the restrictions on dividends and repurchases described in this paragraph are effective and will continue to be effective until we are current on our interest payments with respect to the junior subordinated debentures. See “Business — Our Structure.”

Our ability to pay dividends will also depend, in large part, upon receipt of dividends from the Bank. We will have limited sources of income other than dividends from the Bank and earnings from the investment of proceeds from this offering that we retain. The Bank is also currently subject to a cease and desist order issued by the FDIC and the DFI that prohibits the Bank from declaring, making or paying any dividends on its common stock without prior written consent of the FDIC and the DFI. See “Regulation and Supervision — Cease and Desist Orders” for more information on that regulatory restriction.

For the foregoing reasons, there can be no assurance that we will pay dividends on our common stock in any future period.

 

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SELECTED HISTORICAL CONSOLIDATED FINANCIAL AND OTHER DATA

The following table sets forth selected historical consolidated financial and other data for us at and for each of the periods ended as described below. The selected historical consolidated financial statements represent the combined financial condition and results of operations of HomeStreet, Inc. and its subsidiaries, including the Bank. The selected historical consolidated financial data as of December 31, 2010 and 2009 and for each of the years ended December 31, 2010, 2009 and 2008 have been derived from, and should be read together with, our audited consolidated financial statements and related notes included elsewhere in this prospectus. The selected historical consolidated financial data as of December 31, 2008, 2007 and 2006 and for each of the years ended December 31, 2007 and 2006 have been derived from our audited consolidated financial statements which are not included in this prospectus.

You should read the following selected historical consolidated financial and other data in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and the notes thereto which are included elsewhere in this prospectus.

 

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     December 31,  
     2010 (1)     2009     2008     2007     2006  
(in thousands, except share data)                               

Income Statement Data (for the period ended):

          

Net interest income

   $ 39,034      $ 31,502      $ 75,885      $ 90,037      $ 86,779   

Provision for loan losses

     37,300        153,515        34,411        10,955        6,471   

Noninterest income

     96,931        59,230        40,345        23,298        19,313   

Noninterest expense

     132,215        94,448        70,189        71,253        68,131   
                                        

Net (loss) income before taxes

     (33,550     (157,231     11,631        31,127        31,490   

Income taxes

     697        (46,955     3,202        10,663        10,173   
                                        

Net (loss) income

   $ (34,247   $ (110,276   $ 8,429      $ 20,464      $ 21,317   
                                        

Basic (loss) earnings per common share

   $ (10.14   $ (32.65   $ 2.50      $ 6.06      $ 6.30   

Diluted (loss) earnings per common share

   $ (10.14   $ (32.65   $ 2.50      $ 6.04      $ 6.24   

Common shares outstanding

     3,377,186        3,377,186        3,377,186        3,368,204        3,379,606   

Weighted average common shares

          

Basic

     3,377,186        3,377,186        3,371,622        3,376,351        3,384,162   

Diluted

     3,377,186        3,377,186        3,375,894        3,390,692        3,416,195   

Shareholders equity per share

   $ 17.41      $ 27.21      $ 61.03      $ 58.80      $ 53.36   

Dividends per share

   $      $      $ 0.90      $ 0.90      $ 0.85   

Dividend payout ratio

                   36.00     14.85     13.49

Financial position (at year end):

          

Cash and cash equivalents

   $ 72,639      $ 217,103      $ 270,577      $ 43,635      $ 53,972   

Investment securities available for sale

     313,513        657,840        56,337        111,621        115,327   

Loans held for sale

     212,602        57,046        48,636        77,969        67,914   

Loans held for investment, net

     1,538,521        1,964,994        2,425,887        2,428,214        2,067,247   

Mortgage servicing rights

     87,232        78,372        57,699        53,422        50,270   

Other real estate owned

     170,455        107,782        20,905        1,974        1   

Total assets

     2,485,697        3,209,536        2,958,911        2,793,935        2,428,054   

Deposits

     2,129,742        2,332,333        1,923,616        1,717,681        1,536,768   

FHLB advances

     165,869        677,840        705,764        746,386        575,063   

Shareholder Equity

     58,789        91,895        206,103        198,052        180,322   

Financial position (averages):

          

Investment securities available for sale

     457,930        372,320        119,720        113,333        133,424   

Loans held for investment

     1,868,039        2,307,215        2,519,811        2,239,639        1,901,996   

Total interest earning assets

     2,642,693        3,056,755        2,762,723        2,435,145        2,103,862   

Total interest bearing deposits

     2,071,237        2,012,971        1,557,533        1,452,742        1,255,402   

FHLB advances

     382,083        685,715        734,989        617,225        520,881   

Total interest bearing liabilities

   $ 2,522,767      $ 2,776,163      $ 2,485,786      $ 2,170,807      $ 1,863,969   

Financial performance:

          

Return on average common shareholder equity (2)

     (38.00 %)      (68.90 )%      4.14     10.74     12.54

Return on average assets

     (1.19 %)      (3.47 )%      0.29     0.79     0.96

Net interest margin (3)

     1.49     1.04     2.78     3.68     4.16

Efficiency ratio (4)

     97.24     104.10     60.39     62.87     64.22

Operating efficiency ratio (5)

     73.56     92.55     59.06     62.82     64.17

Credit quality:

          

Allowance for loan losses

   $ 64,177      $ 109,472      $ 58,587      $ 38,804      $ 27,834   

Allowance/Total loans

     4.00     5.28     2.36     1.57     1.33

Total classified assets

   $ 363,945      $ 570,010      $ 376,424      $ 114,797      $ 34,418   

Classified assets/total assets

     14.64     17.76     12.72     4.11     1.42

Total nonaccrual loans (6)

   $ 113,210      $ 374,219      $ 75,385      $ 33,757      $ 3,361   

Nonaccrual loans/Total loans

     7.06     18.03     3.03     1.37     0.06

Total nonperforming assets

   $ 283,665      $ 482,000      $ 96,291      $ 35,732      $ 3,362   

Nonperforming assets/total assets

     11.41     15.00     3.25     1.28     0.05

Net charge-offs

   $ 83,156      $ 101,680      $ 14,628      $ (15   $ 117   

Regulatory capital ratios for the bank:

          

Tier 1 capital to total assets (leverage)

     4.5     4.5     8.7     9.0     9.9

Tier 1 risk-based capital

     6.9     7.2     10.5     9.9     11.0

Total risk-based capital

     8.2     8.5     11.8     11.2     12.3

SUPPLEMENTAL DATA:

          

Loans serviced for others:

          

Single family

   $ 6,343,158      $ 5,820,946      $ 4,695,804      $ 3,775,362      $ 3,389,050   

Multifamily

     776,671        810,910        822,512        715,946        729,715   

Other

     58,765        69,839        74,230        77,329        53,682   
                                        

Total loans serviced for others

   $ 7,178,594      $ 6,701,695      $ 5,592,546      $ 4,568,637      $ 4,172,447   
                                        

Loan origination activity:

          

Single family

   $ 2,069,144      $ 2,727,457      $ 1,735,897      $ 1,568,834      $ 1,445,218   

Other

     120,058        124,433        817,438        1,332,147        1,650,072   
                                        

Total loan origination activity

   $ 2,189,202      $ 2,851,890      $ 2,553,335      $ 2,900,981      $ 3,095,290   
                                        

 

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(1) On January 1, 2010, we elected to carry mortgage servicing rights related to single family loans at fair value, and elected to carry single family mortgage loans held for sale using the fair value option.

 

(2) Net earnings (loss) available to common shareholders divided by average common shareholders’ equity.

 

(3) Net interest income divided by total average earning assets on a taxable-equivalent basis.

 

(4) The efficiency ratio is noninterest expense divided by total revenue (net interest income and noninterest income).

 

(5) We include an operating efficiency ratio which is not calculated based on accounting principles generally accepted in the United States (“GAAP”), but that we believe provides important information regarding our result of operations. Our calculation of the operating efficiency ratio is computed by dividing noninterest expense less costs related to OREO (gains (losses) on sales, valuation allowance adjustments, and maintenance and taxes) by total revenue (net interest income and noninterest income). Management uses this non-GAAP measurement as part of its assessment of performance in managing noninterest expense. We believe that costs related to OREO are more appropriately considered as credit-related costs rather than as an indication of the operating efficiency of the Company.

 

(6) Generally, loans are placed on nonaccrual status when they are 90 or more days past due.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This section presents management’s perspective on the financial condition and results of operations of HomeStreet, Inc. The following discussion and analysis is intended to highlight and supplement data and information presented elsewhere in this prospectus, including the consolidated financial statements and related notes, and should be read in conjunction with the accompanying tables and our audited financial statements. To the extent this discussion describes prior performance, the descriptions relate only to the periods listed and readers are cautioned that prior performance may not be indicative of our future financial outcomes. In addition, some of the information contained in this section or set forth elsewhere in this prospectus, including discussions about our plans and strategy for our business and our expectations for the effects of those plans, includes forward-looking statements that involve risks, uncertainties and assumptions. See “Forward-Looking Statements” described in the Summary section above. Actual results could differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis as a result of many factors, including those discussed in “Risk Factors.”

Overview

We are a 90-year-old diversified financial services company headquartered in Seattle, Washington, that has grown from a small mortgage bank to a full-service community bank serving consumers and businesses in the Pacific Northwest and Hawaii. In 1986 we established the Bank to fund our lending activities and to offer a broader range of products and services. Our banking strategy has allowed us to expand our lending activities while building stable core deposits and a more diversified core customer base that offers cross-selling opportunities. The Bank has the oldest continuous relationship of all Fannie Mae seller servicers in the nation, having been the second company approved by Fannie Mae at its founding in 1938.

Our primary subsidiaries are HomeStreet Bank and HomeStreet Capital Corporation. HomeStreet Bank is a Washington state-chartered savings bank that provides deposit and investment products and cash management services. The Bank also provides loans for single family homes, commercial real estate, construction, land development and commercial businesses. HomeStreet Capital Corporation, a Washington corporation, originates, sells and services multifamily mortgage loans under the Fannie Mae Delegated Underwriting and Servicing Program (“DUS”) in conjunction with HomeStreet Bank. We also provide insurance products and services for consumers and businesses as HomeStreet Insurance and loans for single family homes through a joint venture, Windermere Mortgage Services Series LLC (“WMS”). At December 31, 2010, we had total assets of $2.49 billion, net loans held for investment of $1.54 billion, deposits of $2.13 billion and shareholders’ equity of $58.8 million.

We earn a profit by generating positive “net interest income” which is primarily the difference between our interest income earned on loans and investment securities less the interest we pay on deposits, Federal Home Loan Bank advances, and other borrowings. Our net interest income does not include “noninterest income” from origination, sale and servicing of loans, and fees earned on deposit services and investment and insurance sales.

Beginning in approximately 2004, we increased our concentration in construction lending in an effort to offset the earnings volatility of our single family lending. We also expanded our branch network in order to grow our deposit base to help fund these loans. However, driven by our opportunities to lend in the fast-growing residential construction sector, we also continued to supplement the funding provided by our growing core deposit base with higher cost and potentially more volatile noncore retail and brokered certificates of deposits and with borrowings that included increasing advances on our line of credit with the Federal Home Loan Bank of Seattle (the “FHLB”). Additionally, to fund the scheduled maturity of our $30.0 million senior credit facility with USAA Life Insurance Company and to augment working capital at HomeStreet, Inc. and regulatory capital at the Bank, between 2005 and 2007 we issued approximately $61.9 million in trust preferred securities. As the global

 

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recession began in 2007 and continued until June 2009, our business experienced a series of interrelated events, the combination of which, when coupled with our preceding funding activities, triggered significant loan and operating losses, eroded capital, seriously weakened our financial condition, challenged our ability to maintain liquidity and strained our regulatory relations.

The U.S. economic recession, which began in 2007 and continued until June 2009, resulted in deteriorating conditions in the U.S. housing market that became evident in 2007. These conditions accelerated and extended through 2010, and we believe they will continue or improve slowly, if at all, for the foreseeable future. As a result, many lenders have been forced out of business or have severely curtailed their operations and most remaining lenders have tightened underwriting standards. As a consequence of these changing conditions in real estate loan availability and the reduction in owners’ equity due to falling real estate values, many borrowers have been unable either to refinance existing loans or sell their homes. Similarly, many prospective home buyers have found it harder to obtain credit. Unemployment rates remain elevated, foreclosure rates have increased, housing inventories have ballooned and home prices have declined. Affected borrowers have struggled to keep their loans current or to refinance into lower interest rate products. These forces have combined to result in significant credit deterioration, particularly in our residential construction and land loan portfolio.

Primarily as a result of rising defaults on residential construction and land loans, our ratio of nonperforming loans to total loans increased from 1.4% at December 31, 2007 to 3.0% at December 31, 2008 and 18.0% at December 31, 2009.

Moreover, although our average interest earning assets increased from $2.44 billion during 2007 to $3.06 billion during 2009, our average loans held for investment remained relatively constant over that period, decreasing from $2.43 billion during 2007 to $2.31 billion during 2009. Additionally, due to rising levels of problem assets, nonperforming assets increased from $35.7 million at December 31, 2007 to $482.0 million at December 31, 2009. During this same period, we established and maintained a high level of liquidity and invested this liquidity in short duration, low-yielding investments. At the same time, in response to the economic turmoil in the national economy, the Federal Reserve Open Market Committee reduced the target interest rate for Federal Funds to its lowest level since 1955 and market interest rates, including the prime rate and LIBOR, decreased accordingly. Most of our loans are variable interest rate loans tied to these indexes. The impact of declining interest rates has been more significant than with our peer institutions as a result of the absence of interest rate floors on many of our loans. At December 31, 2007, $1.35 billion of loans, or 54.8% of net loans, did not have interest rate floors. This combination of circumstances led to a substantial decline in our net interest income, which declined from $90.0 million for the year ended December 31, 2007, to $75.9 million for 2008 and to $31.5 million for 2009. In addition, due to deteriorating credit quality, our provision for loan losses increased from $11.0 million for the year ended December 31, 2007 to $34.4 million and $153.5 million for the years ended December 31, 2008 and 2009, respectively. The economic impact of the foregoing on our results of operations, financial condition and regulatory capital ratios has been severe. For the year ended December 31, 2009, we recognized a net loss of $110.3 million. Additionally, despite our efforts to decrease total assets to mitigate the impact of losses on our regulatory capital ratios, our Tier 1 and total risk based capital ratios fell from 9.0% and 11.2% at December 31, 2007, to 4.5% and 8.5% at December 31, 2009.

As a result of the deterioration in our asset quality, operating performance and capital adequacy, on May 8, 2009, we entered into an agreement with HomeStreet Bank’s primary banking regulators, the Federal Deposit Insurance Corporation, or FDIC, and the Washington State Department of Financial Institutions, or DFI, pursuant to which we consented to the entry of an Order to Cease & Desist from certain allegedly unsafe and unsound banking practices. On May 18, 2009, we entered into a similar agreement with HomeStreet, Inc.’s primary regulator, the Office of Thrift Supervision, or OTS. We refer to the Order to Cease & Desist with the FDIC and the DFI as the Bank Order, the Order to Cease & Desist with the OTS as the Company Order, and to the Bank Order and Company Order collectively as the Orders. Among other things, the Orders required us to increase our capital to certain specified levels, improve management, reduce classified assets and improve earnings. The Orders are described in more detail under “Regulation and Supervision — Cease and Desist Orders.”

 

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In light of the then-prevailing economic conditions confronting our organization and to acquire management experienced in bank turnaround and capital raising, the boards of directors of the Company and the Bank recruited a management team that has proven expertise in raising capital and in turning around troubled financial institutions. Beginning in late 2009, we hired Mark Mason, our Chief Executive Officer, David Hooston, our Chief Financial Officer, Jay Iseman, our Chief Credit Officer, and Godfrey Evans, our General Counsel and Chief Administrative Officer. These executives have developed and implemented a plan to manage and reduce our credit risk, reduce other real estate owned, or OREO, and associated loan and real estate loss exposures, improve our asset yields, maintain liquidity, increase and improve our core deposit base, reduce noncore funding dependence, reduce noninterest expenses, raise capital, and improve our relationships with our federal and state banking regulators. See “Business — Turnaround Plan.”

As discussed below in greater detail, our new management team has improved our business since joining us, substantially improving our financial condition, results of operations and credit risk profile. Among other things, under our new management team:

 

   

Classified assets have declined from $737.9 million, or 22.9% of total assets, at September 30, 2009, to $363.9 million, or 14.6% of total assets, at December 31, 2010, and our nonperforming assets declined from $452.0 million, or 14.0% of total assets, to $283.7 million, or 11.4% of total assets, during that same period. More significantly, nonperforming loans have decreased from $388.7 million, or 17.7% of total loans, at September 30, 2009, to $113.2 million, or 7.1% of total loans, at December 31, 2010, and our ratio of total delinquent and nonaccruing loans to total loans has declined from 22.6% to 11.1% over the same period.

 

   

Construction and land loans, the type of loans from which we have experienced the highest default and losses during this economic downturn, have decreased from $733.4 million, or 33.4% of total loans, at September 30, 2009, to $285.1 million, or 17.7% of total loans, at December 31, 2010.

 

   

Loan loss provisions and net charge-offs have decreased from $153.5 million and $101.7 million for 2009 to $37.3 million and $83.2 million, respectively, for 2010.

 

   

Bank noncore funding (retail certificates of deposit greater than $250,000, brokered deposits and FHLB advances) has decreased from $1.09 billion, or 47.2% of Bank funding, at September 30, 2009, to $265.8 million, or 12.5% of Bank funding, at December 31, 2010.

 

   

Bank core funding (checking, savings and core retail certificates of deposit less than $250,000) has increased from $1.70 billion, or 72.0% of Bank funding, at September 30, 2009 to $1.74 billion, or 81.8% of Bank funding, at December 31, 2010, and in particular, total consumer and business checking accounts have increased from $172.8 million and 19,572 accounts to $187.4 million and 21,148 accounts during that same period.

 

   

The yield on earning assets has increased from 3.40% for the third quarter of 2009 to 4.00% for the fourth quarter of 2010. This increase is due to the combined effect of: (1) establishing interest rate floors on loans at origination, extension, renewal or restructuring, (2) reducing our nonperforming assets and (3) changing the composition and extending the average duration of the investment securities portfolio.

 

   

The net interest margin has increased from 0.85% for the third quarter of 2009 to 2.34% for the fourth quarter of 2010.

 

   

Full time equivalent staff has been reduced by 7.4 % in areas other than the single family lending segment between September 2009 and December 2010. This includes a 45.3% reduction in residential construction lending staff and a 3.2% decrease in corporate operations overhead departments.

 

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Our net loss decreased from $110.3 million in 2009 to $34.2 million in 2010. The 2009 net loss included $40.0 million of tax benefit related to the carry back of 2009 net operating losses to prior periods.

 

   

Notwithstanding the net losses incurred in 2009 and 2010, the Bank’s regulatory capital ratios have remained sufficient to be considered “adequately capitalized” within the meaning of the FDIC’s “prompt corrective action” guidelines in part because our total assets decreased from $3.22 billion at September 30, 2009 to $2.49 billion at December 31, 2010.

We have also continued to improve and expand our single family mortgage banking operations. In 2009 and 2010, as a consequence of low and falling interest rates, we experienced high levels of residential loan refinancings. This expansion of our single family mortgage business has produced unanticipated increases in loan volumes and expanded profit margins despite the burdens of increased compliance responsibilities. For the periods ended December 31, 2009 and 2010, the Bank originated $2.73 billion and $2.07 billion of single family loans, respectively. Our single family lending segment produced net income of $23.2 million and $41.7 million for the years ended December 31, 2009 and December 31, 2010, respectively.

Our capital levels declined substantially from 2008 to 2010 as a result of operating losses incurred by the Bank. Declining total assets have mitigated the impact of these losses on our regulatory capital ratios. Our Tier 1 leverage capital and total risk-based capital ratios stood at 4.5% and 8.2%, respectively, at December 31, 2010, as compared to 4.5% and 8.5% at December 31, 2009, and 8.7% and 11.8% at December 31, 2008.

This offering reflects one of management’s primary initiatives to improve our regulatory capital ratios. Based upon our discussions with the OTS, the FDIC, the DFI and the Federal Reserve, if we achieve our projected capital ratios and asset quality levels, we believe we will qualify for termination of the Orders upon the successful completion of the offering. Our regulators have not given us, and we cannot give any assurances, that the Orders will be lifted, nor can we determine what might be the terms, if any, of substitute agreements regarding minimum capital levels with the banking regulators if the Orders were terminated.

Recent Developments

On March 23, 2011 we completed the sale of our recently foreclosed Cascadia land development project for $49.1 million, or net proceeds of $48.1 million, which equaled the then-current book value of that nonperforming asset.

At this time, we are continuing to monitor the ongoing congressional deliberations regarding the proposed restructurings of government agencies or sponsored entities such as Fannie Mae and Freddie Mac. A significant portion of our net income derives from originating residential mortgage loans directly at the Bank and through our WMS joint venture. We resell those mortgage loans to Fannie Mae, Freddie Mac and other government sponsored entities, and earn servicing revenues by continuing to collect on and provide other services in connection with those loans. We expect to adjust our business as necessary to refine our origination and servicing operations to adapt to these developments as they occur. However, at this time, we cannot predict what, if any, adjustments we may make or how any adjustments may affect our business or results of operations.

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with the accounting principles generally accepted in the United States (GAAP) requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expense in the financial statements. Various elements of our accounting policies, by their nature, involve the application of highly sensitive and judgmental estimates and assumptions. Some of these policies and estimates relate to matters that are highly complex and contain inherent uncertainties. It is possible that, in some instances, different estimates and assumptions could reasonably

 

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have been made and used by management, instead of those we applied, which might have produced different results that could have had a material effect on the financial statements.

We have identified the following accounting policies and estimates that, due to the judgments and assumptions inherent in those policies and estimates and the potential sensitivity of its financial statements to those judgments and assumptions, are critical to an understanding of our financial statements. We believe that the judgments, estimates and assumptions used in the preparation of its financial statements are appropriate.

Allowance for Loan Losses

The allowance for loan losses represents management’s estimate of incurred credit losses inherent within our loan portfolio as of the balance sheet date. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for loan losses in those future periods.

We employ a disciplined process and methodology to establish our allowance for loan losses including a specific allowance for impaired loans equal to the amount of impairment calculated on those loans, charging off amounts determined to be uncollectible. A loan is considered impaired when it is probable that all contractual principal and interest payments due will not be collected substantially in accordance with the terms of the loan agreement. The provision for loan losses recorded through earnings is based on management’s assessment of the amount necessary to maintain the allowance for loan losses at a level adequate to absorb probable incurred losses inherent within the loans held for investment portfolio. The amount of provision and the corresponding level of allowance for loan losses are based on our evaluation of the collectability of the loan portfolio based on historical loss experience and other significant qualitative factors, including:

 

   

the level and trends of delinquencies;

 

   

variability in collateral valuations;

 

   

regional economic activity, including trends in regional unemployment;

 

   

the time periods during which the loans were originated;

 

   

the ability of the customer to continue to make payments as interest rates change;

 

   

changes in the experience, ability and depth of lending management;

 

   

the volume of nonaccrual and adversely classified loans; and

 

   

the results of internal and external loan reviews.

The methodology for evaluating the adequacy of the allowance for loan losses has two basic elements: first, the identification of impaired loans and the measurement of impairment for each individual loan identified; and second, a method for estimating an allowance for all other loans.

Factors considered by management in determining whether a loan is impaired include payment status, collateral value, borrower financial condition, guarantor support and the probability of collecting scheduled principal and interest payments when due. In the case of impaired loans for which collection is dependent upon the performance or liquidation of the collateral, impairment is measured as the difference between the balance on the loan and the fair value of the collateral, less estimated selling costs. Impairment for loans that are not

 

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collateral dependent is measured as the difference between the discounted values of their expected future cash flows, based on the current effective interest rate and committed balance of the loan. A specific allowance is provided for equal to the calculated impairment and included in the allowance for loan losses. If the calculated impairment is determined to be permanent, fixed or non-recoverable, the impairment will be charged off.

In estimating the general allowance for loan losses for unimpaired loans, such loans are segregated into loan portfolio segments. Loans are designated into homogeneous pools based on product types and similar risk characteristics or areas of risk concentration.

For each homogeneous loan pool, we estimate inherent losses by applying a rate of loss equal to four trailing quarters of historical losses. Additional incurred losses are also estimated for these same pools of loans based upon key risk indicators. Key risk indicators for each pool include the following: (1) loan delinquency trends, (2) variability in collateral valuation, (3) regional economic activity and trends, (4) current levels of interest rates and (5) the vintage of loans at origination. Key risk indicators are expressed in basis points and are adjusted downward or upward based on management’s judgment as to the potential loss impact of each qualitative factor to a particular loan pool at the date of the analysis.

The FDIC and the DFI, as an integral part of their examination process, review the allowance for loan losses. These agencies may require changes in the classification of criticized or adversely classified loans and additions to the allowance for loan losses based on their judgment about information available at the time of their examinations.

The allowance for loan losses, as reported in our consolidated statements of financial condition, is increased by a provision for loan losses, which is recognized in earnings, and reduced by the charge off of loan amounts, net of recoveries.

Fair Value

A portion of our assets are carried at fair value, including mortgage servicing rights, loans held for sale, interest rate lock commitments, investment securities available for sale and derivatives used in our hedging programs. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The degree of management judgment involved in estimating the fair value of a financial instrument or other asset generally correlates to the level of observable pricing. Fair value measured from observable quoted market prices in an active market will generally require less management judgment. Conversely, financial instruments or other assets rarely traded or not quoted will generally require a higher degree of judgment from management to estimate fair value by choosing and applying valuation models to estimate the fair value. These valuation models may use inputs such as forward yield curves, loan prepayment assumptions, expected loss assumptions, market volatilities and pricing spreads using market-based inputs where available. While we believe that these inputs are comparable to those that would be used by other market participants, different assumptions could result in significant changes in valuation. Estimated fair value cannot be determined with precision and may not be realized in the actual sale or transfer of the asset or liability being valued in a current market exchange.

The following financial instruments and other assets require the management’s most complex judgments and assumptions when estimating fair value:

Mortgage Servicing Rights

Mortgage servicing rights (MSRs) are recorded as separate assets through the purchase of the rights or upon the sale of mortgage loans with servicing rights retained. Net gains on mortgage loan origination and sale activities depend, in part, on the fair value of servicing rights. We value mortgage servicing rights based on

 

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quoted market prices, other observable market data, or a discounted cash flow model depending on the availability of market information.

On January 1, 2007, we adopted Accounting Standards Codification (“ASC”) 860, Transfers and Servicing (ASC 860). ASC 860 requires that an MSR resulting from the sale or securitization of loans be initially measured at fair value at the date of transfer and permits an election between fair value and the lower of amortized cost or fair value for subsequent measurement. As of January 1, 2010, management elected to account for single family mortgage servicing rights at fair value during the life of the MSR, with subsequent changes in fair value recorded through current period earnings. Fair value adjustments encompass market-driven valuation changes as well as run-off of value that occurs due to the passage of time. We continue to value multifamily MSRs at the lower of amortized cost or fair value.

Subsequent fair value measurements of single family MSRs are determined by calculating the present value of estimated future net servicing income because MSRs are not traded in an active market with readily observable market prices. The discounted cash flow model uses several significant assumptions, such as market interest rates, projected prepayment speeds, discount rates, estimated costs of servicing and other income and additional expenses associated with the collection of delinquent loans. In addition, third-party valuations estimating the fair value of the mortgage servicing asset portfolio are obtained at least annually and compared to the carrying values of our MSRs.

Market expectations of the life of loans, and correspondingly the expected future servicing cash flows, may vary from time to time due to changing prepayment activity by borrowers, especially when interest rates rise or fall. Market expectations of increased loan prepayment speeds may negatively impact the fair value of the single family mortgage servicing rights. Fair value is also dependent on the discount rate used in calculating present value, which is imputed from observable market activity and market participants. Management reviews and adjusts the discount rate on an ongoing basis. An increase in the discount rate would reduce the estimated fair value of the single family mortgage servicing rights asset.

The mortgage servicing assets are reported in our consolidated statements of financial condition. The changes in fair value for the single family mortgage servicing assets and the amortization of the multifamily mortgage servicing assets are reported in our consolidated statements of operations.

Investment Securities

Investment securities are classified as available for sale and are carried at fair value. Amortization of premiums and accretion of discounts are recognized in interest income using the interest method, adjusted for anticipated prepayments where applicable. Unrealized holding gains and losses, net of income taxes, are excluded from earnings and reported as a separate component of accumulated other comprehensive income and reclassified into earnings when realized, such as upon sale of the security.

Management monitors the portfolio of securities classified as available for sale for impairment, which may result from credit deterioration of the issuer, changes in market interest rates relative to the rate of the instrument, or changes in prepayment speeds. An evaluation of each investment security is performed no less frequently than quarterly to assess if impairment is considered other-than-temporary. In conducting this evaluation, management considers many factors, including but not limited to whether we expect to recover the entire amortized cost basis of the security in light of adverse changes in expected future cash flows, the length of time the security has been impaired and the severity of the unrealized loss. Management also considers whether we intend to sell the security or if it is more likely than not that we will be required to sell the security prior to recovery. The determination of other-than-temporary impairment is a subjective process, requiring the use of judgments and assumptions in interpreting relevant market data. Other-than-temporary valuation losses on securities classified as available for sale are reported in our consolidated statements of operations.

 

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Derivatives and Hedging Activities

We enter into contracts to manage the various risks associated with certain assets, liabilities or probable forecasted transactions. When we enter into derivative contracts, the derivative instrument is designated as: (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (a fair value hedge), (2) a hedge of the variability in expected future cash flows associated with an existing recognized asset or liability or a probable forecasted transaction (a cash flow hedge) or (3) held for other risk management purposes (risk management derivatives).

All derivatives, whether designated in hedging relationships or not, are recorded at fair value as either assets or liabilities in our consolidated statements of financial condition. Changes in fair value of derivatives that are not in hedge accounting relationships, such as risk management derivatives, are recorded in our consolidated statements of operations in the period in which the change occurs. Changes in the fair value of derivatives in qualifying fair value hedge accounting relationships are recorded each period in earnings along with the change in fair value of the hedged item attributable to the risk being hedged. Changes in fair value of derivatives that are designated as cash flow hedges, to the extent such hedges are deemed highly effective, are recorded as a separate component of accumulated other comprehensive income and reclassified into earnings when the earnings effect of the hedged cash flows is recognized.

The determination of whether a derivative qualifies for hedge accounting requires complex judgments about the application of ASC 815, Derivatives and Hedging. Additionally, this standard requires contemporaneous documentation of our hedging relationships. Such documentation includes the nature of the risk being hedged, the identification of the hedged item, or the group of hedged items that share the risk exposure that is designated as being hedged, the selection of the instrument that will be used to hedge the identified risk and the method used to assess effectiveness of the hedge relationship. The assessment of hedge effectiveness must support the determination that the hedging relationship is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period that the hedge is designated. If our assessment of effectiveness is not considered to be adequate to achieve hedge accounting treatment, the derivative is treated as a free-standing risk management instrument.

Results of Operations—Comparison of 2010 to 2009

For the year ended 2010, we reported a net loss of $34.3 million, compared with a net loss of $110.3 million for 2009.

 

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Average Balances and Rates

Average balances, together with the total dollar amounts of interest income and expense, on a tax equivalent basis related to such balances and the weighted average rates, for fiscal years ended December 31, 2010, 2009 and 2008 were as follows:

 

    Year Ended December 31,  
    2010     2009     2008  
    Average
Balance
    Interest     Average
Yield/
Cost
    Average
Balance
    Interest     Average
Yield/
Cost
    Average
Balance
    Interest     Average
Yield/
Cost
 
(in thousands)                                                      

Assets:

                 

Interest-earning assets(1):

                 

Cash & cash equivalents

  $ 196,109      $ 538        0.27   $ 259,665      $ 584        0.23   $ 32,070      $ 524        1.63

Investment securities

    457,930        7,831        1.71     372,320        4,376        1.18     119,720        5,503        4.60

Loans held for sale

    120,619        6,263        5.19     117,555        7,647        6.51     91,123        5,190        5.70

Loans held for investment

    1,868,035        79,266        4.24     2,307,215        99,130        4.30     2,519,811        156,920        6.23
                                                                       

Total interest-earning assets(2)

    2,642,693        93,898        3.55     3,056,755        111,738        3.66     2,762,723        168,138        6.09

Noninterest-earning assets(3)

    239,051            82,068            96,226       
                                   

Total assets

  $ 2,881,744          $ 3,138,823          $ 2,858,949       
                                   

Liabilities and Shareholders’ Equity:

                 

Deposits:

                 

Interest-bearing demand accounts

    110,637        686        0.62     99,884        1,259        1.26     82,033        1,254        1.53

Savings accounts

    54,340        479        0.88     112,562        2,900        2.58     31,302        631        2.02

Money market accounts

    381,054        3,973        1.04     304,832        4,515        1.48     304,550        7,827        2.57

Certificate accounts

    1,525,206        33,912        2.22     1,495,693        45,679        3.05     1,139,648        44,953        3.94
                                                                       

Deposits

    2,071,237        39,050        1.89     2,012,971        54,353        2.70     1,557,533        54,665        3.51

Fed discount borrowings

                  0.00     688        3        0.50     86,594        1,940        2.24

FHLB advances

    382,083        11,682        3.06     685,715        21,068        3.07     734,989        29,030        3.95

Securities sold under agreements to repurchase

    2,521        11        0.43     9,317        267        2.87     24,159        672        2.78

Long-term debt

    66,857        3,824        5.72     66,857        4,270        6.39     78,890        5,205        6.60

Other borrowings

    69        2        3.03     615        (92     -14.97     3,621        212        5.86
                                                                       

Total interest-bearing liabilities(2)

    2,522,767        54,569        2.16     2,776,163        79,869        2.88     2,485,786        91,723        3.69

Other noninterest-bearing liabilities

    268,245            211,795            174,105       
                             

Total liabilities

    2,791,012            2,987,958            2,659,891       
                                   

Shareholder's equity

    90,732            150,866            199,058       
                                   

Total liabilities and shareholders’ equity

  $ 2,881,744          $ 3,138,823          $ 2,858,949       
                                   

Net interest income(4)

    $ 39,329          $ 31,869          $ 76,414     
                                   

Net interest spread

        1.39         0.78         2.40
                                   

Impact of noninterest-bearing sources

        0.10         0.26         0.38
                                   

Net interest margin

        1.49         1.04         2.78
                                   

 

(1) The daily average balances of nonaccrual assets and related income, if any, are included in their respective categories.

 

(2) Average interest-earning assets and interest-bearing liabilities were computed using daily average balances.

 

(3) Includes loan balances that have been foreclosed and are now reclassified to other real estate owned.

 

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(4) Includes tax equivalent adjustments primarily related to tax-exempt income on certain loans and securities of $295,000, $367,000 and $529,000 for the years ended 2010, 2009 and 2008, respectively. The federal statutory tax rate was 35.0% for the periods presented.

We have not included interest income from nonaccrual loans in interest income. The additional interest income that would have been recorded during the period if the loans had been accruing was $10.1 million, $15.1 million and $3.0 million for the years ended December 31, 2010, 2009 and 2008, respectively.

Rate and Volume Analysis

The following table presents the extent to which changes in interest rates and changes in the volume of our interest-earning assets and interest-bearing liabilities have affected our interest income and interest expense, excluding interest income from nonaccrual loans. Information is provided in each category with respect to: (1) changes attributable to changes in volume (changes in volume multiplied by prior rate), (2) changes attributable to changes in rate (changes in rate multiplied by prior volume), (3) changes attributable to changes in rate and volume (change in rate multiplied by change in volume), which were allocated in proportion to the percentage change in average volume and average rate and included in the relevant column and (4) the net change.

 

     2010 vs. 2009     2009 vs. 2008  
     Increase (Decrease) Due to     Increase (Decrease) Due to  
     Rate     Volume     Total Change     Rate     Volume     Total Change  
(in thousands)             

Assets:

            

Interest-earning assets:

            

Cash & cash equivalents

     113        (160     (47     (8     68        60   

Investment securities

     2,295        1,160        3,455        614        (1,741     (1,127

Loans held for sale

     (1,579     195        (1,384     808        1,649        2,457   

Total loans held for investment

     (1,213     (18,650     (19,863     (45,429     (12,361     (57,790
                                                

Total interest-earning assets

     (385     (17,455     (17,840     (44,015     (12,385     (56,400

Liabilities:

            

Deposits:

            

Interest-bearing demand accounts

     (696     124        (573     (241     246        5   

Savings accounts

     (1,356     (1,066     (2,421     220        2,049        2,269   

Money market accounts

     (1,518     976        (542     (3,319     6        (3,312

Certificate accounts

     (12,652     885        (11,767     (11,478     12,204        726   
                                                

Deposits

     (16,222     919        (15,303     (14,818     14,506        (312

Fed discount borrowings

            (3     (3     (850     (1,086     (1,936

FHLB advances

     (102     (9,285     (9,387     (6,116     (1,846     (7,962

Securities sold under agreements to repurchase

     (138     (118     (256     20        (425     (405

Long-term debt

     (446            (446     (162     (773     (935

Other borrowings

     54        40        94        (247     (58     (304
                                                

Total interest-bearing liabilities

     (16,854     (8,447     (25,301     (22,173     10,319        (11,854
                                                

Total changes in net interest income

     16,469        (9,008     7,461        (21,842     (22,704     (44,546
                                                

Net Interest Income

Our profitability depends partially on net interest income, which is the difference between income earned on our interest-earning assets, primarily loans and investment securities and the rate paid on interest-bearing liabilities. Our interest-bearing liabilities consist primarily of deposits and borrowed funds, including our outstanding trust preferred securities, interest paid on our recently retired senior credit facility and advances from the FHLB.

 

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Net interest income on a tax equivalent basis for the year ended December 31, 2010, was $39.3 million, an increase of $7.5 million, or 23.4%, compared with $31.9 million for 2009. The net interest margin for the year ended December 31, 2010 was 1.49% compared to 1.04% for 2009. Our balance sheet restructuring activities during 2010 included a shift away from high-cost noncore high balance retail certificates of deposit, brokered certificates of deposit and FHLB borrowings toward more stable, lower-cost consumer- and business-based local deposits, resulting in an increase to our net interest income. This trend was partially offset by decreases in our loans held for investment balances which reduced our net interest income. At the same time we have begun to establish floors, or minimum interest rates, on our variable-rate loans upon extension, renewal or restructuring. As we continue to restructure our balance sheet focusing on improving interest margins, we expect a significant improvement in net interest income and our net interest margin.

We experienced a significant change in the components of net interest income from 2009 to 2010. Total interest income, on a tax equivalent basis, decreased $17.8 million, or 16.0%, in 2010 to $93.9 million. Our average balances of outstanding loans held for investment declined by $439.2 million, which had the effect of lowering our interest income by $18.7 million and decreasing the related yield on the loans held for investment portfolio. As a result, our net interest income decreased by $1.2 million. Declines in the yield on loans held for sale balances, resulting from decreased interest rates, also decreased net interest income by $1.6 million in 2010. Partially offsetting these declines was an increase in yield and average balances of investment securities available for sale, increasing net interest income by $2.3 million and $1.2 million, respectively. The increase in the yield of investment securities reflects a shift from shorter- to longer-term instruments as part of our balance sheet restructuring activities. We expect this shift to continue to benefit net interest income over future periods.

At the same time, total interest expense decreased $25.3 million or 31.7% to $54.6 million during 2010, from $79.9 million during 2009, primarily due to a $12.7 million decline interest paid on certificate accounts resulting from a general decline in interest rates and a change in our pricing strategy. During 2010, we allowed higher cost noncore and brokered certificate accounts to mature without renewal. Also driving the decline in interest expense was the maturity and prepayment of $512.0 million of FHLB balances, which generally carry a higher cost than other funding sources such as consumer deposits, resulting in a decrease of $9.3 million in interest expense during 2010. As we continue to emphasize consumer deposits over higher cost brokered or wholesale funding sources, we also expect this shift to benefit net interest income over future periods.

Provision for Loan Losses

Our loan loss provision expense for 2010 was $37.3 million, compared with $153.5 million for 2009, a decline of $116.2 million, or 75.7%. This decline resulted primarily from reductions in classified and nonperforming assets and related reductions in loan charge offs. This improvement reflects improvement in our credit quality in 2010 as we began to experience what we believe was the bottom of the economic cycle in late 2009 and early 2010. We expect to continue recognizing higher than normal provisions for loan losses in the near term as we continue to work through our remaining problem loans; however, in the absence of further economic turmoil, we do not expect a return to the levels of loan loss provisions experienced in recent years. The provision for loan losses is discussed in greater detail below in “— Credit Risk Management.”

Noninterest Income

Noninterest income was $96.9 million for the year ended December 31, 2010, an increase of $37.7 million, or 63.7%, from $59.2 million in 2009. Our noninterest income is heavily dependent upon our single family mortgage banking activities. The level of our mortgage banking activity fluctuates and is influenced by mortgage interest rates, the economy, employment and housing affordability, among other factors. Noninterest income in 2010 benefited from growth in our portfolio of loans serviced for others as well as an improved hedging strategy for single family mortgage servicing rights enabled by our change in accounting to carry single family mortgage servicing assets at fair value, as of January 1, 2010. See “— Critical Accounting Policies and Estimates —

 

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Mortgage Servicing Rights.” Our mortgage banking origination volumes decreased in 2010 as compared with 2009; however, our revenues per loan increased during the same period. While mortgage origination volume decreased from 2009, our origination volume continued to be high in comparison to historic levels as a result of a sustained period of historically low interest rates in 2010 and a one-time federal tax credit to first time home buyers. In addition, our revenues per loan increased as a result of continued higher profit margins available in the market place due to a continued contraction in competition resulting from the economic downturn and increased regulation. Revenues per loan also increased due to somewhat higher purchase volumes as a percentage of overall loan origination because purchase loans have a higher value of retained servicing.

Noninterest income consisted of the following:

 

     Year ended
December 31,
    Dollar Change  
(in thousands)    2010      2009     2010 vs. 2009  

Noninterest income

       

Net gains on mortgage loan origination/sales activities

   $ 57,127       $ 52,831      $ 4,296   

Mortgage servicing

     26,226         (4,495     30,721   

Income from Windermere Mortgage Services

     2,162         4,663        (2,501

Depositor and other retail banking fees

     3,397         3,352        45   

Insurance commissions

     1,164         792        372   

Gain on sale of investment securities available for sale

     6,016         237        5,779   

Other

     839         1,850        (1,011
                         

Total noninterest income

   $ 96,931       $ 59,230      $ 37,701   
                         

The significant components of our noninterest income are described in greater detail, as follows:

Net gains on mortgage loan origination and sales activities were $57.1 million in 2010, an increase of $4.3 million, or 8.1%, from $52.8 million in 2009, and primarily reflects the impact of a change in accounting to carry loans held for sale at fair value and an increase in the profit margin on loans sold offset by a decrease in loan origination and sales volume.

As of January 1, 2010, management elected to carry single family loans held for sale at fair value. Using this methodology, $8.3 million of 2010 origination costs that otherwise would have been deferred and recognized as a reduction to net gain on loan origination and sales activities was instead recognized as noninterest expense. Had 2009 been recorded under the fair value method, thereby excluding these origination costs, net gain on loan origination and sales activities would have been $63.6 million, or $10.7 million higher than reported, which reflects a decrease of $6.4 million between 2009 and 2010 principally associated with a reduction in single family loan origination volume.

On this comparable basis, net gains on mortgage loan origination and sales activities for single family loans decreased to $56.0 million in 2010, from $62.4 million in 2009. This $7.1 million decline was the net result of two factors: volume and rate. A decrease in volume, to $1.88 billion for 2010 compared to $2.55 billion in 2009, was partly offset by higher revenue per loan sold during 2010. The drop in loan sales volumes contributed $16.5 million to the year-over-year decrease in revenue while a partially offsetting increase of $9.4 million was due to an improvement in our net revenue per loan sold. The rate for 2010 was 295 basis points while the comparable rate for 2009 was 245 basis points.

Net gains on mortgage loan origination and sales activities of Fannie Mae Delegated Underwriting and Servicing Program, or DUS, loans was $1.1 million in 2010, down from $1.2 million in 2009. This decrease was primarily due to reduced loan volumes, which were $43.4 million in 2010, down 12.7% from $50.0 million in 2009.

 

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Mortgage servicing income consisted of the following:

 

    Year Ended December 31,     Dollar Change  
    2010     2009     2010 vs. 2009  
    Single-
family
    Multifamily     Total     Single-
family
    Multifamily     Total     Total  
(in thousands)                                          

Servicing fees and other

  $ 20,112      $ 3,167      $ 23,279      $ 15,612      $ 3,477      $ 19,089      $ 4,190   

Changes in fair value, single-family mortgage servicing rights:

             

Due to changes in model or assumptions(1)

    (7,594     n/a        (7,594     n/a        n/a               (7,594

Due to payments on loan balances and other(2)

    (13,513     n/a        (13,513     n/a        n/a               (13,513

Amortization

    n/a        (1,370     (1,370     (17,576     (1,302     (18,878     17,508   

Recovery/(impairment)(3)

    n/a                      1,335               1,335        (1,335

Net gain (loss) from derivatives economically hedging MSRs

    25,424               25,424        (6,041            (6,041     31,465   
                                                       

Total Mortgage servicing

  $ 24,429      $ 1,797      $ 26,226      $ (6,670   $ 2,175      $ (4,495   $ 30,721   
                                                       

 

(1) Principally reflects changes in discount rates and prepayment speed assumptions, mostly due to changes in interest rates.

 

(2) Represents changes due to collection and realization of expected cash flows and curtailments over time.

 

(3) Represents adjustments to the carrying value of MSRs due to temporary (impairment) or recovery in accordance with the lower of amortized cost or fair value methodology.

For the year ended December 31, 2010, mortgage servicing income was $26.2 million, an increase of $30.7 million from a loss of $4.5 million in 2009. During 2010, mortgage servicing income benefited from our election as of January 1, 2010 to value single family mortgage servicing rights, or MSRs, at fair value. As a result of this change, we recognized a $6.5 million increase to carrying value and a corresponding increase in the 2010 beginning shareholders’ equity. Recording single family MSRs at fair value allows for all changes in value to be fully realized in the period of change, whereas the prior accounting method (lower of amortized cost or fair value) limited upward changes in value to a maximum of amortized cost. This change in valuation methodology allowed us to more closely align offsetting changes in value between single family MSRs and hedging derivatives resulting in more effective hedging results.

Prior to 2010 the objective of our hedging strategy was to mitigate the risk associated with deterioration in MSR value due to factors other than normal amortization of loan balances underlying the MSR, including modest levels of loan prepayments. As of January 1, 2010, our strategy shifted to be more comprehensive in considering factors that influence MSR asset values, and now include normal amortization and prepayments of loans underlying the MSR assets as well as appreciation in the MSR above amortized cost. These changes in hedging strategy reduce the volatility in earnings due to changes in MSR values allowing for the declining value due to normal amortization of the loans underlying the MSRs. MSRs resulting from the sale of multifamily loans continue to be valued at fair value at the date of transfer and subsequently valued at the lower of amortized cost or fair value.

During 2009 and 2010 we experienced significant volatility in MSR values because of a significant increase in loan payoffs due to a low interest rate environment followed by an increased rate environment near each year end. To mitigate the impact of changes in the fair value of our single family MSRs, we use a variety of derivative

 

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financial instruments as economic hedges, including positions in futures, options on treasury securities, forward sales commitments on mortgage-backed securities and interest rate swap contracts. In 2010 the net change in the fair value of single family MSRs and related hedging instruments was a gain of $4.3 million as compared to a loss of $22.3 in 2009.

The loans serviced for others portfolio increased to $7.18 billion at December 31, 2010, as compared with $6.70 billion as of December 31, 2009. Substantially all of our new loan originations are designated as held for sale, much of which are sold with servicing retained. Also contributing to the increase in servicing fees was a shift in the composition of loans sold with servicing retained. Ginnie Mae conforming loans generally benefit from a higher servicing fee. During 2008, 2009 and 2010 13.0%, 18.4% and 20.9%, respectively, of loans sold with servicing retained conformed to Ginnie Mae guidelines thereby increasing the average servicing fee per loan sold, from 29 basis points during 2008 to 30 basis points during 2009 and 33 basis points during 2010.

Income from Windermere Mortgage Services was $2.2 million, a decrease of $2.5 million, or 53.6%, from $4.7 million in 2009. This decrease was primarily due to a 24.9% decrease in loans originated by our WMS joint venture. Loan origination fee income also decreased due to the decrease in loan volume, from 83 basis points for 2009 to 58 basis points for 2010.

Depositor and other retail banking fees were $3.4 million, a slight increase from 2009. The following table presents the composition of depositor and other retail banking fees for the periods indicated.

 

     Year Ended December 31,      Dollar Change  
(in thousands)        2010              2009          2010 vs. 2009  

Fees:

        

Monthly maintenance and deposit — related fees

   $ 1,978       $ 2,184       $ (206

Debit Card/ATM fees

     1,217         957         260   

Other fees

     202         211         (9
                          

Total depositor and related fees

   $ 3,397       $ 3,352       $ 45   
                          

Insurance commissions income was $1.2 million in 2010 and $0.8 million in 2009. These commissions increased as a result of increased annuity sales resulting from increased licensing of Bank personnel.

Gain on sale of investment securities available for sale was $6.0 million, as compared to $237,000 in 2009. This increase was predominantly due to the sale of $693.5 million of investment securities at a gain of $5.7 million during 2010, as compared with sales of $93.2 million in 2009. These securities sales were part of our balance sheet restructuring activities during 2010. Balance sheet restructuring is discussed in greater detail in “— Liquidity Risk and Capital Resources—HomeStreet Bank” below.

Other noninterest income was $0.8 million in 2010, down from $1.9 million in 2009. 2009 income included gains on interest rate swaps not repeated in 2010.

Noninterest Expense

Noninterest expense was $132.2 million in 2010, an increase of $37.8 million or 40.0% from $94.5 million in 2009. Noninterest expense increased primarily due to an increase in other real estate owned (OREO) expenses as a result of higher levels of OREO balances and increases in OREO valuation reserves as well as increases in salaries and related costs, general and administrative expenses and FHLB prepayment penalties. These increases were partially offset by decreases in consulting expenses and a FHLB debt extension fee paid in 2009.

 

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Noninterest expense consisted of the following:

 

     Year ended December 31,      Dollar Change  
(in thousands)    2010      2009      2010 vs. 2009  
Noninterest expense         

Salaries and related costs

   $ 49,816       $ 39,926       $ 9,890   

General and administrative

     18,213         12,772         5,441   

Federal Home Loan Bank prepayment penalty

     5,458                 5,458   

Legal

     3,573         3,353         220   

Consulting

     2,761         5,163         (2,402

Federal Deposit Insurance Corporation assessments

     7,618         8,757         (1,139

Occupancy

     7,356         6,486         870   

Information services

     5,223         5,503         (280

Other real estate owned

     32,197         10,479         21,718   

Federal Home Loan Bank debt extension fee

             2,009         (2,009
                          

Total noninterest expense

   $ 132,215       $ 94,448       $ 37,767   
                          

The significant components of our noninterest expense are described in greater detail, as follows:

Salaries and related costs were $49.8 million in 2010, an increase of $9.9 million or 24.8%, from $39.9 million in 2009. Salaries and related costs for 2010 include $8.3 million of direct origination costs that prior to 2010 would have been deferred and recognized as a decrease to net gain on loan origination/sales activities. Upon management’s election to carry single family loans held for sale at fair value, as of January 1, 2010, these costs are no longer deferred and are expensed as incurred. Had 2009 reflected fair value accounting for loans held for sale, salaries and related costs and total noninterest expense would have been $50.7 million and $105.1 million, respectively. After consideration of the foregoing, the remaining decrease in salaries and related costs was due to reduced commissions on lower single formal loan production and staff reductions offset by increased health insurance costs.

General and administrative expense was $18.2 million in 2010, an increase of $5.4 million, or 42.6%, from $12.7 million in 2009. This increase was primarily due to increases in collection and foreclosure expenses. Additionally general and administrative expenses in 2009 included a credit of $1.9 million from a refund of prior year business and occupancy tax.

Federal Home Loan Bank (“FHLB”) prepayment penalty was $5.5 million in 2010 as compared with $0 in 2009. The Company pre-paid $391.0 million of FHLB advances in 2010, incurring a prepayment penalty of $5.5 million, as part of our balance sheet restructuring activities during 2010.

Legal expense was $3.6 million in 2010, an increase of $0.2 million, or 6.6%, from $3.4 million in 2009. This increase was primarily due to our efforts to resolve problem loans and other real estate owned.

Consulting expense was $2.8 million in 2010, a decrease of $2.4 million, or 46.5%, from $5.2 million in 2009. This decrease was primarily due to higher expenses related to our unsuccessful capital raising efforts in 2009.

FDIC Assessments were $7.6 million in 2010, a decrease of $1.1 million or 13.0% from $8.8 million in 2009, predominantly due to a one-time special assessment fee of $1.5 million during 2009, partially offset by an increase in the FDIC fee rate for 2010.

Occupancy expense was $7.4 million in 2010, an increase of $0.9 million, or 13.4%, from $6.5 million in 2009 primarily due to the impacts of lease expenses associated with the Company’s branches and corporate office.

 

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Information services expense was $5.2 million in 2010, a decrease of $0.3 million or 5.1% from $5.5 million in 2009. This decrease was primarily due to a decrease in maintenance related expenses.

Other real estate owned expense was $32.2 million in 2010, an increase of $21.7 million from $10.5 million in 2009. This increase was primarily due to higher levels of other real estate owned (OREO) balances and related increases in OREO valuation reserves, which increased by $18.6 million. This increase reflects ongoing declines in real estate values resulting from continued deterioration in the housing market, as well as an increase of $2.5 million in maintenance and operating expenses, including payment of delinquent property taxes. The remaining annual variance was due to declines in the gains on sale of OREO.

FHLB debt extension fee was $0 in 2010 as compared with $2.0 million in 2009. We paid a debt extension fee to the Seattle FHLB in 2009 to extend maturities on certain FHLB advances.

Income Tax Expense (Benefit)

Income tax expense (benefit) for the years ended December 31, 2010 and 2009 was $697,000 and $(47.0) million, respectively. Our effective tax rate was less than 0.1% and 29.9% for the same periods. As a result of the Worker, Homeownership and Business Assistance Act of 2009, we were able to carry back net operating losses incurred in 2009 to prior taxable years, which had been previously unavailable for carry back. Predominately due to this change, in 2010 and 2009 we recognized current tax benefits of $6.5 million and $41.1 million, respectively. Our effective tax rate in 2010 and 2009 varied from the Federal statutory rate due to valuation allowances established on deferred tax assets because of uncertainty as to our ability to realize these assets in the future.

Capital Expenditures

We had no material capital expenditures in 2009 or 2010. We expect a modest increase in capital expenditures during 2011 targeted to advance strategic initiatives such as branch expansions, new retail and single family products and new methods of product distribution.

Results of Operations — Comparison of 2009 to 2008

For the year ended December 31, 2009, we reported a net loss of $110.3 million, compared with a net gain of $8.4 million for 2008.

Net Interest Income

Net interest income on a tax equivalent basis for the year ended December 31, 2009 was $31.9 million, a decrease of $44.5 million, or 58.4%, from $76.4 million in 2008, largely reflecting a decrease in the net interest margin which declined from 2.78% as of December 31, 2008 to 1.04% as of December 31, 2009. The decline in net interest income is comprised of a decline in total interest income of $56.4 million, or 33.6%, which was partially offset by a decline in interest expense of $11.9 million, or 12.9%. Interest income decreased to $111.7 million for 2009, compared with $168.1 million in 2008. The reduction in interest income is primarily due to a $57.8 million decline in interest earned on loans held for investment, which is comprised of a $45.4 million decline associated with the reduction in average yield from 6.23% to 4.30%, and a $12.4 million decline in interest income associated with the decrease in our average portfolio of loans held for investment from $2.52 billion in 2008 to $2.31 billion in 2009. The decline in yield on loans held for investment reflects the significant decline in market interest rates experienced during the periods compounded by the absence of interest rate floors on a substantial amount of our loans and an increase in nonperforming loans, which increased to $374.2 million as of December 31, 2009 compared with $75.4 million as of December 31, 2008. The decline in

 

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interest expense between 2008 and 2009 primarily reflects the significant decline in market interest rates experienced during the periods and, in turn, the rates we paid on deposits and borrowings, offset by an increase in the average balance of certificate accounts, which increased from $1.14 billion in 2008 to $1.50 billion in 2009.

Provision for Loan Losses

Our loan loss provision expense for 2009 was $153.5 million, an increase of $119.1 million, or more than 100.0%, from $34.4 million in 2008 which resulted primarily from increases in classified and nonperforming assets and related increases in loan charge offs. This deterioration reflects the impact of the economic downturn on our borrowers’ ability to service our loans, declining collateral values and the diminished capacity of our guarantors. The provision for loan losses is discussed in greater detail below in “— Credit Risk Management.”

Noninterest Income

Noninterest income was $59.2 million for the year ended December 31, 2009, an increase of $18.9 million, or 46.8%, from $40.3 million in 2008. The increase in noninterest income was the result of several factors. Our noninterest income is heavily dependent upon loan volumes from our mortgage banking activities. The level of mortgage banking activity fluctuates and is influenced significantly by mortgage interest rates, the health of the general economy and housing affordability among other factors. Our mortgage banking volumes, as well as revenues per loan, increased in 2009 as compared to 2008. Loan volumes increased in 2009 over 2008 due to falling and historically low interest rates on mortgage loans. Revenues per loan increased in 2009 over 2008 due to increased profit margins available in the marketplace because of a reduction in competition in the mortgage industry resulting from the economic downturn and related regulation requirements. The significant components of our noninterest income were:

 

     Year ended December 31,      Dollar Change  
(in thousands)        2009             2008          2009 vs. 2008  

Noninterest income

       

Net gains on mortgage loan origination/sales activities

   $ 52,831      $ 15,833       $ 36,998   

Mortgage servicing

     (4,495     13,025         (17,520

Income from Windermere Mortgage Services

     4,663        2,423         2,240   

Debt extinguishment

            2,451         (2,451

Federal Home Loan Bank dividend

            352         (352

Depositor and other retail banking fees

     3,352        2,885         467   

Insurance commissions

     792        807         (15

Gain on sale of investment securities available for sale

     237        1,067         (830

Other

     1,850        1,503         347   
                         

Total noninterest income

   $ 59,230      $ 40,346       $ 18,884   
                         

Net gains on mortgage loan origination/sales activities was $52.8 million in 2009, an increase of $37.0 million, or more than 100.0%, from $15.8 million in 2008. The increase resulted from higher loan origination volumes and improved revenue per loan on single family loans originated and sold into the secondary market. Lower mortgage interest rates, government stimulus programs for first time home buyers, and reduced competition due to dislocations in the financial services industry influenced our increase in single family residential loan sales volume, which increased to $2.55 billion in 2009 from $1.45 billion in 2008.

In addition, we originated $45.2 million in multifamily residential loans and sold $49.7 million of such loans in 2009 (including some loans originated in 2008 and sold in 2009), compared to $265.6 million originated and $211.6 million sold during 2008. The decline in multifamily origination volume in 2009 was due primarily to decreases in the value of multifamily properties generally and the related decline in the number of purchases and sales of multifamily properties.

 

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Mortgage servicing income consisted of the following:

 

     Year Ended December 31,     Dollar Change  
     2009     2008     2009 vs. 2008  
(in thousands)    Single
family
    Multifamily     Total     Single
family
    Multifamily     Total     Total  

Servicing fees and other

   $ 15,612      $ 3,477      $ 19,089      $ 13,275      $ 3,635      $ 16,910      $ 2,211   

Amortization

     (17,576     (1,302     (18,878     (7,992     (1,282     (9,274     (9,603

Recovery/(impairment)

     1,335               1,335        (9,197            (9,197     10,532   

Net gain (loss) from derivatives economically hedging MSR

     (6,041            (6,041     14,586               14,586        (20,660
                                                        

Mortgage servicing

   $ (6,670   $ 2,175      $ (4,495   $ 10,672      $ 2,353      $ 13,025      $ (17,520
                                                        

 

(1) Principally reflects changes in discount rates and prepayment speed assumptions, mostly due to changes in interest rates.

 

(2) Represents changes due to collection/realization of expected cash flows over time.

 

(3) Represents adjustments to the carrying value of multifamily MSRs due to temporary (impairment) or recovery in accordance with the lower of amortized cost or fair value methodology.

Mortgage servicing revenues, net of amortization and impairment, includes servicing fee income and related fees less amortization of mortgage servicing rights and mortgage servicing rights impairment charges or recoveries, net of hedging gains and losses. We recognized a loss of $4.5 million for 2009 for mortgage servicing, net of amortization and impairment, as compared to income of $13.0 million for 2008.

The decrease of $17.5 million in mortgage servicing income was due to a $9.6 million increase in amortization of servicing rights, which was caused by a high level of prepayments on the loans in our portfolio of loans serviced for others resulting from low mortgage rates in 2009 and a $10.1 million decrease in net servicing impairment or recovery and hedging gains and losses reflecting the volatility in the financial markets during these periods. These decreases in mortgage servicing income in 2009 were partially offset by an increase in loan servicing fees and other fees of $2.2 million as a result of growth in our average portfolio of loans serviced for others. The loans serviced for others portfolio increased to $6.70 billion at December 31, 2009 from $5.59 billion at December 31, 2008. Also contributing to the increase in servicing fees was an increase in the average servicing fee per loan which increased from 29 basis points in 2008 to 30 basis points in 2009, reflecting a shift in the composition of loans sold with servicing retained to a higher composition of Ginnie Mae conforming loans, which carry a higher servicing fee.

Income from Windermere Mortgage Services — Income derived from the Bank’s Windermere Mortgage Services affiliate was $4.7 million, an increase of $2.2 million, or 92.4%, in 2009 from $2.4 million in 2008. The improvement in income was primarily attributable to a 28.2% increase in loan origination volume between 2008 and 2009.

Debt extinguishment — For 2008, we recorded a gain of $2.5 million on the early extinguishment of long-term debt. We prepaid $25.0 million of our senior notes due to USAA at a discount of 10.0% and extended the maturity of the remaining $5.0 million of senior notes from March 1, 2009, to March 1, 2011. This debt was retired for $3.0 million in the first quarter of 2011.

Federal Home Loan Bank (FHLB) dividend — HomeStreet received no dividend income from the FHLB in 2009. In 2008, the Company recorded $0.4 million in FHLB dividends.

 

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Depositor and other retail banking fees was $3.4 million for 2009, an increase of $0.5 million or 16.2% from $2.9 million in 2008. This increase is a reflection of continued growth in our deposits and the related transaction fee income.

 

     Year Ended December 31,      Dollar Change  
(in thousands)        2009              2008          2009 vs. 2008  

Fees:

        

Monthly maintenance and deposit — related fees

   $ 2,184         1,868       $ 316   

Debit Card/ATM fees

     957         799         158   

Other fees

     211         218         (7
                          

Total depositor and related fees

   $ 3,352       $ 2,885       $ 467   
                          

Insurance commissions income was $0.8 million in 2009 and 2008. Agency commissions were generally unchanged during these periods due to limited marketing efforts and market conditions.

Gain on sale of investment securities available for sale was $0.2 million in 2009, a decrease of $0.8 million, or 77.8%, from $1.1 million in 2008, a decline of $0.8 million. The gains in 2008 were the result of repositioning securities to reduce the portfolio’s risk weighting.

Other noninterest income was $1.9 million in 2009, an increase of $0.3 million, or 23.1% from $1.5 million in 2008. The increase was largely due to gains on interest rate swaps.

Noninterest Expense

Noninterest expense increased to $94.4 million in 2009, an increase of $24.3 million, or 34.5% from $70.2 million in 2008. Our levels of noninterest expense in 2009 were significantly impacted by the deterioration in our asset quality, capital, and regulatory status. The significant components of noninterest expense in 2009 and explanations of changes from 2008 are discussed below:

 

     Year ended December 31,      Dollar Change  
(in thousands)        2009              2008          2009 vs. 2008  

Noninterest expense

        

Salaries and related costs

   $ 39,926       $ 38,784       $ 1,142   

General and administrative

     12,772         13,936         (1,164

Legal

     3,353         1,541         1,812   

Consulting

     5,163         985         4,178   

Federal Deposit Insurance Corporation assessments

     8,757         1,606         7,151   

Occupancy

     6,486         6,743         (257

Information services

     5,503         5,051         452   

Other real estate owned

     10,479         1,543         8,936   

Federal Home Loan Bank debt extension fee

     2,009                 2,009   
                          

Total noninterest expense

   $ 94,448       $ 70,189       $ 24,259   
                          

Salaries and related costs was $39.9 million for 2009, an increase of $1.1 million, or 2.9%, from $38.8 million in 2008. The increases were primarily due to increased staffing needs related to credit administration functions and the increased commissions related to the high level of single family loan production. Offsetting these higher compensation expenses were the deferral of direct costs of loan production of $12.2 million for 2009 and $10.0 million for 2008. Retirement contributions decreased to $0.1 million in 2009 from $0.7 million in 2008 due to the elimination of 401(k) matching contributions in mid-2009.

 

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General and administrative expenses was $12.8 million in 2009, a decrease of $1.2 million, or 8.4%, from $13.9 million in 2008. The decrease is primarily due to a $2.1 million decrease in business and occupation tax expense as a result of a favorable outcome from litigation with the State of Washington to exempt payment of business and occupation tax on loan servicing fees. Offsetting this decrease were increases in other general and administrative expenses.

Legal expenses was $3.4 million for 2009, an increase of $1.8 million, or more than 100.0%, from $1.5 million for 2008. These increases were primarily the result of the increased volume of problem loans and other real estate owned and management’s efforts to raise capital.

Consulting expense was $5.2 million in 2009, an increase of $4.2 million, or more than 100.0%, from $1.0 million in 2008. The increase was due primarily to unsuccessful capital raising initiatives in 2009. These items reflect costs that would have been capitalized had the offering proved successful.

Federal Deposit Insurance Corporation assessments was $8.8 million for 2009, an increase of $7.2 million, or more than 100.0%, from $1.6 million in 2008. The increase was due to a one-time special assessment of $1.5 million to replenish the insurance fund as well as increases in risk premium charges due to the Bank’s financial condition.

Occupancy expense was $6.5 million in 2009, a decrease of $0.3 million or 3.8% from $6.7 million in 2008. This decrease was primarily due to the completion of the amortization period for which certain tenant improvement expenses were recognized.

Information services expense was $5.5 million in 2009, an increase of $0.5 million or 8.9% from $5.1 million in 2008. This increase was primarily due to the replacement of certain hardware systems, increasing maintenance related expenses.

Other real estate owned expenses were $10.5 million for 2009, an increase of $8.9 million, or more than 100.0%, from $1.5 million for 2008. The increase of $8.9 million in 2009 was primarily related to the increase in other real estate owned balances. Specifically, OREO valuation provisions increased $8.0 million, while OREO maintenance expenses increased $2.5 million. Partly offsetting these expenses, gains on OREO sales increased $1.6 million.

Federal Home Loan Bank debt extension fee. In 2009, the Bank paid a debt extension fee of $2.0 million to the Federal Loan Bank of Seattle (FHLB) to extend the maturities on certain FHLB advances to strengthen the Company’s long-term liquidity position.

Income Tax Expense (Benefit)

Income tax expense (benefit) for the years ended December 31, 2009 and 2008 was $(47.0) million and $3.2 million, respectively. Our effective tax rate was (29.9)% and 27.5% for the same periods. As a result of the Worker, Homeownership and Business Assistance Act of 2009, we were able to carry back net operating losses incurred in 2009 to prior taxable years, which had been previously unavailable for carry back. Predominately due to this change, in 2009 we recognized current tax benefits of $41.0 million. Our effective tax rate in 2009 and 2008 varied from the Federal statutory rate due to valuation allowances established on deferred tax assets due to uncertainty as to our ability to realize these assets in the future.

Review of Financial Condition

Total assets were $2.49 billion at December 31, 2010, a decrease of $723.8 million, or 22.6%, from $3.21 billion at December 31, 2009. This decrease is predominately due to decreases in our portfolio of loans held for

 

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investment and balance sheet restructuring activities during 2010. The portfolio of loans held for investment has declined due to charge-offs and repayment of loans along with transfers to OREO as a result of foreclosures. To ensure our ability to fund unexpected deposit outflows and to provide confidence to our deposit customers and regulators, in 2008 and 2009 we increased our on-balance sheet liquidity through increased FHLB borrowings and brokered deposits. We invested some of these funds in highly liquid, short duration government securities and we increased our cash position. While this strategy was effective for risk management purposes, this high level of liquidity adversely affected our net interest income and margin. During 2010, with the stabilization of the Company and changing depositors’ attitudes toward the risk of deposits in troubled banks, we began reducing on-balance sheet liquidity. We do not anticipate reducing on-balance sheet liquidity to normalized levels until the Orders are terminated and our overall risk profile returns to normal.

Cash and Cash Equivalents totaled $72.6 million at December 31, 2010, compared with $217.1 million as of December 31, 2009. The decrease in cash and cash equivalent balances during 2010 reflects our decision to maintain lower on-balance sheet liquidity.

Securities Available for Sale totaled $313.5 million at December 31, 2010, compared with $657.8 million as of December 31, 2009. The decrease in the securities portfolio during 2010 reflects our decision to maintain lower on-balance sheet liquidity.

We primarily hold investment securities for liquidity purposes, while providing a relatively stable source of interest income. Substantially all securities held are designated as available for sale.

We carry our available-for-sale securities at fair value. The following table sets forth certain information regarding the amortized cost and fair values of our investment securities available for sale for the periods indicated.

 

     Year ended December 31,  
     2010      2009      2008  
(in thousands)    Amortized
Cost
     Fair Value      Amortized
Cost
     Fair Value      Amortized
Cost
     Fair
Value
 

Available for sale:

                 

Mortgage-backed securities

                 

FNMA

   $ 1,519       $ 1,585       $ 2,151       $ 2,218       $ 3,171       $ 3,148   

GNMA

     2,915         3,112         3,863         3,984         5,235         5,258   

U.S. Government sponsored enterprises

                                     10,227         10,284   

Municipal bonds(1)

     6,648         6,549         8,650         8,535         16,249         15,862   

Collateralized mortgage obligations

     229,415         221,921         157,971         155,900         21,798         21,785   

Corporate Debt Securities(2)

                     20,039         20,196                   

US Treasury Securities

     80,384         80,346         467,017         467,007                   
                                                     

Total available for sale

   $ 320,881       $ 313,513