Item 1. Business
General
First Financial Northwest, Inc. (“First Financial Northwest” or the “Company”), a Washington corporation, was formed on June 1, 2007, for the purpose of becoming the holding company for First Financial Northwest Bank (“the Bank”) in connection with the Bank’s conversion from a mutual holding company structure to a stock holding company structure which was completed on October 9, 2007. At December 31, 2019, the Company had total assets of $1.3 billion, net loans of $1.1 billion, deposits of $1.0 billion and stockholders’ equity of $156.3 million. First Financial Northwest’s business activities generally are limited to passive investment activities and oversight of its investment in First Financial Northwest Bank. Accordingly, the information set forth in this report, including consolidated financial statements and related data, relates primarily to First Financial Northwest Bank.
The Bank was organized in 1923 as a Washington state-chartered savings and loan association, converted to a federal mutual savings and loan association in 1935 and to a Washington state-chartered mutual savings bank in 1992. In 2002, First Savings Bank reorganized into a two-tier mutual holding company structure, became a stock savings bank, and the wholly-owned subsidiary of First Financial of Renton, Inc. In connection with the 2002 conversion, First Savings Bank changed its name to First Savings Bank Northwest. Subsequently, in August 2015, the Bank changed its name to First Financial Northwest Bank to better reflect the commercial banking services it provides beyond those typically provided by a traditional savings bank. In February 2016, the Bank officially changed its charter from a Washington chartered stock savings bank to a Washington chartered commercial bank.
First Financial Northwest became a bank holding company, after converting from a savings and loan holding company on March 31, 2015, and is subject to regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board” or “Federal Reserve”) through the FRB. The change was consistent with First Financial Northwest Bank’s shift in focus from a traditional savings and loan association towards a full service, commercial bank. Additionally, First Financial Northwest Bank is examined and regulated by the DFI and by the FDIC. First Financial Northwest Bank is required to maintain reserves at a level set by the Federal Reserve Board. The Bank is a member of the Federal Home Loan Bank (“FHLB”) of Des Moines, which is one of the 11 regional banks in the Federal Home Loan Bank System (“FHLB System”). For additional information, see “How We are Regulated - Regulation and Supervision of First Financial Northwest Bank - Federal Home Loan Bank System.”
In February 2016, First Financial Northwest Bank converted its charter from a community-based savings bank to a commercial bank as a way of better serving its customer needs. The Bank’s largest concentration of customers is in King County, with additional concentrations in Snohomish, Pierce, and Kitsap counties, Washington. The Bank is headquartered in Renton, in King County, where it has a full-service branch as well as a smaller branch located in a commercial development known as “The Landing”. The Bank has additional smaller branches in King County located in Bellevue, Woodinville, Bothell, Kent and Kirkland. In Snohomish County, Washington, the Bank has five additional smaller branches located in Mill Creek, Edmonds, Clearview, Smokey Point, and Lake Stevens. In addition, the Bank opened a branch in University Place, in Pierce County, Washington, in March 2020. These smaller branches are focused on efficiency through the extensive use of the latest banking technology. First Financial Northwest Bank’s business consists of attracting deposits from the public and utilizing these funds to originate one-to-four family residential, multifamily, commercial real estate, construction/land, business and consumer loans.
The principal executive office of First Financial Northwest is located at 201 Wells Avenue South, Renton, Washington, 98057; our telephone number is (425) 255-4400.
Market Area
We consider our primary market area to be the Puget Sound Region that consists primarily of King, Snohomish and, to a lesser extent, Pierce and Kitsap counties. During 2019, the Region experienced slowing appreciation in residential real estate prices compared to the increases experienced in 2018. Price appreciation was strongest in areas with lower median home prices. Price appreciation in more expensive areas of King County such as Seattle and Bellevue have slowed due primarily to affordability issues. Home prices in Snohomish, Pierce and Kitsap counties have continued to experience price appreciation higher than the national average. Lower mortgage rates helped stimulate demand in the fourth quarter of 2019 with sales up over last year and a decline in housing inventory at the end of the year. The number of homes listed for sale in King County, Pierce, Snohomish and Kitsap counties at the end of 2019 have all declined over 30% compared to December 2018 and there was less than one month of inventory available at December 31, 2019.
King County has the largest population of any county in the state of Washington and covers approximately 2,100 square miles. It has a population of approximately 2.23 million residents and a median household income of approximately $89,400, according to U.S. Census estimates. King County has a diversified economic base with many nationally recognized firms including the Boeing Company (“Boeing”), Microsoft, Amazon, Starbucks, Nordstrom, Costco and Paccar. According to the Washington State Employment Security Department, the unemployment rate for King County was 2.1% at December 31, 2019, compared to 3.3% at December 31, 2018, and the national average of 3.5% at December 31, 2019. The median sales price of a residential home in King County for December 2019 was $615,000, an increase of 3.0% from 2018, according to the Northwest Multiple Listing Service ("MLS"). Residential sales volumes increased 2.1% in 2019 compared to 2018 and inventory levels as of December 31, 2019 were at 0.9 months according to the MLS.
Pierce County, covering approximately 1,700 square miles, has the second largest population of any county in the state of Washington. It has approximately 891,000 residents and a median household income of approximately $67,900, according to U.S. Census estimates. The Pierce County economy is diversified with the presence of military-related government employment (Joint Base Lewis-McChord), transportation and shipping employment (Port of Tacoma), and aerospace-related employment (Boeing). According to the Washington State Employment Security Department, the unemployment rate for Pierce County was 4.8% in December 2019, compared to 5.3% at year-end 2018. The median sales price of a residential home in Pierce County was $369,000 for December 2019, an 8.6% increase compared to 2018, according to the MLS. Residential sales volumes declined by 4.4% in 2019 compared to 2018 and inventory levels as of December 31, 2019 were at 0.9 months according to the MLS.
Snohomish County has the third largest population of any county in the state of Washington and covers approximately 2,100 square miles. It has approximately 815,000 residents and a median household income of approximately $82,800, according to U.S. Census estimates. The economy of Snohomish County is diversified with the presence of military-related government employment (Naval Station Everett), aerospace-related employment (Boeing), and retail trade. According to the Washington State Employment Security Department, the unemployment rate for Snohomish County was 2.4% in December 2019 compared to 3.6% in December 2018. The median sales price of a residential home in Snohomish County was $495,900 for December 2019, an 8.8% increase compared to December 2018, according to the MLS. Residential sales volumes rose by 2.1% in 2019 compared to 2018 and inventory levels as of December 31, 2018 were at 0.9 months according to the MLS.
Kitsap County has the seventh largest population of any county in the state of Washington and covers approximately 400 square miles. It has approximately 270,000 residents and a median household income of approximately $71,600, according to U.S. Census estimates. The Kitsap County economy is diversified with the presence of military-related government employment (Naval Base Kitsap, Puget Sound Naval Shipyard), health care, retail trade and education. According to the Washington State Employment Security Department, the unemployment rate for Kitsap County was 4.1% in December 2019, compared to 4.9% for December of 2018. The median sales price of a residential home was $385,000 for December 2019 an increase of 12.2% over December of 2018, according to the MLS. Residential sales volumes declined by 3.4% in 2019 compared to 2018 and inventory levels as of December 31, 2019 were at 0.8 months according to the MLS.
For a discussion regarding competition in our primary market area, see “- Competition” later in Item 1 of this report.
Lending Activities
General. We focus our lending activities primarily on loans secured by commercial real estate, construction/land, first mortgages on one-to-four family residences, multifamily, and business lending. We offer a variety of secured consumer loans, including savings account loans, auto loans and home equity loans that include lines of credit and second mortgage term loans. As of December 31, 2019, our net loan portfolio totaled $1.1 billion and represented 82.6% of our total assets.
Our current loan policy generally limits the maximum amount of loans we can make to one borrower to 15% of the Bank’s total risk-based capital, or $22.2 million at December 31, 2019. Exceptions to this policy are allowed only with the prior approval of the Board of Directors and if the borrower exhibits financial strength or sufficient, measurable compensating factors exist after consideration of the loan-to-value ratio, borrower’s financial condition, net worth, credit history, earnings capacity, installment obligations, and current payment history. The regulatory limit of loans we can make to one borrower is 20% of total risk-based capital, or $29.6 million, at December 31, 2019. At this date, our single largest lending relationship, totaled $21.5 million.
During 2019, the concentration of loans to our five largest lending relationships increased. At December 31, 2019, loans to our five largest lending relationships totaled $86.9 million compared to $79.9 million at December 31, 2018, an increase of $7.0 million, or 8.8%. While the total of these relationships increased during 2019, their percentage of total loans, net of loans in process (“LIP”) remained at 7.7% at December 31, 2019, and 2018. The total number of loans comprising these relationships
decreased slightly to 16 at December 31, 2019 from 19 at December 31, 2018. The following table details the types of loans to our five largest lending relationships at December 31, 2019.
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(1) The composition of borrowers represented in the table may change between periods.
(2) The one-to-four family residential loans for these borrowers are all owner occupied. The commercial real estate loans are for non-owner occupied, income producing properties.
The composition of loans to our five largest borrowers has changed at December 31, 2019, as compared to December 31, 2018, with an increase in commercial real estate loans of $35.0 million. Partially offsetting this increase, total multifamily loans decreased by $5.2 million and construction/land development loans and business loans decreased by $12.5 million and $9.8 million, respectively, to none. At December 31, 2019, all of the borrowers listed in the table above were in compliance with the original repayment terms of their respective loans.
Loan Portfolio Analysis. The following table sets forth the composition of our loan portfolio by type of loan at the dates indicated.
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(1) Included in the construction/land category are “rollover” loans, which are loans that will convert upon completion of the construction period to permanent loans. At December 31, 2019, we included rollover loans of $3.5 million of one-to-four family residential loans, $38.6 million of multifamily loans and $18.3 million of commercial real estate loans in the construction/land category. In addition, the construction/land category included $8.7 million of loans for raw land or buildable lots where the Company does not intend to finance the construction.
The following table shows the composition of our loan portfolio by fixed- and adjustable-rate loans at the dates indicated.
Geographic Distribution of our Loans. The following table shows the geographic distribution of our loan portfolio in dollar amounts and percentages at December 31, 2019.
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(1) Includes King, Snohomish, Pierce and Kitsap counties.
(2) Includes loans in California, Utah, Oregon, Georgia, and 36 other states.
One-to-Four Family Residential Lending. As of December 31, 2019, $372.5 million, or 33.2% of our total loan portfolio consisted of loans secured by one-to-four family residences.
First Financial Northwest Bank is a traditional portfolio lender when it comes to financing residential home loans. In 2019, we originated $91.8 million and purchased $653,000 in one-to-four family residential loans. At December 31, 2019, $210.9 million, or 56.6% of our one-to-four family residential portfolio consisted of owner occupied loans with the remaining $161.6 million, or 43.4% consisting of non-owner occupied loans. In addition, at December 31, 2019, $184.2 million, or 49.4% of our one-to-four family residential loan portfolio consisted of fixed-rate loans. Substantially all of our one-to-four family residential loans require monthly principal and interest payments.
Our fixed-rate, one-to-four family residential loans are generally originated with 15 to 30 year terms, although such loans typically remain outstanding for substantially shorter periods, particularly in the current low interest rate environment. We also originate hybrid loans with initial fixed-rate terms of five to ten years that convert to variable-rate which adjusts annually thereafter. In addition, substantially all of our one-to-four family residential loans contain due-on-sale clauses that allow us to declare the unpaid amount due and payable upon the sale of the property securing the loan. Typically, we enforce these due-on-sale clauses to the extent permitted by law and as a standard course of business. The average period of time a loan is outstanding is a function of, among other factors, the level of purchase and sale activity in the real estate market, prevailing interest rates, and the interest rates payable on outstanding loans.
Our lending policy generally limits the maximum loan-to-value ratio on mortgage loans secured by one-to-four family residential properties to 85% of the lesser of the appraised value or the purchase price. Properties securing our one-to-four family residential loans are appraised by independent appraisers approved by us. We require the borrowers to obtain title insurance and if necessary, flood insurance. We generally do not require earthquake insurance due to competitive market factors.
Loans secured by rental properties represent potentially higher risk and, as a result, we adhere to more stringent underwriting guidelines. Of primary concern in non-owner occupied real estate lending is the consistency of rental income of the property. Payments on loans secured by rental properties depend primarily on the tenants’ continuing ability to pay rent to the property owner, the character of the borrower or, if the property owner is unable to find a tenant, the property owner’s ability to repay the loan without the benefit of a rental income stream. In addition, successful operation and management of non-owner occupied properties, including property maintenance standards, may affect repayment. As a result, repayment of such loans may be subject to adverse conditions in the real estate market or the economy. We request that borrowers and loan guarantors, if any, provide annual financial statements, a budget factoring in a rental income cash flow analysis of the borrower as well as the net operating income of the property, information concerning the borrower’s expertise, credit history and profitability, and the value of the underlying property. These loans are generally secured by a first mortgage on the underlying collateral property along with an assignment of rents and leases. If the borrower has multiple rental property loans with us, the loans are typically not cross-collateralized. At December 31, 2019, a $95,000 one-to-four family residential loan was in nonaccrual status and was performing in accordance with its repayment terms at that date.
Multifamily and Commercial Real Estate Lending. As of December 31, 2019, $172.9 million, or 15.4% of our total loan portfolio was secured by multifamily and $395.2 million, or 35.2% of our loan portfolio was secured by commercial real estate properties. Our commercial real estate loans are typically secured by office and medical buildings, retail shopping centers, hotels, mini-storage facilities, industrial use buildings and warehouses. Commercial real estate and multifamily loans are subject to similar underwriting standards and processes. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate.
Typically, multifamily and commercial real estate loans have higher balances, are more complex to evaluate and monitor, and involve a greater degree of risk than one-to-four-family residential loans. In an attempt to compensate for and mitigate this risk, these loans are generally priced at higher interest rates than one-to-four family residential loans and generally have a maximum loan-to-value ratio of 80% of the lesser of the appraised value or purchase price. We generally require loan guarantees by any parties with a property ownership interest of 20% or more. If the borrower is a corporation or partnership, we generally require personal guarantees from the principals based upon a review of their personal financial statements and individual credit reports.
The following table presents a breakdown of our multifamily and commercial real estate loan portfolio at December 31, 2019, and 2018:
The average loan size in our multifamily and commercial real estate loan portfolios was $1.0 million and $2.0 million, respectively, as of December 31, 2019. At this date, $61.3 million, or 35.5%, of our multifamily loans and $131.0 million, or 33.2%, of our commercial real estate loans were located outside of our primary market area. We currently target individual multifamily, and commercial real estate loans between $1.0 million and $5.0 million. The largest multifamily loan as of December 31, 2019, was a 105-unit apartment complex with a net outstanding principal balance of $9.7 million located in King County, Washington. As of December 31, 2019, the largest commercial real estate loan had a net outstanding balance of $14.0 million and was secured by a hotel located in King County, Washington. Both of these loans were performing according to their respective loan repayment terms as of December 31, 2019.
The credit risk related to multifamily and commercial real estate loans is considered to be greater than the risk related to one-to-four family residential loans because the repayment of multifamily and commercial real estate loans typically is dependent on the income stream from the real estate securing the loan as collateral and the successful operation of the borrower’s business, that can be significantly affected by adverse conditions in the real estate markets or in the economy. For example, if the cash flow from the borrower’s project is reduced due to leases not being obtained or renewed, the borrower’s ability to repay the loan may be impaired. In addition, many of our multifamily and commercial real estate loans are not fully amortizing and contain large balloon payments upon maturity. These balloon payments generally require the borrower to either refinance or occasionally sell the underlying property in order to make the balloon payment.
If we foreclose on a multifamily or commercial real estate loan, our holding period for the collateral typically is longer than for one-to-four family residential mortgage loan foreclosures because there are fewer potential purchasers of the collateral. Our multifamily and commercial real estate loans generally have relatively large balances to single borrowers or related groups of borrowers. Accordingly, if we make any errors in judgment in the collectability of our multifamily or commercial real estate loans, any resulting charge-offs may be larger on a per loan basis than those incurred in our one-to-four family residential or consumer loan portfolios. At December 31, 2019, there were no multifamily or commercial real estate loans past due 90 days or more, or in nonaccrual status. In addition, there were no multifamily or commercial real estate loans charged-off during the years ended December 31, 2019, 2018, and 2017.
Construction/Land Loans. We originate construction/land loans primarily to residential builders for the construction of single-family residences, condominiums, townhouses, multifamily properties and residential developments located in our market area. Land loans include land non-development loans for the purchase or refinance of unimproved land held for future residential development, improved residential lots held for speculative investment purposes or lines of credit secured by land, and land
development loans. Construction/land loans to builders generally require the borrower to have an existing relationship with the Bank and a proven record of successful projects. At December 31, 2019, our total construction/land loans increased to $113.7 million, or 10.1% of our total loan portfolio, from $108.9 million, or 10.5% of our total loans, at December 31, 2018. The Company’s strategic plan projects continued growth in construction loan origination activity in 2020 in support of our overall loan growth. The Bank’s lending policy sets forth the guideline that the balance of our net acquisition, development, and construction loans and deferred fees and costs, not exceed 100% of the Bank’s risk-based capital. The Bank was in compliance with this policy at December 31, 2019, with a balance equal to 81.9% of the Bank’s risk-based capital. Management intends to maintain levels near this guideline, however the uncertainty of the timing associated with construction loan draws occasionally results in the actual concentration exceeding the guideline. There were no construction/land loans classified as nonaccrual at either December 31, 2019 or 2018. There were no construction/land loan charge-offs during the years ended December 31, 2019, 2018, and 2017, respectively. At December 31, 2019, the LIP balance on construction/land loans was $89.6 million.
Following is the composition of our total construction/land loan portfolio, which excludes LIP, at the dates indicated. All of the loans represented were performing:
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(1) Includes loans where the builder does not intend to sell the property after the construction phase is completed.
The following table includes construction/land loans by county at December 31, 2019:
Loans to finance the construction of single-family homes, subdivisions and land loans are generally offered to builders in our primary market areas. Loans that are termed “speculative” are those where the builder does not have, at the time of loan origination, a signed contract with a buyer for the home or lot who has a commitment for permanent financing with either us or another lender. The buyer may be identified either during or after the construction period, with the risk that the builder may have to fund the debt service on the speculative loan along with real estate taxes and other carrying costs for the project for a significant
period of time after completion of the project until a buyer is identified. The maximum loan-to-value ratio applicable to these loans is generally 100% of the actual cost of construction, provided that the loan-to-completed value does not exceed 80%, with approval required from the Chief Credit Officer (“CCO”) for loan-to-value ratios over 80%. In addition, a minimum of 20% verified equity is generally also required. Verified equity refers to cash equity invested in the project. Development plans are required from builders prior to committing to the loan. We require that builders maintain adequate title insurance and other appropriate insurance coverage, and, if applicable, appropriate environmental data report(s) that the land is free of hazardous or toxic waste. While maturity dates for residential construction loans are largely a function of the estimated construction period of the project and typically do not exceed one year, land loans generally are for 12 to 18 months. Substantially all of our residential construction loans have adjustable-rates of interest based on The Wall Street Journal prime rate. During the term of construction, the accumulated interest on the loan is either added to the principal of the loan through an interest reserve or billed monthly. At December 31, 2019, the LIP balance on construction/land loans included $5.4 million set aside for interest reserves. When these loans exhaust their original reserves set up at origination, no additional reserves are permitted unless the loan is re-analyzed and it is determined that the additional reserves are appropriate, based on the updated analysis. Construction loan proceeds are disbursed periodically as construction progresses and as inspections by our approved inspectors warrant. At December 31, 2019, our three largest construction/land loans consisted of a $12.5 million commercial real estate construction/land loan, an $8.4 million multifamily construction loan, and a $6.4 million multifamily construction loan. All three loans will rollover to a permanent loan at the completion of the construction period and all three properties are located in King County.
Our residential construction loans to borrowers for one-to-four family, non-owner occupied residences typically are structured to be converted to fixed-rate permanent loans at the end of the construction phase with one closing for both the construction loan and the permanent financing. Prior to making a commitment to fund a construction loan, we require an appraisal of the post-construction value of the project by an independent appraiser. During the construction phase, which typically lasts 12 to 18 months, an approved inspector or designated Bank employee makes periodic inspections of the construction site to certify construction has reached the stated percentage of completion. Typically, disbursements are made in monthly draws and interest-only payments are required. These loans are converted to fixed-rate permanent loans at the end of the construction phase. At December 31, 2019, there was a $3.5 million non-owner occupied construction loan that will rollover to a permanent non-owner occupied one-to-four family residential loan in 2020.
We also make construction loans for commercial development projects. The projects include multifamily, retail, office/warehouse, hotels and office buildings. These loans typically have an interest-only payment phase during construction and generally convert to permanent financing when construction is complete. Disbursement of funds is at our sole discretion and is based on the progress of construction. The Bank uses an independent third party or Bank employee to conduct monthly inspections to certify that construction has reached the stated percentage of completion and that previous disbursements are reflected in the degree of work performed to date. Generally, the maximum loan-to-value ratio applicable to these loans is 90% of the actual cost of construction or 80% of the prospective value at completion. At December 31, 2019, $56.9 million of multifamily and commercial real estate construction loans will rollover to permanent loans with the Bank at the end of their construction period.
Land development loans are generally made to builders for preparation of a building site and do not include the construction of buildings on the property. The maximum loan-to-value ratio for these loans is 75%. Land non-development loans are generally for raw land where we do not finance the cost of preparing the site for building and are subject to a maximum loan-to-value ratio of 65%.
Our construction/land loans are based upon estimates of costs in relation to values associated with the completed project. Construction/land lending involves additional risks when compared with permanent residential lending because funds are advanced upon the collateral for the project based on an estimate of costs that will produce a future value at completion. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation on real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the completed project loan-to-value ratio. Changes in the demand, such as for new housing and higher than anticipated building costs may cause actual results to vary significantly from those estimated. For these reasons, this type of lending also typically involves higher loan principal amounts and is often concentrated with a small number of builders. These loans often involve the disbursement of funds with repayment substantially dependent on the success of the ultimate project and the ability of the borrower to sell or lease the property or obtain permanent take-out financing, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of a completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project and may incur a loss. Because construction loans require active monitoring of the building process, including cost comparisons and on-site inspections, these loans are more difficult and costly to monitor. Increases in market rates of interest may have a more pronounced effect on construction loans by rapidly increasing the end-purchasers’ borrowing costs, thereby reducing the overall demand for the project. Properties under construction are often difficult to sell and typically must be completed in order to be successfully sold which also complicates the process of working out problem construction loans. This may require us to advance additional funds and/or contract with
another builder to complete construction. Furthermore, in the case of speculative construction loans, there is the added risk associated with identifying an end-purchaser for the finished project. Land loans also pose additional risk because of the lack of income being produced by the property and the potential illiquid nature of the collateral. These risks can also be significantly influenced by supply and demand conditions.
Business Lending. Business loans totaled $37.8 million, or 3.4% of the loan portfolio at December 31, 2019. Business loans are generally secured by business equipment, accounts receivable, inventory or other property. Loan terms typically vary from one to five years. The interest rates on such loans are either fixed-rate or adjustable-rate. The interest rates for the adjustable-rate loans are indexed to the prime rate published in The Wall Street Journal plus a margin. Our business lending policy includes credit file documentation and requires analysis of the borrower’s background, capacity to repay the loan, the adequacy of the borrower’s capital and collateral, as well as an evaluation of other conditions affecting the borrower. Analysis of the borrower’s past, present and future cash flows is also an important aspect of our credit analysis. We generally obtain personal guarantees on our business loans. The largest business loan had an outstanding balance of $11.2 million at December 31, 2019 and was performing according to its repayment terms. At December 31, 2019, we did not have any business loans delinquent in excess of 90 days or in nonaccrual status.
At December 31, 2019, the Bank’s aircraft loan portfolio had an outstanding balance of $14.0 million, or 37.1% of total business loans. These loans are collateralized by new or used, single-engine piston aircraft to light jets for business or personal use. Our aircraft loans will generally range in size from $250,000 to $3.0 million with the primary focus of our underwriting guidelines on the asset value of the collateral rather than the ability of the borrower to repay the loan. The average loan size in our aircraft loan portfolio was $667,000 and the largest loan was $2.8 million at December 31, 2019. For additional information regarding these loans, see Item 1A.
Item 1A. Risk Factors.
An investment in our common stock is subject to risks inherent in our business. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included in this report and our other filings with the SEC. In addition to the risks and uncertainties described below, other risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially and adversely affect our business, financial condition, capital levels, cash flows, liquidity, results of operations and prospects. The risks discussed below also include forward-looking statements, and our actual results may differ substantially from those discussed in these forward-looking statements. The market price of our common stock could decline significantly due to any of these identified or other risks and you could lose some or all of your investment. This report is qualified in its entirety by these risk factors.
Our business may be adversely affected by downturns in the national economy and in the economies in our market areas.
Our loans are primarily to businesses and individuals in the state of Washington with 85.7% of loans to borrowers or secured by properties located in Washington and 14.3% of loans to borrowers or secured by properties in other states. Through our efforts to geographically diversify our loan portfolio, our portfolio includes $160.2 million of loans to borrowers or secured by properties located in 40 other states, including at December 31, 2019, $48.3 million, or 4.3% of loans secured by properties or to borrowers in California. A decline in the national economy or the economies of the four counties which we consider to be our primary market area could have a material adverse effect on our business, financial condition, results of operations, and prospects. Weakness in the global economy has adversely affected many businesses operating in our markets that are dependent upon international trade and it is not known how tariffs being imposed on international trade may also affect these businesses. Changes in agreements or relationships between the United States and other countries may also affect these businesses.
While real estate values and unemployment rates have remained strong, a deterioration in economic conditions in the market areas we serve, in particular the Puget Sound area of Washington State, could result in the following consequences, any of which could have a materially adverse impact on our business, financial condition, results of operations:
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loan delinquencies, problem assets and foreclosures may increase;
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we may increase our allowance for loan losses;
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demand for our products and services may decline resulting in a decrease in our total loans or assets;
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collateral for loans, especially real estate, may decline in value, exposing us to increased risk of loss on existing loans, reducing customers’ borrowing power, and reducing the value of assets and collateral associated with existing loans;
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the net worth and liquidity of loan guarantors may decline, impairing their ability to honor commitments to us; and
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the amount of our low-cost or noninterest-bearing deposits may decrease and the composition of our deposits may be adversely affected.
A decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose real estate loan portfolios are geographically diverse. Many of the loans in our portfolio are secured by real estate. Deterioration in the real estate markets where collateral for a mortgage loan is located could negatively affect the borrower’s ability to repay the loan and the value of the collateral securing the loan. Real estate values are affected by various other factors, including changes in general or regional economic conditions, governmental rules or policies and natural disasters such as earthquakes and tornadoes. If we are required to liquidate a significant amount of collateral during a period of reduced real estate values, our financial condition and profitability could be adversely affected.
In this regard, Boeing has a significant presence in our market area and the production facility for the 737 MAX commercial jet aircraft is located in Renton. The 2019 grounding and decline in production of the 737 MAX commercial jet aircraft (production of which was suspended entirely in January 2020), has adversely affected Boeing, its employees and its suppliers, as well as other local businesses and their employees. Until production resumes and production rates return to pre-grounding levels, there may be an adverse impact on the ability of those borrowers impacted by the suspension of the production of the 737 MAX commercial jet to repay their existing loans to the Bank and demand for new loans may be reduced which could adversely affect the level of our nonperforming loans, deposits, financial condition and profitability.
Adverse changes in the regional and general economy could reduce our growth rate, impair our ability to collect loans and generally have a negative effect on our financial condition and results of operations.
The coronavirus outbreak may have an adverse impact on the Company’s customers and employees.
The coronavirus outbreak may have an adverse impact on certain of the Company's customers directly or indirectly engaged in international trade, travel and tourism. Their businesses may be adversely affected by quarantines and travel restrictions in countries most affected by the coronavirus. In addition, entire industries such as agriculture, may be adversely impacted due to lower exports caused by reduced economic activity in the affected countries.
The Bank may be negatively impacted by reduced attendance from employees impacted by the virus. While the Bank has contingency plans in place for significant outbreaks, the uncertainty of the coronavirus creates risk that cannot be fully assessed.
Our results of operations, liquidity and cash flows are subject to interest rate risk.
Our earnings and cash flows are largely dependent upon our net interest income. Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies, and, in particular, the Federal Reserve Board. After steadily increasing the targeted federal funds rate in 2018 and 2017, the Federal Reserve decreased the targeted federal funds rate 25 basis points three times during 2019 to 1.50% - 1.75% at December 31, 2019, in response to some recent weaknesses in economic data and indicated possible further decreases, subject to economic conditions. If the Federal Reserve instead increases the targeted federal funds rate, overall interest rates will likely rise, which may negatively impact both the housing markets by reducing refinancing activity and new home purchases and the U.S. economy. In addition, deflationary pressures, while possibly lowering our operating costs, could have a significant negative effect on our borrowers, especially our business borrowers, and the values of collateral securing loans, which could negatively affect our financial performance.
We principally manage interest rate risk by managing our volume and mix of our earning assets and funding liabilities. Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and investments and the amount of interest we pay on deposits and borrowings, but these changes could also affect (i) our ability to originate and/or sell loans and obtain deposits, (ii) the fair value of our financial assets and liabilities, which could negatively impact shareholders’ equity, and our ability to realize gains from the sale of such assets, (iii) our ability to obtain and retain deposits in competition with other available investment alternatives, (iv) the ability of our borrowers to repay adjustable or variable rate loans, and (v) the average duration of our investment securities portfolio and other interest-earning assets. In a changing interest rate environment, we may not be able to manage this risk effectively. If we are unable to manage interest rate risk effectively, our business, financial condition and results of operations could be materially affected.
Changes in interest rates could also have a negative impact on our results of operations by reducing the ability of borrowers to repay their current loan obligations or by reducing our margins and profitability. Our net interest margin is the difference between the yield we earn on our assets and the interest rate we pay for deposits and our other sources of funding. Changes in interest rates-up or down-could adversely affect our net interest margin and, as a result, our net interest income. Although the yield we earn on our assets and our funding costs tend to move in the same direction in response to changes in interest rates, one can rise or fall faster than the other, causing our net interest margin to expand or contract. Our liabilities tend to be shorter in duration than our assets, so they may adjust faster in response to changes in interest rates. As a result, when interest rates rise, our funding costs may rise faster than the yield we earn on our assets, causing our net interest margin to contract until the yields on interest-earning assets catch up. Changes in the slope of the “yield curve”, or the spread between short-term and long-term interest rates-could also reduce our net interest margin. Normally, the yield curve is upward sloping, meaning short-term rates are lower than long-term rates. Because our liabilities tend to be shorter in duration than our assets, when the yield curve flattens or even inverts, we could experience pressure on our net interest margin as our cost of funds increases relative to the yield we can earn on our assets. Also, interest rate decreases can lead to increased prepayments of loans and mortgage-backed securities as borrowers refinance their loans to reduce borrowing costs. Under these circumstances, we are subject to reinvestment risk as we may have to redeploy such repayment proceeds into lower yielding investments, which would likely hurt our income.
A sustained increase in market interest rates could adversely affect our earnings. As is the case with many banks and savings institutions, our emphasis on increasing the development of core deposits, those deposits bearing no or a relatively low rate of interest with no stated maturity date, has resulted in an increasing percentage of our deposits being comprised of deposits bearing no or a relatively low rate of interest and having a shorter duration than our assets. We would incur a higher cost of funds to retain these deposits in a rising interest rate environment. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income, and therefore earnings, could be adversely affected
In addition, a portion of our adjustable-rate loans have interest rate floors below which the loan’s contractual interest rate may not adjust. At December 31, 2019, 55.8% of our net loans were comprised of adjustable-rate loans. At that date, $359.0 million, or 57.3%, of these loans with an average interest rate of 4.80% were at their floor interest rate. The inability of our loans to adjust downward can contribute to increased income in periods of declining interest rates, although this result is subject to the risks that borrowers may refinance these loans during periods of declining interest rates. Also, when loans are at their respective floor, which is above the fully-indexed rate, there is a further risk that our interest income may not increase as rapidly as our cost of funds during periods of increasing interest rates and could have a material adverse effect on our results of operations.
Changes in interest rates also affect the value of our interest-earning assets, including our securities portfolio. Generally, the fair value of fixed-rate securities fluctuates inversely with changes in interest rates. Unrealized gains and losses on securities available for sale are reported as a separate component of equity, net of tax. Decreases in the fair value of securities available for sale resulting from increases in interest rates could have an adverse effect on stockholders’ equity.
Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on our results of operations, any substantial, unexpected or prolonged change in market interest rates could have a material adverse effect on our financial condition and results of operations. Also, our interest rate risk modeling techniques and assumptions likely may not fully predict or capture the impact of actual interest rate changes on our balance sheet or projected operating results. For further discussion of how changes in interest rates could impact us, see Item 7A. “Quantitative and Qualitative Disclosures About Market Risk” for additional information about our interest rate risk management.
Our construction/land loans are based upon estimates of costs and the value of the completed project.
We make construction/land loans to contractors and builders primarily to finance the construction of single and multifamily homes, subdivisions, as well as commercial properties. We originate these loans whether or not the collateral property underlying the loan is under contract for sale. At December 31, 2019, construction/land loans totaled $113.7 million, or 10.1% of our total
loan portfolio, an increase of $4.8 million or 4.4% since December 31, 2018. At December 31, 2019, $44.5 million were one-to-four family construction loans, $41.0 million were multifamily construction loans, and $19.6 million were commercial construction loans. Land loans, which are loans made with land as security, totaled $8.7 million, or less than one percent of our total loan portfolio at December 31, 2019. Land loans include land non-development loans for the purchase or refinance of unimproved land held for future residential development, improved residential lots held for speculative investment purposes and lines of credit secured by land, and land development loans.
Construction/land lending involves additional risks when compared with permanent residential lending because funds are advanced upon the collateral for the project based on an estimate of costs that will produce a future value at completion. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation on real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the completed project loan-to-value ratio. Changes in the demand, such as for new housing and higher than anticipated building costs, may cause actual results to vary significantly from those estimated. For these reasons, this type of lending also typically involves higher loan principal amounts and is often concentrated with a small number of builders. A downturn in housing, or the real estate market, could increase loan delinquencies, defaults and foreclosures, and significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. Some of our builders have more than one loan outstanding with us and also have residential mortgage loans for rental properties with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss.
In addition, during the term of most of our construction loans, no payment from the borrower is required since the accumulated interest is added to the principal of the loan through an interest reserve. As a result, these loans often involve the disbursement of funds with repayment substantially dependent on the success of the ultimate project and the ability of the borrower to sell or lease the property or obtain permanent take-out financing, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of a completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project and may incur a loss. Because construction loans require active monitoring of the building process, including cost comparisons and on-site inspections, these loans are more difficult and costly to monitor. Increases in market rates of interest may have a more pronounced effect on construction loans by rapidly increasing the end-purchasers’ borrowing costs, thereby reducing the overall demand for the project. Properties under construction are often difficult to sell and typically must be completed in order to be successfully sold which also complicates the process of working out problem construction loans. This may require us to advance additional funds and/or contract with another builder to complete construction. Furthermore, in the case of speculative construction loans, there is the added risk associated with identifying an end-purchaser for the finished project. Land loans also pose additional risk because of the lack of income being produced by the property and the potential illiquid nature of the collateral. These risks can also be significantly impacted by supply and demand conditions.
At December 31, 2019, $44.6 million of our construction/land loans were for speculative construction loans. All of our permanent construction loans have a take-out commitment for a permanent loan with us. At December 31, 2019, all of our construction/land loans were classified as performing.
Our level of commercial and multifamily real estate loans may expose us to increased lending risks.
While commercial and multifamily real estate lending may potentially be more profitable than single-family residential lending, it is generally more sensitive to regional and local economic conditions, making loss levels more difficult to predict. Collateral evaluation and financial statement analysis in these types of loans requires a more detailed analysis at the time of loan underwriting and on an ongoing basis. At December 31, 2019, we had $395.2 million of commercial real estate loans, representing 35.2% of our total loan portfolio and $172.9 million of multifamily loans, representing 15.4% of our total loan portfolio. These loans typically involve higher principal amounts than other types of loans and some of our commercial borrowers have more than one loan outstanding with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to a one-to-four family residential loan. Repayment on these loans is dependent upon income generated, or expected to be generated, by the property securing the loan in amounts sufficient to cover operating expenses and debt service that may be adversely affected by changes in the economy or local market conditions. For example, if the cash flow from the borrower’s project is reduced as a result of leases not being obtained or renewed, the borrower’s ability to repay the loan may be impaired. Commercial and multifamily loans also expose a lender to greater credit risk than loans secured by one-to-four family residential real estate because the collateral securing these loans typically cannot be sold as easily as residential real estate. In addition, many of our commercial and multifamily real estate loans are not fully amortizing and contain large balloon payments upon maturity. Such balloon payments may require the borrower to either sell or refinance the underlying property in order to make the payment that may increase the risk of default or non-payment.
A secondary market for most types of commercial and multifamily real estate loans is not readily available, so we have less opportunity to mitigate credit risk by selling part or all of our interest in these loans. As a result of these characteristics, if we foreclose on a commercial or multifamily real estate loan, our holding period for the collateral typically is longer than for one-to-four family residential loans because there are fewer potential purchasers of the collateral. Accordingly, charge-offs on commercial real estate loans may be larger on a per loan basis than those incurred with our residential or consumer loan portfolios.
The level of our commercial real estate loan portfolio may subject us to additional regulatory scrutiny.
The FDIC, the Federal Reserve Board and the Office of the Comptroller of the Currency have promulgated joint guidance on sound risk management practices for financial institutions with concentrations in commercial real estate lending. Under this guidance, a financial institution that, like us, is actively involved in commercial real estate lending should perform a risk assessment to identify concentrations. A financial institution may have a concentration in commercial real estate lending if, among other factors (i) total reported loans for construction, land development, and other land represent 100% or more of total capital, or (ii) total reported loans secured by multifamily and non-farm residential properties, loans for construction, land development and other land, and loans otherwise sensitive to the general commercial real estate market, including loans to commercial real estate related entities, represent 300% or more of total capital. Based on the FDIC criteria, the Bank has a concentration in commercial real estate lending as total loans for multifamily, non-farm/non-residential, construction, land development and other land represented 449.7% of total risk-based capital at December 31, 2019. The particular focus of the guidance is on exposure to commercial real estate loans that are dependent on the cash flow from the real estate held as collateral and that are likely to be at greater risk to conditions in the commercial real estate market (as opposed to real estate collateral held as a secondary source of repayment or as an abundance of caution). The purpose of the guidance is to guide banks in developing risk management practices and capital levels commensurate with the level and nature of real estate concentrations. The guidance states that management should employ heightened risk management practices including board and management oversight and strategic planning, development of underwriting standards, risk assessment and monitoring through market analysis and stress testing. While we believe we have implemented policies and procedures with respect to our commercial real estate lending consistent with this guidance, bank regulators could require us to implement additional policies and procedures consistent with their interpretation of the guidance that may result in additional costs to us.
Expansion of our business loans may expose the Company to greater risk of loss.
The Company’s strategic plan includes growth in originations of business loans that are collateralized by non-real estate assets. Our business loans are primarily made based on the cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. The borrowers’ cash flow may prove to be unpredictable, and collateral securing these loans may fluctuate in value. Most often, this collateral is accounts receivable, inventory, or equipment. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. Other collateral securing loans may depreciate over time, may be difficult to appraise, may be illiquid and may fluctuate in value based on the success of the business. Further, the borrowers’ ability to repay these loans may be impacted more from general economic conditions as compared to real estate secured loans.
Our non-owner occupied real estate loans may expose us to increased credit risk.
At December 31, 2019, $161.6 million, or 43.4% of our one-to-four family residential loan portfolio and 14.4% of our total loan portfolio, consisted of loans secured by non-owner occupied residential properties. At December 31, 2019, all of our non-owner occupied one-to-four family residential loans were performing in accordance with their repayment terms. Loans secured by non-owner occupied properties generally expose a lender to greater risk of non-payment and loss than loans secured by owner occupied properties because repayment of such loans depend primarily on the tenant’s continuing ability to pay rent to the property owner, who is our borrower, or, if the property owner is unable to find a tenant, the property owner’s ability to repay the loan without the benefit of a rental income stream. In addition, the physical condition of non-owner occupied properties is often below that of owner occupied properties due to lenient property maintenance standards that negatively impact the value of the collateral properties. Furthermore, some of our non-owner occupied residential loan borrowers have more than one loan outstanding with us. At December 31, 2019, we had 88 non-owner occupied residential loan relationships with an outstanding balance over $500,000 and an aggregate balance of $129.8 million. Consequently, an adverse development with respect to one credit relationship may expose us to a greater risk of loss compared to an adverse development with respect to an owner occupied residential mortgage loan.
Our business may be adversely affected by credit risk associated with residential property.
At December 31, 2019, $372.5 million, or 33.2% of our total loan portfolio, was secured by first liens on one-to-four family residential loans. In addition, at December 31, 2019, our home equity lines of credit totaled $10.6 million. A significant
portion of our one-to-four family residential real estate loan portfolio consists of jumbo loans that do not conform to secondary market mortgage requirements, and therefore are not immediately salable to Fannie Mae or Freddie Mac because such loans exceed the maximum balance allowable for sale (generally $484,000 to $727,000 for single-family homes in our primary market areas in 2019). Jumbo one-to-four family residential loans may expose us to increased risk because of their larger balances, and because they cannot be immediately sold to government sponsored enterprises.
In addition, one-to-four family residential loans are generally sensitive to regional and local economic conditions that significantly impact the ability of borrowers to meet their loan payment obligations, making loss levels difficult to predict. A decline in residential real estate values resulting from a downturn in the housing market may reduce the value of the real estate collateral securing these types of loans and increase our risk of loss if borrowers default on their loans. Recessionary conditions or declines in the volume of real estate sales and/or the sales prices coupled with elevated unemployment rates may result in higher than expected loan delinquencies or problem assets, and a decline in demand for our products and services. These potential negative events may cause us to incur losses, adversely affect our capital and liquidity and damage our financial condition and business operations.
To meet our growth objectives we may originate or purchase loans outside of our market area which could affect the level of our net interest margin and nonperforming loans.
In order to achieve our desired loan portfolio growth, we have and may continue to opportunistically originate or purchase loans outside of our market area either individually, through participations, or in bulk or “pools”. We perform certain due diligence procedures and may re-underwrite these loans to our underwriting standards prior to purchase, and anticipate acquiring loans subject to customary limited indemnities, however, we may be exposed to a greater risk of loss as we acquire loans of a type or in geographic areas where management may not have substantial prior experience and which may be more difficult for us to monitor. Further, when determining the purchase price we are willing to pay to acquire loans, management will make certain assumptions about, among other things, how borrowers will prepay their loans, the real estate market and our ability to collect loans successfully and, if necessary, to dispose of any real estate that may be acquired through foreclosure. To the extent that our underlying assumptions prove to be inaccurate or the basis for those assumptions change (such as an unanticipated decline in the real estate market), the purchase price paid may prove to have been excessive, resulting in a lower yield or a loss of some or all of the loan principal. For example, if we purchase “pools” of loans at a premium and some of the loans are prepaid before we anticipate, we will earn less interest income on the acquired loans than expected. Our success in increasing our loan portfolio through loan purchases will depend on our ability to price the loans properly and on general economic conditions in the geographic areas where the underlying properties or collateral for the loans acquired are located. Inaccurate estimates or declines in economic conditions or real estate values in the markets where we purchase loans could significantly adversely affect the level of our nonperforming loans and our results of operations. At December 31, 2019, our loan portfolio included $85.2 million, or 7.6% of total loans, located in counties within Washington State that are outside of our primary market area. In addition, our portfolio included $160.2 million, or 14.3% of total loans, in loans located outside of Washington State.
We engage in aircraft, classic and collectible car financing transactions, in which high-value collateral is susceptible to potential catastrophic loss. Consequently, if any of these transactions becomes nonperforming, we could suffer a loss on some or all of our value in the assets.
Because our primary focus for aircraft, classic and collectible car loans is on the asset value of the collateral, the collectability of these loans ultimately may be dependent on the value of the underlying collateral. Aircraft values have from time to time experienced sharp decreases due to a number of factors including, but not limited to, the availability of used aircraft, decreases in passenger and air cargo demand, increases in fuel costs, government regulation and the comparative value of newly manufactured similar aircraft. Classic and collectible car values are similarly affected by availability and demand. An aircraft, classic or collectible car as collateral also presents unique risks because of its high-value and being susceptible to rapid movement across different locations and potential catastrophic loss. Although the loan documentation for these transactions will include insurance covenants and other provisions to protect us against risk of loss, there can be no assurance that the insurance proceeds would be sufficient to ensure our full recovery of the loan. Moreover, a relatively small number of nonperforming loans could have a significant negative impact on the value of our loan portfolio. If we are required to liquidate a significant amount of aircraft or classic car collateral during a period of reduced values, our financial condition and profitability could be adversely affected. At December 31, 2019, our loan portfolio included $18.5 million in classic and collectible car loans and $14.0 million in aircraft loans.
If interest rate swaps we entered into prove ineffective, it could result in volatility in our operating results, including potential losses, which could have a material adverse effect on our results of operations and cash flows.
We are exposed to the effects of interest rate changes as a result of the borrowings we use to maintain liquidity and fund our expansion and operations. To limit the impact of interest rate changes on earnings, prepayment penalties and cash flows and to lower overall borrowing costs while taking into account variable interest rate risk, we may borrow at fixed rates or variable rates depending upon prevailing market conditions. We may also enter into derivative financial instruments such as interest rate swaps in order to mitigate our interest rate risk on a related financial instrument.
Our interest rate contracts expose us to:
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basis or spread risk, which is the risk of loss associated with variations in the spread between the interest rate contract and the hedged item;
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credit or counter-party risk which is the risk of the insolvency or other inability of another party to the transaction to perform its obligations;
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interest rate risk;
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volatility risk which is the risk that the expected uncertainty relating to the price of the underlying asset differs from what is anticipated; and
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liquidity risk.
If we suffer losses on our interest rate contracts, our business, financial condition and prospects may be negatively affected, and our net income will decline.
We record the swaps at fair value and designate them as an effective cash flow hedge under ASC 815, Derivatives and Hedging. Each quarter, we measure hedge effectiveness using the “hypothetical derivative method” and record in earnings any gains or losses resulting from hedge ineffectiveness. The hedge provided by our swaps could prove to be ineffective for a number of reasons, including early retirement of the debt, as is allowed under the debt, or in the event the counterparty to the interest rate swaps were determined to not be creditworthy. Any determination that the hedge created by the swaps was ineffective could have a material adverse effect on our results of operations and cash flows and result in volatility in our operating results. In addition, any changes in relevant accounting standards relating to the swaps, especially ASC 815, Derivatives and Hedging, could materially increase earnings volatility.
As of December 31, 2019, we had interest rate swaps outstanding with an aggregate notional amount of $75.0 million. At December 31, 2019, the fair value of our interest rate swaps was $426,000. For additional information, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management”.
Uncertainty relating to the London Interbank Offered Rate ("LIBOR") calculation process and potential phasing out of LIBOR may adversely affect our results of operations.
On July 27, 2017, the Chief Executive of the United Kingdom Financial Conduct Authority, which regulates LIBOR, announced that it intends to stop persuading or compelling banks to submit rates for the calibration of LIBOR to the administrator of LIBOR after 2021. The announcement indicates that the continuation of LIBOR on the current basis cannot and will not be guaranteed after 2021. It is impossible to predict whether and to what extent banks will continue to provide LIBOR submissions to the administrator of LIBOR or whether any additional reforms to LIBOR may be enacted in the United Kingdom or elsewhere. At this time, no consensus exists as to what rate or rates may become acceptable alternatives to LIBOR and it is impossible to predict the effect of any such alternatives on the value of LIBOR-based securities and variable rate loans, or other securities or financial arrangements, given LIBOR's role in determining market interest rates globally. The Federal Reserve Board, in conjunction with the Alternative Reference Rates Committee, a steering committee comprised of large U.S. financial institutions, is considering replacing U.S. dollar LIBOR with a new index calculated by short-term repurchase agreements, backed by Treasury securities ("SOFR"). SOFR is observed and backward looking, which stands in contrast with LIBOR under the current methodology, which is an estimated forward-looking rate and relies, to some degree, on the expert judgment of submitting panel members. Given that SOFR is a secured rate backed by government securities, it will be a rate that does not consider bank credit risk (as is the case with LIBOR). SOFR is therefore likely to be lower than LIBOR and is less likely to correlate with the funding costs of financial institutions. Whether or not SOFR attains market traction as a LIBOR replacement tool remains in question, although some transactions using SOFR have been completed in 2019, including some by Fannie Mae. Both Fannie Mae and Freddie Mac have
recently announced that they will cease accepting adjustable rate mortgages tied to LIBOR by the end of 2020 and will soon begin accepting mortgages based on SOFR. Continued uncertainty as to the nature of alternative reference rates and as to potential changes or other reforms to LIBOR may adversely affect LIBOR rates and the value of LIBOR-based loans, and to a lesser extent, securities in our portfolio, and may impact the availability and cost of hedging instruments and borrowings. If LIBOR rates are no longer available, and we are required to implement substitute indices for the calculation of interest rates under our loan agreements with our borrowers or our existing borrowings, we may incur significant expenses in effecting the transition, and may be subject to disputes or litigation with customers and creditors over the appropriateness or comparability to LIBOR of the substitute indices, which could have an adverse effect on our results of operations.
Our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolio.
While conditions in the housing and real estate markets and economic conditions in our market areas have remained strong, if slow economic conditions return or real estate values and sales deteriorate, we may experience higher delinquencies and credit losses. As a result, we could be required to increase our provision for loan losses and to charge-off additional loans in the future. If charge-offs in future periods exceed the ALLL, we may need additional provisions to replenish the ALLL.
The determination of the appropriate level of the ALLL inherently involves a high degree of subjectivity and requires us to make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. In determining the amount of the ALLL, we review our loans and the loss and delinquency experience and evaluate economic conditions and make significant estimates of current credit risks and future trends, all of which may undergo material changes. If our estimates are incorrect, the ALLL may not be sufficient to cover losses inherent in our loan portfolio, resulting in the need for increases in our provision for loan losses which is charged against income. Deterioration in economic conditions, new information regarding existing loans, identification of additional problem loans or relationships, and other factors, both within and outside of our control, may increase our loan charge-offs and/or may otherwise require an increase in the ALLL. Management also recognizes that significant new growth in loan portfolios, new loan products and the refinancing of existing loans can result in portfolios comprised of unseasoned loans that may not perform in a historical or projected manner and will increase the risk that our allowance may be insufficient to absorb losses without significant additional provisions. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs based on their judgment about information available to them at the time of their examination. Any increases in the provision for loan losses will result in a decrease in net income and may have a material adverse effect on our financial condition, results of operations, and capital.
In addition, the Financial Accounting Standards Board has adopted a new accounting standard referred to as Current Expected Credit Loss, or CECL, which will require financial institutions to determine periodic estimates of lifetime expected credit losses on loans, and recognize the expected credit losses as allowances for credit losses. This will change the current method of providing allowances for credit losses only when they have been incurred and are probable, which may require us to increase our allowance for loan losses, and may greatly increase the types of data we would need to collect and review to determine the appropriate level of the allowance for credit losses. This accounting pronouncement is expected to be applicable to us for our first fiscal year after December 15, 2022. We are evaluating the impact the CECL accounting model will have on our accounting, but expect to recognize a onetime cumulative-effect adjustment to the allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective. We cannot yet determine the magnitude of any such one-time cumulative adjustment or of the overall impact of the new standard on our financial condition or results of operations. The federal banking regulators, including the Federal Reserve and the FDIC, have adopted a rule that gives a banking organization the option to phase in over a three-year period the day-one adverse effects of CECL on its regulatory capital. For more on this new accounting standard, see Note 1 of the Notes to Consolidated Financial Statements contained in Item 8 of this report.
We may incur losses on our securities portfolio as a result of changes in interest rates.
Factors beyond our control can significantly influence the fair value of securities in our portfolio and can cause potential adverse changes to the fair value of these securities. These factors include, but are not limited to, rating agency actions in respect of the securities, defaults by, or other adverse events affecting, the issuer or with respect to the underlying securities, and changes in market interest rates and continued instability in the capital markets. Any of these factors, among others, could cause other-than-temporary impairments and realized and/or unrealized losses in future periods and declines in other comprehensive income, which could have a material effect on our business, financial condition and results of operations. The process for determining whether impairment of a security is other-than-temporary usually requires complex, subjective judgments about the future financial performance and liquidity of the issuer and any collateral underlying the security to assess the probability of receiving all contractual principal and interest payments on the security. There can be no assurance that the declines in market value will not result in other-than-temporary impairments of these assets, and would lead to accounting charges that could have a material adverse effect on
our net income and capital levels. For the year ended December 31, 2019, we did not incur any other-than-temporary impairments on our securities portfolio.
Conditions in the financial markets may limit our access to additional funding to meet our liquidity needs.
Liquidity is essential to our business, therefore, the inability to obtain adequate funding may negatively affect growth and, consequently, our earnings capability and capital levels. We rely on a number of different sources in order to meet our potential liquidity demands. We require sufficient liquidity to meet customer loan requests, customer deposit maturities and withdrawals, payments on our debt obligations as they come due and other cash commitments under both normal operating conditions and other unpredictable circumstances, including events causing industry or general financial market stress. An inability to raise funds through deposits, borrowings, the sale of loans or investment securities, or other sources could have a substantial negative effect on our liquidity. Our access to funding sources in amounts adequate to finance our activities on terms that are acceptable to us could be impaired by factors that affect us specifically or the financial services industry or economy in general. Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity as a result of a downturn in the Washington markets in which our loans are concentrated, negative operating results, or adverse regulatory action against us. Our ability to borrow could also be impaired by factors that are not specific to us, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry and the continued uncertainty in credit markets. In particular, our liquidity position could be significantly constrained if we are unable to access funds from the FHLB Des Moines, the FRB or other wholesale funding sources, or if adequate financing is not available at acceptable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources, our revenues may not increase proportionately to cover our costs. Any decline in available funding could adversely impact our ability to originate loans, invest in securities, meet our expenses, or fulfill obligations such as repaying our borrowings or meeting deposit withdrawal demands, any of which could, in turn, have a material adverse effect on our business, financial condition and results of operations. Additionally, collateralized public funds are bank deposits of state and local municipalities. These deposits are required to be secured by certain investment grade securities to ensure repayment that, on the one hand, tends to reduce our contingent liquidity risk by making these funds somewhat less credit sensitive, but on the other hand, reduces standby liquidity by restricting the potential liquidity of the pledged collateral. Although these funds historically have been a relatively stable source of funds for us, availability depends on the individual municipality’s fiscal policies and cash flow needs. At December 31, 2019 we held $34.0 million in public funds.
If limitations arise in our ability to utilize the national brokered deposit market or to replace short-term deposits, our ability to replace maturing deposits on acceptable terms could be adversely impacted.
First Financial Northwest Bank utilizes the national brokered deposit market for a portion of our funding needs. At December 31, 2019, the balance of brokered certificates of deposit was $94.5 million, with remaining maturities of 1 to 13 months. Under FDIC regulations, in the event we are deemed to be less than well-capitalized, we would be subject to restrictions on our use of brokered deposits and the interest rate we can offer on our deposits. If this happens, our use of brokered deposits and the rates we would be allowed to pay on deposits may significantly limit our ability to use deposits as a funding source. If we are unable to participate in this market for any reason in the future, our ability to replace these deposits at maturity could be adversely impacted.
Further, there may be competitive pressures to pay higher interest rates on deposits, which would increase our funding costs. If deposit clients move money out of the Bank deposits and into other investments (or into similar products at other institutions that may provide a higher rate of return), we could lose a relatively low cost source of funds, increasing our funding costs and reducing our net interest income and net income. Additionally, any such loss of funds could result in reduced loan originations, which could materially negatively impact our growth strategy and results of operations.
Our limited branch locations limit our ability to attract deposits and as a result, a large portion of our deposits are certificates of deposit, including “jumbo” certificates that may not be as stable as other types of deposits.
With twelve branch locations in operation during 2019, our ability to compete with larger institutions for noninterest bearing deposits is limited as these institutions have a larger branch network providing greater convenience to customers. As a result, we are dependent on more interest rate sensitive deposits. At December 31, 2019, $425.1 million, or 41.1%, of our total deposits were retail certificates of deposit and, of that amount, $352.4 million were “jumbo” certificates greater than or equal to $100,000, with $130.6 million of these certificates greater than or equal to $250,000. In addition, deposit inflows are significantly influenced by general interest rates. Our money market accounts and jumbo certificates of deposit and the retention of these deposits are particularly sensitive to general interest rates, making these deposits traditionally a more volatile source of funding than other deposit accounts. In order to retain our money market accounts and jumbo certificates of deposit, we may have to pay a higher rate, resulting in an increase in our cost of funds. In a rising rate environment, we may be unwilling or unable to pay a competitive rate because of the resulting compression in our interest rate spread. To the extent that such deposits do not remain
with us, they may need to be replaced with borrowings or other deposits that could increase our cost of funds and negatively impact our interest rate spread and financial condition.
Our branching strategy may cause our expenses to increase faster than revenues.
During 2019, we opened two new branch offices in Kent, Washington and Kirkland, Washington. In addition, the Bank secured a lease and opened our thirteenth branch in March 2020, in University Place, Washington. Our current business strategy includes continued similar branch expansion in areas to enhance our market presence. These offices are much smaller than traditional bank branch offices, utilizing the improved technology available with our core data processor. This allows us to maintain management’s focus on efficiency, while working to expand the Bank’s presence into new markets. The success of our expansion strategy into new markets, however, is contingent upon numerous factors, such as our ability to select suitable locations, assess each market’s competitive environment, secure managerial resources, hire and retain qualified personnel and implement effective marketing strategies. The opening of new offices may not increase the volume of our loans and deposits as quickly or to the degree that we hope, and opening new offices will increase our operating expenses. On average, de novo branches do not become profitable until three to four years after opening. We currently expect to lease rather than own the additional branch properties. Further, the projected time line and the estimated dollar amounts involved in opening de novo branches could differ significantly from actual results. The success of our acquired branches is dependent on retention of existing customers’ deposits as well as expanding our market presence in these locations. We may not successfully manage the costs and implementation risks associated with our branching strategy. Accordingly, any new branch may negatively impact our earnings for some period of time until the branch reaches certain economies of scale. Finally, there is a risk that our new branches will not be successful even after they have been established or acquired.
We may be required to raise additional capital in the future, but that capital may not be available when it is needed, or it may only be available on unacceptable terms, which could adversely affect our financial condition and results of operations.
We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. We may at some point, however, need to raise additional capital to support continued growth or be required by our regulators to increase our capital resources. Any capital we obtain may result in the dilution of the interests of existing holders of our common stock. Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside of our control, and on our financial performance. Accordingly, we may not be able to raise additional capital, if needed, on terms acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations and pursue our growth strategy 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 our bank regulators, we may be subject to adverse regulatory action.
Development of new products and services may impose additional costs on us and may expose us to increased operational risk.
Our financial performance depends, in part, on our ability to develop and market new and innovative services and to adopt or develop new technologies that differentiate our products or provide cost efficiencies, while avoiding increased related expenses. This dependency is exacerbated in the current “FinTech” environment, where financial institutions are investing significantly in evaluating new technologies, such as “Blockchain,” and developing potentially industry-changing new products, services and industry standards. The introduction of new products and services can entail significant time and resources, including regulatory approvals. Substantial risks and uncertainties are associated with the introduction of new products and services, including technical and control requirements that may need to be developed and implemented, rapid technological change in the industry, our ability to access technical and other information from our clients, the significant and ongoing investments required to bring new products and services to market in a timely manner at competitive prices and the preparation of marketing, sales and other materials that fully and accurately describe the product or service and its underlying risks. Our failure to manage these risks and uncertainties also exposes us to enhanced risk of operational lapses which may result in the recognition of financial statement liabilities. Regulatory and internal control requirements, capital requirements, competitive alternatives, vendor relationships and shifting market preferences may also determine if such initiatives can be brought to market in a manner that is timely and attractive to our clients. Failure to successfully manage these risks in the development and implementation of new products or services could have a material adverse effect on our business and reputation, as well as on our consolidated results of operations and financial condition.
Non-compliance with the USA PATRIOT Act, Bank Secrecy Act, or other laws and regulations could result in fines or sanctions.
The USA PATRIOT Act and Bank Secrecy Acts and related regulations require financial institutions to develop programs to prevent financial institutions from being used for money laundering and terrorist activities. If such activities are detected, financial institutions are obligated to file suspicious activity reports with the U.S. Treasury’s Office of Financial Crimes Enforcement Network. These rules require financial institutions to establish procedures for identifying and verifying the identity of customers seeking to open new financial accounts and beneficial owners of accounts. Failure to comply with these regulations could result in fines or sanctions. During the last few years, several banking institutions have received large fines for non-compliance with these laws and regulations. While we have developed policies and procedures designed to assist in compliance with these laws and regulations, no assurance can be given that these policies and procedures will be effective in preventing violations of these laws and regulations. If our policies and procedures are deemed deficient, we would be subject to liability, including fines and regulatory actions, which may include restrictions on our ability to pay dividends and the denial of regulatory approvals to proceed with certain aspects of our business plan, including acquisitions.
Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us. Any of these results could have a material adverse effect on our business, financial condition, results of operations and growth prospects.
We rely on other companies to provide key components of our business infrastructure.
We rely on numerous external vendors to provide us with products and services necessary to maintain our day-to-day operations. Accordingly, our operations are exposed to risk that these vendors will not perform in accordance with the contracted arrangements under service level agreements. The failure of an external vendor to perform in accordance with the contracted arrangements under service level agreements because of changes in the vendor's organizational structure, financial condition, support for existing products and services or strategic focus or for any other reason, could be disruptive to our operations, which in turn could have a material negative impact on our financial condition and results of operations. We also could be adversely affected to the extent such an agreement is not renewed by the third party vendor or is renewed on terms less favorable to us. Additionally, the bank regulatory agencies expect financial institutions to be responsible for all aspects of our vendors’ performance, including aspects which they delegate to third parties. Disruptions or failures in the physical infrastructure or operating systems that support our business and customers, or cyber-attacks or security breaches of the networks, systems or devices that our customers use to access our products and services could result in client attrition, regulatory fines, penalties or intervention, reputational damage, reimbursement or other compensation costs, and/or additional compliance costs, any of which could materially adversely affect our results of operations or financial condition.
We are subject to certain risks in connection with our use of technology.
Our security measures may not be sufficient to mitigate the risk of a cyber-attack. Communications and information systems are essential to the conduct of our business, as we use such systems to manage our customer relationships, our general ledger and virtually all other aspects of our business. Our operations rely on the secure processing, storage, and transmission of confidential and other information in our computer systems and networks. Although we take protective measures and endeavor to modify them as circumstances warrant, the security of our computer systems, software, and networks may be vulnerable to breaches, fraudulent or unauthorized access, denial or degradation of service attacks, misuse, computer viruses, malware or other malicious code and cyber-attacks that could have a security impact. If one or more of these events occur, this could jeopardize our or our customers’ confidential and other information processed and stored in, and transmitted through, our computer systems and networks, or otherwise cause interruptions or malfunctions in our operations or the operations of our customers or counterparties. We may be required to expend significant additional resources to modify our protective measures or to investigate and remediate vulnerabilities or other exposures, and we may be subject to litigation and financial losses that are either not insured against or not fully covered through any insurance maintained by us. We could also suffer significant reputational damage.
Security breaches in our internet banking activities could further expose us to possible liability and damage our reputation. Increases in criminal activity levels and sophistication, advances in computer capabilities, new discoveries, vulnerabilities in third party technologies (including browsers and operating systems), or other developments could result in a compromise or breach of the technology, processes and controls that we use to prevent fraudulent transactions and to protect data about us, our clients and underlying transactions. Any compromise of our security also could deter customers from using our internet banking services that involve the transmission of confidential information. We rely on standard internet security systems to provide the security and authentication necessary to effect secure transmission of data. Although we have developed and continue to invest in systems and processes that are designed to detect and prevent security breaches and cyber-attacks and periodically test our security, these precautions may not protect our systems from compromises or breaches of our security measures, and could result in losses to us
or our customers, our loss of business and/or customers, damage to our reputation, the incurrence of additional expenses, disruption to our business, our inability to grow our online services or other businesses, additional regulatory scrutiny or penalties, or our exposure to civil litigation and possible financial liability, any of which could have a material adverse effect on our business, financial condition and results of operations.
Our security measures may not protect us from system failures or interruptions. While we have established policies and procedures to prevent or limit the impact of systems failures and interruptions, there can be no assurance that such events will not occur or that they will be adequately addressed if they do. In addition, we outsource certain aspects of our data processing and other operational functions to certain third-party providers. While we select third-party vendors carefully, we do not control their actions. If our third-party providers encounter difficulties, including those resulting from breakdowns or other disruptions in communication services provided by a vendor, failure of a vendor to handle current or higher transaction volumes, cyber-attacks and security breaches, or if we otherwise have difficulty in communicating with them, our ability to adequately process and account for transactions could be affected, and our ability to deliver products and services to our customers and otherwise conduct business operations could be adversely impacted. Replacing these third-party vendors could also entail significant delay and expense. Threats to information security also exist in the processing of customer information through various other vendors and their personnel.
We cannot assure you that such breaches, failures or interruptions will not occur or, if they do occur, that they will be adequately addressed by us or the third parties on which we rely. We may not be insured against all types of losses as a result of third party failures and insurance coverage may be inadequate to cover all losses resulting from breaches, system failures or other disruptions. If any of our third-party service providers experience financial, operational or technological difficulties, or if there is any other disruption in our relationships with them, we may be required to identify alternative sources of such services, and we cannot assure you that we could negotiate terms that are as favorable to us, or could obtain services with similar functionality as found in our existing systems without the need to expend substantial resources, if at all. Further, the occurrence of any systems failure or interruption could damage our reputation and result in a loss of customers and business, could subject us to additional regulatory scrutiny, or could expose us to legal liability. Any of these occurrences could have a material adverse effect on our financial condition and results of operations.
The board of directors oversees the risk management process including the risk of cybersecurity and engages with management on cybersecurity issues.
If our enterprise risk management framework is not effective at mitigating risk and loss to us, we could suffer unexpected losses and our results of operations could be materially adversely affected.
Our enterprise risk management framework seeks to achieve an appropriate balance between risk and return, which is critical to optimizing stockholder value. We have established processes and procedures intended to identify, measure, monitor, report, analyze and control the types of risk to which we are subject. These risks include liquidity risk, credit risk, market risk, interest rate risk, operational risk, legal and compliance risk, and reputational risk, among others. We also maintain a compliance program to identify measure, assess, and report on our adherence to applicable laws, policies and procedures. While we assess and improve these programs on an ongoing basis, there can be no assurance that our risk management or compliance programs, along with other related controls, will effectively mitigate all risk and limit losses in our business. 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 our business, financial condition and results of operations could be materially adversely affected.
We are subject to certain risks in connection with our data management or aggregation.
We are reliant on our ability to manage data and our ability to aggregate data in an accurate and timely manner to ensure effective risk reporting and management. Our ability to manage data and aggregate data may be limited by the effectiveness of our policies, programs, processes and practices that govern how data is acquired, validated, stored, protected and processed. While we continuously update our policies, programs, processes and practices, many of our data management and aggregation processes are manual and subject to human error or system failure. Failure to manage data effectively and to aggregate data in an accurate and timely manner may limit our ability to manage current and emerging risks, as well as to manage changing business needs.
Our business may be adversely affected by an increasing prevalence of fraud and other financial crimes.
As a bank, we are susceptible to fraudulent activity that may be committed against us or our customers which may result in financial losses or increased costs to us or our customers, disclosure or misuse of our information or our customer’s information, misappropriation of assets, privacy breaches against our customers, litigation ,or damage to our reputation. Such fraudulent activity
may take many forms, including check fraud, electronic fraud, wire fraud, phishing, social engineering and other dishonest acts. Nationally, reported incidents of fraud and other financial crimes have increased. We have also experienced losses due to apparent fraud and other financial crimes. While we have policies and procedures designed to prevent such losses, there can be no assurance that such losses will not occur.
We are dependent on key personnel and the loss of one or more of those key personnel may materially and adversely affect our prospects.
Competition for qualified employees and personnel in the banking industry is intense and there are a limited number of qualified persons with knowledge of, and experience in, the community banking industry where First Financial Northwest Bank conducts its business. The process of recruiting personnel with the combination of skills and attributes required to carry out our strategies is often lengthy. Our success depends to a significant degree upon our ability to attract and retain qualified management, loan origination, finance, administrative, marketing, and technical personnel and upon the continued contributions of our management and personnel. In particular, our success has been and continues to be highly dependent upon the abilities of key executives, including our President, and certain other employees. In addition, our success has been and continues to be highly dependent upon the services of our directors, many of whom are at or nearing retirement age, and we may not be able to identify and attract suitable candidates to replace such directors.
We participate in a multiple employer defined benefit pension plan for the benefit of our employees. If we were to withdraw from this plan, or if Pentegra, the multiple employer defined benefit pension plan sponsor, requires us to make additional contributions, we could incur a substantial expense in connection with the withdrawal or the request for additional contributions.
We participate in the Pentegra Defined Benefit Plan for Financial Institutions, a multiple employer pension plan for the benefit of our employees. Effective March 31, 2013, we did not allow additional employees to participate in this plan. On March 31, 2013, we froze the future accrual of benefits under this plan with respect to those participating employees. In connection with our decision to freeze our benefit accruals under the plan, and since then, we considered withdrawing from the plan.
The actual expense that would be incurred in connection with a withdrawal from the plan is primarily dependent upon the timing of the withdrawal, the total value of the plan’s assets at the time of withdrawal, general market interest rates at that time, expenses imposed on withdrawal, and other conditions imposed by Pentegra as set forth in the plan. If we choose to withdraw from the plan in the future, we could incur a substantial expense in connection with the withdrawal.
Even if we do not withdraw from the plan, Pentegra, as sponsor of the plan, may request that we make an additional contribution to the plan, in addition to contributions that we are regularly required to make, or obtain a letter of credit in favor of the plan, if our financial condition worsens to the point that it triggers certain criteria set out in the plan. If we fail to make the contribution or obtain the requested letter of credit, then we may be forced to withdraw from the plan and establish a separate, single employer defined benefit plan that we anticipate would be underfunded to a similar extent as under the multiple employer plan.
We rely on dividends from the Bank for substantially all of our revenue at the holding company level.
We are an entity separate and distinct from our principal subsidiary, First Financial Northwest Bank, and derive substantially all of our revenue at the holding company level in the form of dividends from that subsidiary. Accordingly, we are, and will be, dependent upon dividends from the Bank to pay the principal of and interest on our indebtedness, to satisfy our other cash needs and to pay dividends on our common stock. First Financial Northwest Bank’s ability to pay dividends is subject to its ability to earn net income and to meet certain regulatory requirements, including the capital conservation buffer requirement. In the event the Bank is unable to pay dividends to us, we may not be able to pay dividends on our common stock or continue our stock repurchases. Also, our right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors.
Item 1B.
Item 1B. Unresolved Staff Comments
First Financial Northwest has not received any written comments from the SEC regarding its periodic or current reports under the Securities Exchange Act of 1934, as amended.
Item 2.
Item 2. Properties
The corporate office for First Financial Northwest and First Financial Northwest Bank is located at 201 Wells Avenue South, Renton, Washington and is owned by us. The Bank’s full service retail operation is also at this location. In addition, the Bank owns a retail office located at 17424 SR 9, Snohomish, Washington. At December 31, 2019, the Bank had ten leased locations in Washington currently in operation: Mill Creek, Edmonds, “The Landing” in Renton, Bellevue, Bothell, Woodinville, Smokey Point, Lake Stevens, Kent, and Kirkland. In addition, the Bank opened a location in University Place, Washington, in March 2020. The lending division operations of First Financial Northwest Bank are at our owned location at 207 Wells Avenue South, Renton, Washington. This location is also the site for the operations of First Financial Northwest’s wholly-owned subsidiary, First Financial Diversified. The lease terms for our properties are for an initial term of three to five years with the option to extend for additional three to five year periods. In the opinion of management, all properties are adequately covered by insurance, are in a good state of repair and are appropriately designed for their present and future use. For additional information on our lease commitments, see Note 14- “Leases” of the Notes to Consolidated Financial Statements in Item 8 of this report.
Item 3.
Item 3. Legal Proceedings
From time to time, we are involved as plaintiff or defendant in various legal actions arising in the normal course of business. As of December 31, 2019, we were not involved in any significant litigation and do not anticipate incurring any material liability as a result of any such litigation.
Item 4.
Item 4. Mine Safety Disclosures
Not applicable.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our common stock is traded on The Nasdaq Stock Market LLC’s Global Select Market (“NASDAQ”), under the symbol “FFNW.” As of December 31, 2019, there were 10.3 million shares of common stock issued and outstanding and we had 519 shareholders of record, excluding persons or entities that hold stock in nominee or “street name” accounts with brokers. Our cash dividend payout policy is reviewed regularly by management and the Board of Directors. As of December 31, 2019, our board of directors had declared 27 consecutive quarterly cash dividends on our common stock. Any dividends declared and paid in the future would depend upon a number of factors, including capital requirements, our financial condition and results of operations, tax considerations, statutory and regulatory limitations, and general economic conditions. No assurances can be given that any dividends will be paid or that, if paid, will not be reduced or eliminated in future periods. Our future payment of dividends may depend, in part, upon receipt of dividends from the Bank, which are restricted by federal regulations.
Stock Repurchases
The Company’s Board of Directors authorized a stock repurchase plan that began on November 5, 2018 and expired on May 3, 2019. The plan authorized the repurchase of up to 550,000 shares of the Company’s stock. At completion of the plan on May 3, 2019, the Company had repurchased all 550,000 shares authorized, including 346,100 shares purchased during 2019 at an average price of $15.89 per share.
In addition, the Company’s Board of Directors authorized a stock repurchase plan that began on July 30, 2019 and expired on December 17, 2019. At the completion of this plan, the Company had repurchased 132,952 shares at an average price of $14.21 per share.
The following table represents the share repurchased during the fourth quarter ended December 31, 2019.
Subsequently, in January 2020 the Company’s Board of Directors authorized the repurchase of up to five percent (5%) of the Company’s outstanding common stock, or approximately 513,000 shares beginning no earlier than January 27, 2020 and ending no later than July 27, 2020. The Company will purchase the shares from time to time in the open market or through privately negotiated depending on market conditions and other corporate considerations.
Equity Compensation Plan Information
The equity compensation plan information presented under subparagraph (d) in Part III, Item 12 of this report is incorporated herein by reference.
Performance Graph
The following graph compares the cumulative total shareholder return on First Financial Northwest’s Common Stock with the cumulative total return on the Russell 2000 Index, the SNL Micro CAP U.S. Bank Index, and the SNL Thrift Index, a peer group index.
The graph assumes that total return includes the reinvestment of all dividends and that the value of the investment in First Financial Northwest’s common stock and each index was $100 on December 31, 2014, and is the base amount used in the graph. The closing price of First Financial Northwest’s common stock on December 31, 2019 was $14.94.
Item 6.
Item 6. Selected Financial Data
The following table sets forth certain information concerning our consolidated financial position and results of operations at and for the dates indicated and has been derived from our audited consolidated financial statements. The information below is qualified in its entirety by the detailed information included elsewhere herein and should be read along with Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This discussion and analysis reviews our consolidated financial statements and other relevant statistical data for the years ending December 31, 2019 and 2018, and is intended to enhance your understanding of our financial condition and results of operations. The information in this section has been derived from the Consolidated Financial Statements and footnotes thereto that appear in Item 8 of this Form 10-K. The information contained in this section should be read in conjunction with these Consolidated Financial Statements and footnotes and the business and financial information provided in this Form 10-K. Unless otherwise indicated, the financial information presented in this section reflects the consolidated financial condition and results of operations of First Financial Northwest and its subsidiaries. For a discussion and review of our consolidated financial statements and other relevant statistical data for the years ending December 31, 2018 and 2017 see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Form 10-K for the fiscal year ended December 31, 2018.
Overview
First Financial Northwest Bank is a wholly-owned subsidiary of First Financial Northwest and, as such, comprises substantially all of the activity for First Financial Northwest. First Financial Northwest Bank was a community-based savings bank until February 4, 2016, when the Bank converted to a Washington state chartered commercial bank reflecting the commercial banking services it now provides to its customers. The Bank primarily serves King, Snohomish, Pierce and Kitsap counties, Washington through its full-service banking office and headquarters in Renton, Washington, as well as six retail branches in King County, Washington and five retail branches in Snohomish County, Washington at December 31, 2019. The Bank purchased four of these branches in 2017 and acquired $74.7 million in deposits (the “Branch Acquisition”). The Branch Acquisition expanded our retail footprint and provided an opportunity to extend our unique brand of community banking into those communities. In addition, the Bank opened a new branch office in University Place, Washington in March 2020.
The Bank’s business consists predominantly of attracting deposits from the general public, combined with borrowing from the Federal Home Loan Bank of Des Moines (“FHLB”) and raising funds in the wholesale market, then utilizing these funds to originate one-to-four family residential, multifamily, commercial real estate, construction/land, business, and consumer loans.
Our current business strategy emphasizes commercial real estate, construction, one-to-four family residential, and multifamily lending. With the current low interest rate environment, we are not aggressively pursuing longer term assets, but rather are focused on financing shorter term loans and loans with adjustable interest rates. During 2019, originations of new loans and refinances modestly outpaced repayments, resulting in net loans receivable of $1.11 billion at December 31, 2019, as compared to $1.02 billion at December 31, 2018. Originations and purchases of construction/land loans were $110.0 million in 2019 as compared to $118.2 million in 2018. However, payoffs were higher in 2018 than in 2019, resulting in this portfolio increasing modestly to $113.7 million at December 31, 2019 as compared to $108.9 million at December 31, 2018. We anticipate that construction/land lending will continue to be a strong element of our total loan portfolio in future periods. We will continue to take a disciplined approach in our construction/land lending by concentrating our efforts on residential loans to builders known to us, including multifamily loans to developers with proven success in this type of construction. These loans typically mature in six to eighteen months and funding is usually not fully disbursed at origination, therefore the impact to net loans receivable is generally minimal in the short term.
We have also geographically expanded our loan portfolio through loan purchases or loan participations of commercial and multifamily real estate loans that are outside of our primary market area. Through our efforts to geographically diversify our loan portfolio with direct loan originations, loan participations, or loan purchases, our portfolio includes $160.2 million of loans to borrowers or secured by properties located in 40 other states, including concentrations in California, Utah, Oregon and Georgia of $48.3 million, $16.1 million, $12.2 million and $8.2 million, respectively at December 31, 2019.
Net income for the year ended December 31, 2019, was $10.4 million, or $1.03 per diluted share, compared to $14.9 million, or $1.43 per diluted share, for the year ended December 31, 2018. The most significant contributor to this decrease was a $3.7 million decrease in the recapture of provision for loan losses in 2019, primarily as a result of net recoveries in 2018 of $4.5 million on previously charged-off loans. Net interest income also decreased by $2.3 million, primarily as a result of higher rate increases on our deposit liabilities as compared to our interest-earning assets. Noninterest expenses increased by $957,000, reflecting continued growth in our operations.
Our primary source of revenue is interest income, which is the income that we earn on our loans and investments. Interest expense is the interest that we pay on our deposits and borrowings. Net interest income is the difference between interest income and interest expense. Changes in levels of interest rates affect interest income and interest expense differently and, thus, impacts our net interest income. First Financial Northwest Bank is generally liability-sensitive, meaning our interest-bearing liabilities reprice at a faster rate than our interest-earning assets. Primarily as a result of increasing interest rates during 2019, our net interest margin decreased to 3.19% for the year ended December 31, 2019, as compared to 3.56% for the year ended December 31, 2018.
An offset to net interest income is the provision for loan losses, or the recapture of the provision for loan losses, that is required to establish the ALLL at a level that adequately provides for probable losses inherent in our loan portfolio. As our loan portfolio increases, or due to an increase for probable losses inherent in our loan portfolio, our ALLL may increase, resulting in a decrease to net interest income. Improvements in loan risk ratings, increases in property values, or receipt of recoveries of amounts previously charged off may partially or fully offset any increase to ALLL due to loan growth or an increase in probable loan losses. For the year ended December 31, 2019, we had a recapture of provision of $300,000 as compared to a recapture of $4.0 million for the year ended December 31, 2018. The recapture was primarily the result of a construction/land loan with a balance of $12.5 million at December 31, 2019, that was technically in default and classified as impaired, however, the Bank’s impairment analysis concluded there were no anticipated losses from the loan at this time, and therefore, funds previously allocated in the ALLL to this loan were recaptured. All payments on the loan were current as of December 31, 2019, and the loan is well collateralized. In addition, although total loans increased, the impact to the provision from this loan growth was offset by a shift in our loan concentrations to lower risk categories and reduction in the risk factor related to the collateral on certain loan types. Further impacting the ALLL, our total adversely classified loans decreased to $629,000 at December 31, 2019 from $1.3 million at December 31, 2018. The recapture of provision for loan losses in 2018 was primarily the result of $4.5 million of loan recoveries received on previously charged off loans, partially offset by the provision necessary for the $34.2 million increase in net loans receivable. We will continue to monitor our loan portfolio and make adjustments to our ALLL as we deem necessary.
Noninterest income is generated from various loan or deposit fees, increases in the cash surrender value of bank owned life insurance (“BOLI”), and revenue earned on our wealth management brokerage services. This income is increased or partially offset by any net gain or loss on sales of investment securities. Our noninterest income increased $1.3 million during the year ended December 31, 2019 as compared to 2018. The increase was primarily attributable to a $576,000 increase in loan related
fees, a $268,000 increase in the wealth management revenue, $180,000 increase in the cash surrender value of our BOLI policies and a $171,000 change from a loss to a $151,000 net gain on sales of investments.
Our noninterest expenses consist primarily of salaries and employee benefits, professional fees, regulatory assessments, occupancy and equipment, and other general and administrative expenses. Salaries and employee benefits consist primarily of the salaries and wages paid to our employees, payroll taxes, expenses for retirement, and other employee benefits. OREO-related expenses consist primarily of maintenance and costs of utilities for the OREO inventory, market valuation adjustments, build-out expenses, gains and losses from OREO sales, legal fees, real estate taxes, and insurance related to the properties included in the OREO inventory. Professional fees include legal services, auditing and accounting services, computer support services, and other professional services in support of strategic plans. Occupancy and equipment expenses, which are the fixed and variable costs of buildings and equipment, consist primarily of lease expenses, real estate taxes, depreciation expenses, maintenance, and costs of utilities. Also included in noninterest expense are changes to the Company’s unfunded commitment reserve which are reflected in general and administrative expenses. This unfunded commitment reserve expense can vary significantly each quarter, based on the amount believed by management to be sufficient to absorb estimated probable losses related to unfunded credit facilities, and reflects changes in the amounts that the Company has committed to fund but has not yet disbursed. Our noninterest expenses increased $957,000 during the year ended December 31, 2019 as compared to 2018. The increase was primarily attributable to a $639,000 increase in data processing expenses, a $429,000 increase in occupancy and equipment expenses, a $293,000 increase in salaries and employee benefits, partially offset by a $315,000 decrease in other general and administrative expenses.
Business Strategy
Our long-term business strategy is to operate and grow First Financial Northwest Bank as a well-capitalized and profitable community bank, offering one-to-four family residential, commercial and multifamily, construction/land, consumer and business loans along with a diversified array of deposit and other products and services to individuals and businesses in our market areas. We intend to accomplish this strategy by leveraging our established name and franchise, capital strength, and loan production capability by:
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Capitalizing on our intimate knowledge of our local communities to serve the convenience and needs of customers, and delivering a consistent, high-quality level of professional service;
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Offering competitive deposit rates and developing customer relationships to diversify our deposit mix, growing lower cost deposits, attracting new customers, and expanding our footprint in the geographical area we serve;
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Utilizing wholesale funding sources, including but not limited to FHLB advances and acquiring deposits in the national brokered certificate of deposit market, to assist with funding needs and interest rate risk management efforts, as needed;
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Managing our loan portfolio to minimize concentration risk and diversify the types of loans within the portfolio;
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Managing credit risk to minimize the risk of loss and interest rate risk to optimize our net interest margin; and
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Improving profitability through disciplined pricing, expense control and balance sheet management, while continuing to provide excellent customer service.
Critical Accounting Policies
Critical accounting policies are those that involve significant judgments and assumptions by management and that have, or could have, a material impact on our income or the carrying value of our assets. The following are our critical accounting policies.
Allowance for Loan Losses. Management recognizes that loan losses may occur over the life of a loan and that the ALLL must be maintained at a level necessary to absorb specific losses on impaired loans and probable losses inherent in the loan portfolio. Our methodology for analyzing the ALLL consists of two components: general and specific allowances. The general allowance is determined by applying factors to our various groups of loans. Management considers factors such as charge-off history, the current and expected economic conditions, borrower’s ability to repay, the regulatory environment, competition, geographic and loan type concentrations, policy and underwriting standards, nature and volume of the loan portfolio, management’s experience level, our loan review and grading systems, the value of underlying collateral, and the level of problem loans in assessing the ALLL. Specific allowances result when management performs an impairment analysis on a loan when it determines it is probable that all contractual amounts of principal and interest will not be paid as scheduled. The analysis usually occurs when a loan has been classified as substandard or placed on nonaccrual status or is a TDR because the borrower has been granted a rate concession. If the market value less costs to sell (“market value”) of the impaired loan is less than the recorded investment in the loan, impairment is recognized by establishing a specific reserve in the ALLL for the loan or by adjusting an existing reserve amount. The amount of the specific reserve is computed using current appraisals, listed sales prices, and other available information
less costs to complete, if any, and costs to sell the property. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available or as future events differ from predictions. In addition, specific reserves may be created upon a loan’s restructuring, based on a discounted cash flow analysis, comparing the present value of the anticipated repayments under the restructured terms to the outstanding principal balance of the loan.
Our Board of Directors’ Internal Asset Review Committee reviews and recommends for approval the allowance for loan losses on a quarterly basis, and any related provision or recapture of provision for loan losses, and the full Board of Directors approves the provision or recapture after considering the Committee’s recommendations. The allowance is increased by the provision for loan losses which is charged against current period earnings. When analysis of the loan portfolio warrants, the allowance is decreased and a recapture of provision of loan losses is included in current period earnings.
We believe that the ALLL is a critical accounting estimate because it is highly susceptible to change from period-to-period requiring management to make assumptions about probable losses inherent in the loan portfolio. The impact of an unexpected large loss could deplete the allowance and potentially require increased provisions to replenish the allowance, thereby reducing earnings. For additional information see Item 1A. “Risk Factors - Our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolio,” in this Form 10-K.
Valuation of OREO. Real estate properties acquired through foreclosure or by deed-in-lieu of foreclosure are recorded at fair value less estimated costs to sell. Fair value is generally determined by management based on a number of factors, including third-party appraisals of fair value in an orderly sale. Accordingly, the valuation of OREO is subject to significant external and internal judgment. If the carrying value of the loan at the date a property is transferred into OREO exceeds the fair value less estimated costs to sell, the excess is charged to the ALLL. Management periodically reviews OREO values to determine whether the property continues to be carried at the lower of its recorded book value or fair value, net of estimated costs to sell. Any further decreases in the value of OREO are considered valuation adjustments and are charged to noninterest expense in the Consolidated Income Statements. Expenses and income from the maintenance and operations and any gains or losses from the sales of OREO are included in noninterest expense.
Deferred Taxes. Deferred tax assets arise from a variety of sources, the most significant being expenses recognized in our financial statements but disallowed in the tax return until the associated cash flow occurs, and write-downs in the value of assets for financial statement purposes that are not deductible for tax purposes until the asset is sold or deemed worthless.
When warranted, we record a valuation allowance to reduce our deferred tax assets to the amount that can be recognized in line with the relevant accounting standards. The level of deferred tax asset recognition is influenced by management’s assessment of our historic and future profitability profile. At each balance sheet date, existing assessments are reviewed and, if necessary, revised to reflect changed circumstances. In a situation where income is less than projected or recent losses have been incurred, the relevant accounting standards require convincing evidence that there will be sufficient future tax capacity. For additional information regarding our deferred taxes, see Note 12 of the Notes to Consolidated Financial Statements contained in Item 8.
Other-Than-Temporary Impairments on the Market Value of Investments. Declines in the fair value of available-for-sale or held-to-maturity investments below their cost that is deemed to be other-than-temporary results in a reduction in the carrying amount of such investments to their fair value. A charge to earnings and an establishment of a new cost basis for the investment is made. Unrealized investment losses are evaluated at least quarterly to determine whether such declines should be considered other-than-temporary and therefore be subject to immediate loss recognition. Although these evaluations involve significant judgment, an unrealized loss in the fair value of a debt security is generally deemed to be temporary when the fair value of the investment security is below the carrying value primarily due to changes in interest rates and there has not been significant deterioration in the financial condition of the issuer. Other factors that may be considered in determining whether a decline in the value of a debt security is other-than-temporary include ratings by recognized rating agencies; the extent and duration of an unrealized loss position; actions of commercial banks or other lenders relative to the continued extension of credit facilities to the issuer of the security; the financial condition, capital strength and near-term prospects of the issuer and recommendations of investment advisers or market analysts. Therefore, deterioration of market conditions could result in impairment losses recognized within the investment portfolio.
Fair Value. FASB ASC 820, Fair Value Measurements and Disclosures, establishes a hierarchical disclosure framework associated with the level of pricing observability utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no pricing observability and a higher degree of judgment utilized in measuring fair value. Pricing observability is impacted by a number of factors, including the type of financial
instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction. See Note 6 of the Notes to Consolidated Financial Statements contained in Item 8 for additional information about the level of pricing transparency associated with financial instruments carried at fair value.
Derivatives and Hedge Accounting. The Bank recognizes its interest rate swaps as cash flow hedge derivative instruments, and as such, reports the net fair value as an asset or liability. Fair value is based on dealer quotes, pricing models, discounted cash flow methodologies or similar techniques for which the determination of fair value may require significant management judgment or estimation. The derivatives are marked to their fair value through other comprehensive income. The net gain or loss on derivatives is reclassified into earnings in the same income statement line item that is used to present the earnings effect of hedged items.
Intangible Assets. The Company incurred goodwill and a core deposit intangible asset through the Branch Acquisition during 2017. These assets were booked at fair value at the time of the acquisition. Goodwill is evaluated annually for impairment, with any impairment recognized as noninterest expense. The core deposit intangible is amortized into noninterest expense.
Comparison of Financial Condition at December 31, 2019 and December 31, 2018
Assets. The following table details the changes in the composition of our assets at December 31, 2019 from December 31, 2018.
The $89.5 million increase in total assets during 2019 was primarily a result of our deploying the funds available from $94.5 million of deposit growth after repayment of $8.8 million of FHLB advances, to increase our loan portfolio by $85.6 million. Additional factors in our asset growth are described below.
Interest-earning deposits with banks. Our interest-earning deposits with banks, consisting primarily of funds held at the Federal Reserve Bank of San Francisco, increased by $4.0 million to $12.9 million at December 31, 2019 from December 31, 2018. We monitor the balance of these funds daily in relation to our expected funding needs and adjust accordingly. Excess funds are generally used to pay down overnight funding at the FHLB.
Investments available-for-sale. Our investments available-for-sale decreased by $5.6 million, or 3.9%, during 2019. To enhance the income from our investment portfolio, we had sales, maturities, and calls on $14.3 million of our securities, with an average yield of 2.08%. The sales of investments available-for-sale generated a net gain of $151,000 for the year ended December 31, 2019. The proceeds were partially reinvested in $14.4 million of investments with an expected yield of 2.79%. Continued restructuring of our available-for-sale investments in 2019 combined with increases in the target federal funds rate throughout 2018 that outpaced decreases in the targeted federal funds rate in the second half of 2019 contributed to an increase in the average yield on investment securities to 3.11% for 2019 from 2.92% in 2018. Securities purchased in 2019 included
$7.6 million in fixed rate and $6.5 million in variable rate securities. In addition to the purchase and redemption activity, we received principal repayments of $7.4 million on our investments available-for-sale during 2019.
The effective duration of our securities portfolio decreased to 2.54% at December 31, 2019 as compared to 3.00% at December 31, 2018. Effective duration is a measure that attempts to quantify the anticipated percentage change in the value of an investment (or portfolio) in the event of a 100 basis point change in market yields. Since the Bank’s portfolio includes securities with embedded options (including call options on bonds and prepayment options on mortgage-backed securities), management believes that effective duration is an appropriate metric to use as a tool when analyzing the Bank’s investment securities portfolio, as effective duration incorporates assumptions relating to such embedded options, including changes in cash flow assumptions as interest rates change.
Loans receivable. Net loans receivable increased by $85.6 million during 2019 to $1.11 billion. The most significant increase occurred in one-to-four family residential loans, with a $30.6 million, or 8.9% increase. In addition, commercial real estate loans increased by $21.4 million, or 5.7%. Commercial real estate and one-to-four family residential loans continue to be the largest concentrations in our loan portfolio at 35.2% and 33.2%, respectively, of total loans. Growth occurred in all of our loan types, with a $17.2 million increase in consumer loans, a $7.3 million increase in business loans, a $4.8 million increase in construction/land loans, and a $3.6 million increase in multifamily loans. During 2019, we supplemented our loan originations and participations by purchasing $38.0 million in loans, which primarily included performing commercial real estate loans, classic or collectible car and construction/land loans. The loans were purchased at an average premium of 3.1% and included $16.6 million of loans secured by commercial real estate properties located in Arizona, California, Colorado, and Illinois, reflecting our efforts to geographically diversify our loan portfolio with loans meeting our investment and credit quality objectives.
The quality of our loan portfolio remained stable during 2019, with a decrease in nonperforming loans to $95,000 at December 31, 2019 from $752,000 at December 31, 2018, primarily as a result of payoffs on all but one of our nonperforming properties. Nonperforming loans as a percent of our total loans remained low at 0.01% and 0.07% at December 31, 2019 and 2018, respectively. Adversely classified loans, defined as substandard or below, decreased to $629,000 at December 31, 2019, from $1.3 million at December 31, 2018. The following table presents a breakdown of our nonperforming assets:
We continued to focus on reducing our nonperforming assets through loan work outs or pursuing foreclosure. Foregone interest during the year ended December 31, 2019 relating to nonperforming loans totaled $12,000. There was no LIP related to nonperforming loans at December 31, 2019 or 2018. OREO decreased to $454,000 at December 31, 2019 as a result of $29,000 in write-downs reflecting market value decreases on the two properties in this portfolio. We did not foreclose on any properties during either 2019 or 2018. The stability in our nonperforming assets reflects the quality of our loan portfolio and our commitment to identify any problem loans and take prompt actions to turn nonperforming assets into performing assets.
Allowance for loan and lease losses. We believe that we use the best information available to establish the ALLL, and that the ALLL as of December 31, 2019 was adequate to absorb the probable and inherent losses in the loan portfolio at that date. While we believe the estimates and assumptions used in our determination of the adequacy of the allowance are reasonable, there can be no assurance that such estimates and assumptions will not be proven incorrect in the future, or that the actual amount of future provisions will not exceed the amount of past provisions, or that any increased provisions that may be required will not adversely impact our financial condition and results of operations. Future additions to the allowance may become necessary based upon changing economic conditions, the level of problem loans, business conditions, credit concentrations, increased loan balances, or changes in the underlying collateral of the loan portfolio. In addition, the determination of the amount of our ALLL is subject to review by bank regulators as part of the routine examination process that which may result in the establishment of additional
loss reserves or the charge-off of specific loans against established loss reserves based upon their judgment of information available to them at the time of their examination.
The ALLL was $13.2 million, or 1.18% of total loans receivable at December 31, 2019, as compared to $13.3 million, or 1.29% of total loans receivable at December 31, 2018. The following table details activity and information related to the ALLL for the years ended December 31, 2019 and 2018.
Intangible assets. As a result of our Branch Acquisition in 2017, the Bank recognized goodwill of $889,000 and a core deposit intangible (“CDI”) of $1.3 million. Goodwill was calculated as the excess purchase price of the branches over the fair value of the assets acquired and liabilities assumed at August 25, 2017.
The CDI was provided by a third party valuation service and represents the fair value of the customer relationships that provide a low-cost source of funding. The analysis was performed on the acquired noninterest-bearing checking, interest-bearing checking, savings, and money market accounts. The initial ratio of CDI to the acquired balances of core deposits was 2.23%. This amount will amortize into noninterest expense on an accelerated basis over ten years and had a balance of $968,000 at December 31, 2019.
Deposits. During the year ended December 31, 2019, deposits increased $94.5 million from December 31, 2018. Details of deposit balances and their concentrations are as follows:
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(1) Retail certificates of deposit are shown net of a $28,000 and $58,000 fair value adjustment at December 31, 2019, and 2018, respectively, from acquired deposits.
The $97.9 million growth in retail deposits during 2019 was primarily the result of continued focus on core deposit growth. During 2019, with the enhancements in treasury management products offered to our customers and the focus of our retail team, we were very successful in acquiring core deposits by building business checking and money market relationships. As a result, money market accounts grew by $38.7 million, retail certificates of deposit grew by $33.9 million and interest-bearing
demand accounts grew by $25.8 million. The growth in retail deposits allowed us to reduce our borrowings and enhance our liquidity.
Our portfolio of brokered certificates of deposit decreased by $3.4 million to $94.5 million at December 31, 2019. During 2019, the Bank exercised its call option on $27.7 million of certain higher rate brokered certificates of deposit, replacing the funds in the short term with lower rate fed funds advances from the FHLB. While brokered certificates of deposit may carry a higher cost than our retail certificates, the enhanced call features of a portion of these deposits assist us in our efforts to manage interest rate risk.
At December 31, 2019 and December 31, 2018, we held $34.0 million and $28.5 million in public funds, respectively, nearly all of which were retail certificates of deposit. These funds were secured at December 31, 2019 with the Washington State Public Deposit Protection Commission by $19.0 million in pledged investment securities.
Advances. We use advances from the FHLB as an alternative funding source to manage interest rate risk and to leverage our balance sheet. Total FHLB advances at December 31, 2019 were $137.7 million as compared to $146.5 million at December 31, 2018. During 2019, as part of our ongoing liquidity management efforts, we restructured our FHLB advances to include $60.0 million of fixed-rate three-month advances that renew quarterly, and a $15.0 million fixed-rate one-month advance that renews monthly, that are utilized in cash flow hedge agreements, as described below. In addition, at December 31, 2019, we had a $36.0 million fixed-rate 21-day advance. At December 31, 2019, we held $26.7 million of purchased FHLB Fed Funds. The short-term nature of our advances and overnight FHLB advances provides us flexibility to adjust the level of our borrowings as our customer deposit balances change consistent with our asset/liability objectives. Our average borrowings during 2019 were $129.9 million. At December 31, 2019, all of our FHLB advances were due to mature in less than two months.
Cash Flow Hedge. To assist in managing interest rate risk, the Bank entered into three interest rate swap agreements with qualified institutions designated as cash flow hedge instruments: a five-year, $50 million notional, pay fixed, receive floating cash flow hedge on October 25, 2016, at 1.34%; a five-year, $15.0 million notional, pay fixed, receive floating cash flow hedge on September 27, 2019, at 1.44%; and a four-year, $10.0 million notional, pay fixed, receive floating cash flow hedge on November 20, 2019, at 1.585%. Under the terms of the interest rate swap agreements, the Bank pays a fixed interest rate and in return receives an interest payment based on the corresponding LIBOR index, which resets quarterly or monthly, depending on the hedge term. Concurrently, the Bank borrowed a fixed rate FHLB advance that will be renewed quarterly or monthly, as designated by the hedge agreement, at the fixed interest rate at that time. Effectiveness of the interest rate swap is evaluated quarterly with any ineffectiveness recognized as a gain or a loss on the income statement in noninterest income. A change in the fair value of the cash flow hedge created by the interest rate swap agreements is recognized as an other asset or other liability on the balance sheet with the tax-effected portion of the change included in other comprehensive income. At December 31, 2019, we recognized a $426,000 fair value asset as a result of the increase in market value of the interest rate swap agreements.
Stockholders’ Equity. Total stockholders’ equity increased $2.6 million, or 1.7% to $156.3 million at December 31, 2019 from $153.7 million at December 31, 2018. The increase in stockholders’ equity was primarily a result of $10.4 million in net income partially offset by the repurchase of 479,052 shares of stock at an aggregate cost of $7.4 million and $3.5 million in shareholder cash dividends. In addition, net stock-based compensation totaled $2.2 million and other comprehensive loss, net of tax, decreased $882,000 during the year ended December 31, 2019. Additional shares of common stock were issued from authorized shares due to the exercise of stock options and restricted stock awards in 2019 totaling 21,349 shares, resulting in a net decrease to stockholders’ equity of $72,000.
Comparison of Operating Results for the Years Ended December 31, 2019 and December 31, 2018
Net Interest Income. Net interest income in 2019 was $38.9 million, a $2.3 million or 5.5% decrease from $41.2 million in 2018, due primarily to an $6.0 million increase in interest expense partially offset by a $3.7 million increase in interest income. Interest income increased during the year ended December 31, 2019, primarily as a result of the $65.6 million growth in the average balance of net loans receivable and in particular, one-to-four family, commercial real estate and consumer loans. In addition, the average yield of interest-earning assets increased to 4.88% for the year ended December 31, 2019 from 4.83% for the year ended December 31, 2018. The increase in average assets was funded by a $63.8 million increase in average interest-bearing liabilities. The average cost of these funds increased to 1.92% for the year ended December 31, 2019 from 1.46% for the year ended December 31, 2018, primarily as a result of an increase in the targeted federal funds rate during the first six months of 2019, and to a lesser extent, higher deposit balances. Our interest-bearing liabilities reprice faster than our interest-earning assets in response to changes in market interest rates, resulting in a 37 basis point reduction in our net interest margin to 3.19% for the year ended December 31, 2019, from 3.56% for the year ended December 31, 2019. For more information on this, see “Asset and Liability Management and Market Risk.”
The following table compares average interest-earning asset balances, associated yields, and resulting changes in interest and dividend income for the years ended December 31, 2019 and 2018:
During the year ended December 31, 2019, the $3.5 million increase in loan interest income was the result of a $65.6 million increase in the average balance of net loans receivable combined with a slight increase in the average loan yield of two basis points. The loan yield for the year ended December 31,2018, benefited from repayments of previously charged off notes, which contributed $1.0 million to loan interest income on loans with a zero book balance at the time of payoff.
Interest income from investments available-for-sale increased $203,000 during 2019 as a combined result of a $1.7 million increase in the average balance of our investments and a 19 basis point increase in the average yield to 3.11% from 2.92% during 2018. Our variable rate available-for-sale investments benefited from the increases in the targeted Fed Funds rate that occurred throughout 2018 and that outpaced the decreases in the targeted federal funds rate in the second half of 2019.
Interest income on interest-earning deposits increased $91,000 during the year ended December 31, 2019, primarily as a result of a $2.0 million increase in the average balance of these deposits, combined with a 41 basis point increase in the average yield to 2.15% for the year ended December 31, 2019 from 1.74% for the year ended December 31, 2018. The rate increase was the result of the increase in the Federal Reserve’s targeted federal funds rate during the initial six months of 2019.
The following table details average balances, cost of funds and the resulting increase in interest expense for the years ended December 31, 2019 and 2018:
Interest expense increased $6.0 million to $20.7 million for the year ended December 31, 2019 from $14.7 million for the year ended December 31, 2018. The increase in interest expense during 2019 was primarily a result of the increase in the average cost of interest-bearing deposits of 55 basis points and the increase in the average cost of our FHLB borrowings of 17 basis points reflecting higher market interest rates. In support of our asset growth, the average balances of interest-bearing deposits increased by $117.5 million. The growth in our deposits more than met our funding needs, allowing the Bank to pay down certain FHLB advances, resulting in a $53.8 million decrease in the average balance of these borrowings for 2019.
The average cost of our retail deposits increased as a result of the continued strength in market interest rates that occurred during 2019. Money market interest expense increased by $1.5 million as a result of a $2.9 million increase in the average balance primarily due to continued branch growth, combined with a 44 basis point increase in the average cost of these funds. The cost of retail and brokered certificates of deposit increased by 66 and 44 basis points, respectively, as the rates required to compete for these deposits in the marketplace have increased in response to increases in the targeted federal funds rate. Our average balance of brokered certificates of deposit increased by $47.8 million during 2019 as opportunities to obtain short-term funding were utilized.
Provision for Loan Losses. Our recapture of provision for loan losses was $300,000 for the year ended December 31, 2019 as compared to $4.0 million for the year ended December 31, 2018, resulting in a decrease in the ALLL to total loans to 1.18% at December 31, 2019, as compared to 1.29% at December 31, 2018. The recapture in 2019 was primarily the result of a construction/land loan with a balance of $12.5 million at December 31, 2019, that was technically in default and classified as impaired, however, the Bank’s impairment analysis concluded there were no anticipated losses from the loan at this time, and therefore funds previously allocated in the ALLL to this loan were recaptured. In addition, although total loans increased, the impact to the provision from this loan growth was offset by a shift in our loan concentrations to lower risk categories and reduction in the risk factor related to the collateral on certain loan types. Further, our total adversely classified loans decreased to $629,000 at December 31, 2019 from $1.3 million at December 31, 2018. In comparison, the recapture of provision in 2018 was primarily the result of $4.5 million in net recoveries of previously charged off loans, partially reduced by the provision for loan losses required as a result of the $34.2 million increase in net loans receivable. Although our total loans evaluated for specific reserves increased by $9.8 million as impaired loans increased, the related specific reserves after evaluation declined to $31,000 at December 31, 2019 from $62,000 at December 31, 2018.
Noninterest Income. Noninterest income increased $1.3 million to $4.1 million for the year ended December 31, 2019 from $2.9 million for the year ended December 31, 2018. The following table provides a detailed analysis of the changes in the components of noninterest income:
The largest change to our noninterest income was the $576,000 increase on loan related fees primarily as a result of a $320,000 increase in interest rate swap servicing fees. The Bank has an interest rate swap program for commercial loan customers, under which the customer participates in an interest rate swap with a third party broker institution for which the Bank receives a servicing fee that is recognized at the time the loan is originated. In addition, loan prepayment penalties increased by $290,000 for the year ended December 31, 2019, as compared to the year ended December 31, 2018.
Wealth management revenue increased by $268,000 as a result of an increase in assets we manage and as a result of normal fluctuations in the timing and mix of commissions received on serviced accounts due to the nature and timing of the underlying investments. This line of business assists the Bank with providing options to our customers to better meet their financial needs. Total assets managed by our wealth management division increased to $96.0 million at December 31, 2019, from $64.8 million at December 31, 2018.
Our BOLI noninterest income increased by $180,000 for the year ended December 31, 2019, primarily as a result of the timing in recognizing policy expenses and dividends on new policies purchased in 2017 and 2018. Policy expenses were deducted from earnings over the first year subsequent to the purchase date of certain policies, partially reducing the noninterest income on our BOLI policies we otherwise would recognize. We recognized the net $994,000 increase in cash surrender value of these policies as noninterest income, which assists in offsetting expenses for employee benefits.
The Bank sold certain available-for-sale securities during the year ended December 31, 2019, resulting in a $151,000 gain. In comparison, sales of investments for the year ended December 31, 2018, resulted in a $20,000 loss. During 2019, selected
securities were strategically sold, with the funds reinvested in securities and loans that were expected to improve the Company’s total return on investments. The timing of these sales resulted in net gains, and in most instances, with proceeds reinvested into securities with superior anticipated yields.
Deposit related fees of $733,000 were recorded for the year ended December 31, 2019, a $52,000 increase over the prior year. As a result of our deposit growth and corresponding increase in customer transactions, our transactional based fee revenue also increased.
Noninterest Expense. Noninterest expense increased $957,000 to $30.4 million for the year ended December 31, 2019 from $29.5 million for the year ended December 31, 2018. The following table provides a detailed analysis of the changes in the components of noninterest expense:
The primary contributor to the increase in noninterest expense was our continued focus on product and branch expansion. For the year ended December 31, 2019, salaries and employee benefits increased by $293,000, as compared to the previous year, to $19.6 million partially as a result of $541,000 in normal wage increases combined with severance and related benefits for a terminated employee. These increases were partially offset by a $357,000 reduction in stock based compensation.
Occupancy and equipment expense increased $429,000 to $3.7 million during 2019 primarily as a result of the addition of two new branch locations in 2019. Lease expense increased by $188,000 and depreciation expense increased by $134,000, primarily as a result of additional leasehold improvements and fixed assets related to opening the new branches.
Data processing expense increased by $639,000 in support of continued growth of our loan and deposit accounts. In addition, the completion of our new online banking platform, incurred both one-time costs and an increase in monthly core processor service fees.
Partially offsetting these increases, our regulatory expenses decreased by $195,000 for 2019, as compared to 2018, as a result of the application of $282,000 in small bank assessment credits to offset a portion of our quarterly expense. Further reducing our noninterest expense for 2019, as compared to 2018, the Bank received a $125,000 insurance settlement for a $225,000 wire related fraud that was recognized in other general and administrative expense in 2019.
Federal Income Tax Expense. We recorded a $2.6 million federal income tax provision for 2019, compared to $3.7 million for 2018. The decrease in federal income tax provision for 2019 was primarily the result of a $5.7 million decrease in pretax net income.
Average Balances, Interest and Average Yields/Cost
The following table presents information regarding average balances of assets and liabilities as well as interest income from average interest-earning assets and interest expense on average interest-bearing liabilities, resultant yields, interest rate spreads, net interest margins and the ratio of average interest-earning assets to average interest-bearing liabilities. Average balances have been calculated using the average daily balances during the period. Interest and dividends are not reported on a tax equivalent basis.
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(1) The average loans receivable, net balances include nonaccruing loans and deferred fees.
Yields Earned and Rates Paid
The following table presents the weighted-average yields earned on our assets and the weighted-average interest rates paid on our liabilities, together with the net yield on interest-earning assets and liabilities, for the dates indicated.
Rate/Volume Analysis
The following table presents the effects of changing rates and volumes on our net interest income. Information is provided with respect to: (1) effects on interest income attributable to changes in volume (changes in volume multiplied by prior rate); and (2) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume). Changes in rate/volume are allocated proportionately to the changes in rate and volume.
Asset and Liability Management and Market Risk
General. Our Board of Directors has approved an asset/liability management policy to guide management in maximizing interest rate spread by managing the differences in terms between interest-earning assets and interest-bearing liabilities while maintaining acceptable levels of liquidity, capital adequacy, interest rate risk, credit risk, and profitability. The policy established an Investment, Asset/Liability Committee (“ALCO”) comprised of certain members of senior management and the Board of Directors. The Committee’s purpose is to communicate, coordinate and manage our asset/liability position consistent with our business plan and Board-approved policies. The ALCO meets quarterly to review various areas including:
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economic conditions;
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interest rate outlook;
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asset/liability mix;
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interest rate risk sensitivity;
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current market opportunities to promote specific products;
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historical financial results;
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projected financial results; and
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capital position.
The Committee also reviews current and projected liquidity needs. As part of its procedures, the Committee regularly reviews interest rate risk by forecasting the impact that changes in interest rates may have on net interest income and the market value of portfolio equity, which is defined as the net present value of an institution’s existing assets, liabilities and off-balance sheet instruments and evaluating such impacts against the maximum potential change in the market value of portfolio equity that is authorized by the Board of Directors.
Our Risk When Interest Rates Change. The rates of interest we earn on assets and pay on liabilities generally are established contractually for a period of time. Market interest rates change over time. Our loans generally have longer maturities than our deposits. Accordingly, our results of operations, like those of other financial institutions, are impacted by changes in
interest rates and the interest rate sensitivity of our assets and liabilities. The risk associated with changes in interest rates and our ability to adapt to these changes is known as interest rate risk and is our most significant market risk.
We have utilized the following strategies in our efforts to manage interest rate risk:
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we are originating shorter term, higher yielding loans, whenever possible;
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we have attempted, where possible, to extend the maturities of our deposits which typically fund our long-term assets;
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we have invested in securities with relatively short average lives, generally less than eight years;
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we have added adjustable-rate loans to our loan portfolio;
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we have added brokered certificates of deposit with a call option as a funding source; and
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we have utilized interest rate swaps to effectively fix the rate on $75.0 million of FHLB advances.
How We Measure the Risk of Interest Rate Changes. We monitor our interest rate sensitivity on a quarterly basis by measuring the impact of changes to net interest income in multiple rate environments. Management retains the services of a third party consultant with over 30 years of experience in asset-liability management to assist in its interest rate risk and asset-liability management. Management uses various assumptions to evaluate the sensitivity of our operations to changes in interest rates. Although management believes these assumptions are reasonable, the interest rate sensitivity of our assets and liabilities on net interest income and the market value of portfolio equity could vary substantially if different assumptions were used or actual results differ from these assumptions. Although certain assets and liabilities may have similar maturities or periods of repricing, they may react differently to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities lag behind changes in market interest rates. Non-uniform changes and fluctuations in market interest rates across various maturities will also affect the results presented. In addition, certain assets, such as adjustable-rate mortgage loans, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. Further, a portion of our adjustable-rate loans have interest rate floors below which the loan’s contractual interest rate may not adjust. Approximately 55.8% of our net loans were adjustable-rate loans at December 31, 2019. At that date, $359.0 million, or 57.3%, of these loans with a weighted-average interest rate of 4.80% were at their floor interest rate. The inability of our loans to adjust downward can contribute to increased income in periods of declining interest rates. However, when loans are at their floors, there is a further risk that our interest income may not increase as rapidly as our cost of funds during periods of increasing interest rates. Further, in the event of a significant change in interest rates, prepayment and early withdrawal levels would likely deviate from those assumed. Finally, the ability of many borrowers to service their debt may decrease in the event of an interest rate increase. We consider all these factors in monitoring our interest rate exposure.
The assumptions we use are based upon a combination of proprietary and market data that reflect historical results and current market conditions. These assumptions relate to interest rates, prepayments, deposit decay rates and the market value of certain assets under the various interest rate scenarios. We use market data to determine prepayments and maturities of loans, investments and borrowings and use our own assumptions on deposit decay rates except for time deposits. Time deposits are modeled to reprice to market rates upon their stated maturities. We also assume that non-maturity deposits can be maintained with rate adjustments not directly proportionate to the change in market interest rates, based upon our historical deposit decay rates, which are substantially lower than market decay rates. We have observed in the past that our deposit accounts during changing rate environments have relatively lower volatility and less than market rate changes. When interest rates rise, we do not have to raise interest rates proportionately on less rate sensitive accounts to retain these deposits. These assumptions are based upon our analysis of our customer base, competitive factors, and historical experience.
Our income simulation model examines changes in net interest income in scenarios where interest rates were assumed to remain at their base level, instantaneously increase by 100, 200 and 300 basis points or decline immediately by 100 basis points. A decline by 200 and 300 basis points is not reported as the current targeted federal funds rate is between 1.50% and 1.75%.
The following table illustrates the estimated change in our net interest income over the next 12 months from December 31, 2019, that would occur in the event of an immediate change in interest rates equally across all maturities, with no effect given to any steps that we might take to counter the effect of that interest rate movement.
The following table illustrates the change in our net portfolio value (“NPV”) at December 31, 2019 that would occur in the event of an immediate change in interest rates equally across all maturities, with no effect given to any steps that we might take to counter the effect of that interest rate movement.
__________
(1)
No rates in the model are allowed to go below zero. Given the relatively low level of market interest rates, a calculation for a decrease of greater than 100 basis points has not been prepared.
(2)
The net portfolio value is the difference between the present value of the discounted cash flows of assets and liabilities and represents the market value of the Company’s equity for any given interest rate scenario. Net portfolio value is useful for determining, on a market value basis, how equity changes in response to various interest rate scenarios. Large changes in net portfolio value reflect increased interest rate sensitivity and generally more volatile earnings streams.
(3)
The increase or decrease in the estimated net portfolio value at the indicated interest rates compared to the net portfolio value assuming no change in interest rates.
(4)
Net portfolio value divided by the market value of assets.
(5)
The increase or decrease in the net portfolio value divided by the market value of assets.
(6)
The market value of assets represents the value of assets under the various interest rate scenarios and reflects the sensitivity of those assets to interest rate changes.
The net interest income and net portfolio value tables presented above are predicated upon a stable balance sheet with no growth or change in asset or liability mix. In addition, the net portfolio value is based upon the present value of discounted cash flows using our estimates of current replacement rates to discount the cash flows. The effects of changes in interest rates in the net interest income table are based upon a cash flow simulation of our existing assets and liabilities and assuming that delinquency rates would not change as a result of changes in interest rates, although there can be no assurance that this will be the case. Delinquency rates may change when interest rates change as a result of changes in the loan portfolio mix, underwriting conditions, loan terms or changes in economic conditions that have a delayed effect on the portfolio. Even if interest rates change in the designated amounts, there can be no assurance that our assets and liabilities would perform as assumed. Also, a change in U.S. Treasury rates in the designated amounts accompanied by a change in the shape of the Treasury yield curve would cause changes to the net portfolio value and net interest income other than those indicated above.
Liquidity
We are required to have enough cash flow in order to maintain sufficient liquidity to ensure a safe and sound operation. We maintain cash flows above the minimum level believed to be adequate to meet the requirements of normal operations, including potential deposit outflows. On a daily basis, we review and update cash flow projections to ensure that adequate liquidity is maintained.
Our primary sources of funds are customer deposits, scheduled loan and investment repayments, including interest payments, maturing loans and investment securities, and advances from the FHLB. These funds, together with equity, are used to fund loans, acquire investment securities and other assets, and fund continuing operations. While maturities and the scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by the level of interest rates, economic conditions and competition. We believe that our current liquidity position, and our forecasted operating results are sufficient to fund all of our existing commitments.
Liquidity management is both a daily and long-term function of business management. Excess liquidity is generally invested in short-term investments such as overnight deposits or agency or mortgage-backed securities. On a longer term basis, we maintain a strategy of investing in various lending products as described in greater detail under Item 1. “Business - Lending Activities.” At December 31, 2019, the undisbursed portion of construction LIP totaled $89.6 million and unused lines of credit were $38.1 million. In addition, we had commitments to originate loans of $2.0 million that includes a $230,000 standby letter of credit. We use our sources of funds primarily to meet ongoing commitments, to pay maturing certificates of deposit and withdrawals on other deposit accounts, to fund loan commitments, and to maintain our portfolio of investment securities. Certificates of deposit scheduled to mature in one year or less at December 31, 2019 totaled $222.1 million. Management’s policy is to maintain deposit rates at levels that are competitive with other local financial institutions. Based on historical experience, we believe that a significant portion of maturing certificates of deposit will remain with First Financial Northwest Bank. As further funding sources, we had the ability at December 31, 2019 to borrow an additional $451.0 million from the FHLB, $80.1 million from the FRB and $35.0 million from unused lines of credit with other financial institutions to meet commitments and for liquidity purposes. See the Consolidated Statements of Cash Flows in Item 8 of this report for further details on our cash flow activities.
We measure our liquidity based on our ability to fund our assets and to meet liability obligations when they come due. Liquidity (and funding) risk occurs when funds cannot be raised at reasonable prices, or in a reasonable time frame, to meet our normal or unanticipated obligations. We regularly monitor the mix between our assets and our liabilities to manage our liquidity and funding requirements.
Our primary source of funds is our retail deposits. When retail deposits are not available to provide the funds for our assets, we use alternative funding sources. These sources include, but are not limited to, advances from the FHLB, wholesale funding, brokered deposits, federal funds purchased, and dealer repurchase agreements, as well as other short-term alternatives. We may also liquidate assets to meet our funding needs.
On a monthly basis, we estimate our liquidity sources and needs for the next twelve months. Also, we determine funding concentrations and our need for sources of funds other than deposits. This information is used by our Asset/Liability Management Committee in forecasting funding needs and investing opportunities.
Capital
Our total stockholders’ equity was $156.3 million at December 31, 2019. Consistent with our goal to operate a sound and profitable financial organization we will actively seek to maintain the Bank as a “well capitalized” institution in accordance with regulatory standards. As of December 31, 2019, First Financial Northwest Bank exceeded all regulatory capital requirements. Regulatory capital ratios for First Financial Northwest Bank were as follows as of December 31, 2019: Total capital to risk-weighted assets was 14.38%; Tier 1 capital and Common equity tier 1 capital to risk-weighted assets was 13.13%; and Tier 1 capital to total assets was 10.27%. At December 31, 2019, First Financial Northwest Bank met the financial ratios to be considered well-capitalized under the regulatory guidelines. See Item 1. “Business - How We Are Regulated - Regulation and Supervision of First Financial Northwest Bank - Capital Requirements.”
Commitments and Off-Balance Sheet Arrangements
We are a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and the unused portions of lines of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition. Commitments to extend credit and lines of credit are not recorded as an asset or liability by us until the instrument is exercised. At December 31, 2019 and 2018, we had no commitments to originate loans for sale.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the loan agreement. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The
amount of collateral obtained, if deemed necessary by us upon extension of credit, is based on our credit evaluation of the customer. The amount and type of collateral required varies, but may include real estate and income-producing commercial properties.
The following table summarizes our outstanding commitments to advance additional amounts pursuant to outstanding lines of credit, and to disburse funds related to our construction loans at December 31, 2019.
First Financial Northwest and its subsidiaries from time to time are involved in various claims and legal actions arising in the ordinary course of business. There are currently no matters that in the opinion of management would have a material adverse effect on First Financial Northwest’s consolidated financial position, results of operation or liquidity.
We anticipate that we will continue to have sufficient funds and alternative funding sources to meet our current commitments.
The following table presents a summary of significant contractual obligations as of December 31, 2019, maturing as indicated:
___________
(1)
Deposit accounts with indeterminate maturities, such as noninterest bearing, interest-bearing demand, savings and money market accounts are reflected as obligations due in less than one year.
(2)
Includes maximum payments related to employee benefit plans, assuming all future vesting conditions are met. Additional information about employee benefit plans is provided in Note 11 of the Notes to Consolidated Financial Statements included in Item 8 of this report.
Impact of Inflation
The Consolidated Financial Statements and related financial data presented herein have been prepared in accordance with accounting principles generally accepted in the United States of America. These principles generally require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation.
Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. The primary impact of inflation is reflected in the increased cost of our operations. As a result, interest rates generally have a more significant impact on a financial institution’s performance than do general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services. In a period of rapidly rising interest rates, the liquidity and maturity structures of our assets and liabilities are critical to the maintenance of acceptable performance levels.
The principal effect of inflation on earnings, as distinct from levels of interest rates, is in the area of noninterest expense. Expense items such as employee compensation, employee benefits, and occupancy and equipment costs may be subject to increases
as a result of inflation. An additional effect of inflation is the possible increase in dollar value of the collateral securing loans that we have made. Our management is unable to determine the extent, if any, to which properties securing loans have appreciated in dollar value due to inflation.
Recent Accounting Pronouncements
See Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The information contained under Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management and Market Risk” of this Form 10-K is incorporated herein by reference.
Item 8.
Item 8. Financial Statements and Supplementary Data
Index to Consolidated Financial Statements
[Letterhead of Moss Adams LLP]
Report of Independent Registered Public Accounting Firm
To the Shareholders and the Board of Directors of
First Financial Northwest, Inc.
Opinions on the Financial Statements and Internal Control over Financial Reporting
We have audited the accompanying consolidated balance sheets of First Financial Northwest, Inc. and Subsidiaries (the “Company”) as of December 31, 2019 and 2018, the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for the years then ended, and the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company’s internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2019 and 2018, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by COSO.
Basis for Opinions
The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report on Internal Control over Financial Reporting included in Item 9A. Our responsibility is to express an opinion on the Company’s consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.
Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures to respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
Definition and Limitations of Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ Moss Adams, LLP
Everett, Washington
March 12, 2020
We have served as the Company’s auditor since 2009.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(Dollars in thousands, except share data)
See accompanying notes to consolidated financial statements.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Income Statements
(Dollars in thousands, except share data)
See accompanying notes to consolidated financial statements.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income
(In thousands)
See accompanying notes to consolidated financial statements.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Statements of Stockholders’ Equity
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(In thousands)
continued
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(In thousands)
See accompanying notes to consolidated financial statements.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 - Summary of Significant Accounting Policies
Nature of Operations and Principles of Consolidation
First Financial Northwest, Inc. (“First Financial Northwest”), a Washington corporation, was formed on June 1, 2007 for the purpose of becoming the holding company for First Financial Northwest Bank (“the Bank”) in connection with the conversion from a mutual holding company structure to a stock holding company structure completed on October 9, 2007. First Financial Northwest’s business activities generally are limited to passive investment activities and oversight of its investment in First Financial Northwest Bank. Accordingly, the information presented in the consolidated financial statements and related data, relates primarily to First Financial Northwest Bank. First Financial Northwest converted from a savings and loan holding company to a bank holding company in 2015 and is subject to regulation by the Board of Governors of the Federal Reserve Bank of San Francisco (“FRB”). First Financial Northwest Bank is regulated by the Federal Deposit Insurance Corporation (“FDIC”) and the Washington State Department of Financial Institutions (“DFI”).
First Financial Northwest Bank was organized in 1923 as a Washington state-chartered savings and loan association, converted to a federal mutual savings and loan association in 1935, and converted to a Washington state-chartered mutual savings bank in 1992. In 2002, First Financial Northwest Bank reorganized into a two-tier mutual holding company structure, became a stock savings bank and became the wholly-owned subsidiary of First Financial of Renton, Inc. In connection with the mutual to stock conversion in 2007, the Bank changed its name to First Savings Bank Northwest. In August 2015, the Bank changed its name to First Financial Northwest Bank to support the expansion of focus to being more than a traditional “savings” bank. In February 2016, the Bank changed its charter from a Washington chartered stock savings bank to a Washington chartered commercial bank.
First Financial Northwest Bank is a community-based commercial bank primarily serving King and Snohomish Counties, and to a lesser extent, Pierce and Kitsap Counties, Washington. In King County, the headquarters and full-service banking office, as well as one branch office, are located in Renton. Additional King County branch offices are located in Bellevue, Woodinville, Bothell, and Kent. In Snohomish County, five additional branch offices serve Mill Creek, Edmonds, Clearview, Smokey Point, and Lake Stevens. First Financial Northwest Bank’s business consists of attracting deposits from the public and utilizing these deposits to originate one-to-four family residential, multifamily, commercial real estate, construction/land, business and consumer loans.
First Financial Diversified Corporation (“FFD”), a wholly-owned subsidiary of First Financial Northwest, held a portfolio of one-to-four family, land and consumer loans that were serviced by the Bank, however, at December 31, 2019, FFD’s loan portfolio had been fully paid off.
The accompanying consolidated financial statements include the accounts of First Financial Northwest and its wholly-owned subsidiaries First Financial Northwest Bank and First Financial Diversified Corporation (collectively, “the Company”). All significant intercompany balances and transactions between First Financial Northwest and its subsidiaries have been eliminated in consolidation.
Basis of Presentation and Use of Estimates
The accounting and reporting policies of First Financial Northwest and its subsidiaries conform to U.S. generally accepted accounting principles (“GAAP”). In preparing the consolidated financial statements, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided. Actual results could differ from these estimates. Material estimates particularly subject to change include the allowance for loan and lease losses (“ALLL”), other real estate owned (“OREO”), deferred tax assets and the fair values of financial instruments.
Subsequent Events
The Company has evaluated events and transactions subsequent to December 31, 2019 for potential recognition or disclosure. For more information, see Note 19 - Subsequent Events.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash on hand and in banks, interest-bearing deposits and federal funds sold all with maturities of three months or less.
The Bank is required to maintain an average reserve balance with the FRB or maintain such reserve balance in the form of cash. At December 31, 2019, a $750,000 reserve was required and was maintained with the FRB. At December 31, 2018, cash balances were sufficient where no additional reserve was required.
Investments
Investments are classified into one of three categories: (1) held-to-maturity, (2) available-for-sale, or (3) trading. We had no held-to-maturity or trading securities at December 31, 2019, or 2018. Investments are categorized as held-to-maturity when we have the positive intent and ability to hold them to maturity.
Investments are classified as available-for-sale if the Company intends to hold the securities for an indefinite period of time, but not necessarily to maturity. Investments available-for-sale are reported at fair value. Unrealized holding gains and losses on investments available-for-sale are excluded from earnings and are reported in other comprehensive income (loss), net of applicable taxes. Gains and losses on sales are recorded on the trade date and determined using the specific identification method. Amortization or accretion of purchase premiums and discounts are included in investment income using the level-yield method over the remaining period to contractual maturity. Dividend or interest income is recognized when it is earned.
The estimated fair value of investments is based on quoted market prices for investments traded in active markets or dealer quotes. Mortgage-backed investments represent participation interest in pools of first mortgage loans originated and serviced by the issuers of the investments.
Management makes an assessment to determine whether there have been any events or economic circumstances to indicate that a security on which there is an unrealized loss is impaired on an other-than-temporary basis. Management considers many factors including the severity and duration of the impairment, recent events specific to the issuer or industry, and for debt securities, external credit ratings and recent downgrades. Securities on which there is an unrealized loss that is deemed to be an other-than-temporary impairment (“OTTI”) are written down to fair value. For equity securities, the write-down is recorded as a realized loss in noninterest income in the Consolidated Income Statements. For debt securities, if management intends to sell the security or it is likely that management will be required to sell the security before recovering its cost basis, the entire impairment loss would be recognized in earnings as an OTTI. If management does not intend to sell the security and it is not likely that management will be required to sell the security but management does not expect to recover the entire amortized cost basis of the security, only the portion of the impairment loss representing credit losses would be recognized in earnings. The credit loss on a security is measured as the difference between the amortized cost basis and the present value of the cash flows expected to be collected. Projected cash flows are discounted by the original or current effective interest rate depending on the nature of the security being measured for potential OTTI. The remaining impairment related to all other factors, the difference between the present value of the cash flows expected to be collected and fair value, is recognized as a charge to other comprehensive income (“OCI”). Impairment losses related to all other factors are presented as separate categories within OCI.
Loans Receivable
Loans are recorded at their outstanding principal balance adjusted for charge-offs, the ALLL and net deferred fees or costs. Interest on loans is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method without anticipating prepayments.
The accrual of interest on loans is discontinued at the time the loan is 90 days delinquent unless the loan is well secured and in the process of collection. Consumer and other loans are typically managed in the same manner. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is doubtful.
All interest accrued but not collected on loans that are placed on nonaccrual is reversed against interest income. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. In order to return a nonaccrual loan to accrual status, each loan is evaluated on a case-by-case basis. We evaluate the borrower’s financial condition to ensure that future loan payments are reasonably assured. We also take into consideration the borrower’s willingness and ability to make the loan payments and historical repayment performance. We require the borrower to make the loan payments consistently for a period of at least six months as agreed to under the terms of any modified loan agreement before we will consider reclassifying the loan to accrual status.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Impaired Loans
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, market conditions, rent rolls and the financial strength of the borrower(s) and guarantor(s), if any. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.
Management determines the significance of payment delays and shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrowers, including the length of the delay, the reasons for the delay, the borrower’s prior payment history and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured by the fair value method on a loan-by-loan basis.
When a loan is identified as impaired, its impairment is measured using the present value of expected future cash flows, discounted at the loan’s effective interest rate, except when the sole (remaining) source of repayment for the loan is the operation or liquidation of the collateral. In these cases, the Company uses an observable market price or current fair value of the collateral, less certain completion costs and closing costs when foreclosure is probable, instead of discounted cash flows. The Company obtains annual updated appraisals for impaired collateral dependent loans that exceed $1.0 million. In addition, the Company may order appraisals on properties not included within these guidelines when there are extenuating circumstances where the Company is not otherwise able to determine the fair value of the property. Appraised values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation and/or management’s expertise and knowledge of the borrower. If management determines that the value of the impaired loan is less than the recorded investment in the loan, an impairment is recognized through an allowance estimate or a charge-off to the ALLL.
Troubled Debt Restructurings
Certain loan modifications or restructurings are accounted for as troubled debt restructurings (“TDR”). In general, the modification or restructuring of a debt is considered a TDR if, for economic or legal reasons related to the borrower’s financial difficulties, a concession is granted to the borrower that the Company would not otherwise consider. Examples of these modifications or restructurings include advancement of maturity date, accepting interest only payments for a period of time, or granting an interest rate concession for a period of time. The impaired portion of the loan with an interest rate concession and/or interest-only payments for a specific period of time are calculated based on the present value of expected future cash flows discounted at the loan’s effective interest rate. The effective interest rate is the rate of return implicit on the original loan. This impaired amount reduces the ALLL and a valuation allowance is established to reduce the loan balance. As loan payments are received in future periods, the ALLL entry is reversed and the valuation allowance is reduced utilizing the level-yield method over the modification period. A loan that is determined to be classified as a TDR is generally reported as a TDR until the loan is paid in full or otherwise settled, sold, or charged-off.
Allowance for Loan and Lease Losses
The allowance for loan and lease losses (“ALLL”) is a valuation allowance for probable incurred credit losses. Losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Any subsequent recoveries are credited to the allowance.
The ALLL is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans and factors such as the nature and volume of the loan portfolio, historical loss considerations, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. The evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.
While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions or changes to the credit quality of the loan portfolio. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s ALLL. Such agencies may require management to make adjustments to the allowance based on their judgments about information available to them at the time of their examination.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets. The estimated useful lives used to compute depreciation and amortization is 15 to 40 years for buildings and building improvements, and is three to seven years for furniture, fixtures, and equipment. Leasehold improvements are amortized over the life of the lease. Management reviews buildings, improvements and equipment for impairment on an annual basis or whenever events or changes in the circumstances indicate that the undiscounted cash flows for the property are less than its carrying value. If identified, an impairment loss is recognized through a charge to earnings based on the fair value of the property.
Federal Home Loan Bank Stock
As a member of the Federal Home Loan Bank System, the Bank is required to maintain a minimum level of investment in the Federal Home Loan Bank of Des Moines (“FHLB”) stock, based on specified percentages of total assets and the Bank’s outstanding FHLB advances. Ownership of FHLB stock is restricted to the FHLB and member institutions. The Bank’s investment in FHLB stock is carried at par value ($100 per share), which reasonably approximates its fair value.
Transfer of Financial Assets
Transfers of an entire financial asset, a group of entire financial assets, or participating interest in an entire financial asset are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Bank, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Bank does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Other Real Estate Owned
OREO consists principally of properties acquired through foreclosure and is stated at the lower of cost or estimated market value less selling costs. Losses arising from the acquisition of property, in full or partial satisfaction of loans, are charged to the ALLL.
Subsequent to the transfer of foreclosed assets held for sale, the assets continue to be recorded at the lower of cost or fair value (less estimated costs to sell), based on periodic evaluations. Subsequent write-downs in value are charged to noninterest expense. Generally, legal and professional fees associated with foreclosures are expensed as incurred. Costs incurred to improve property prior to sale are capitalized; however, in no event are recorded costs allowed to exceed estimated fair value. Subsequent gains, losses, or expenses recognized on the sale of these properties are included in noninterest expense. The amounts that will ultimately be recovered from foreclosed assets may differ substantially from the carrying value of the assets because of future market factors beyond management’s control.
Bank-Owned Life Insurance
The Company has purchased life insurance on certain key executives and officers. Bank-owned life insurance (“BOLI”) is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement. Increases to the cash surrender value are recorded as noninterest income and partially offset expenses for employee benefits. Certain BOLI contracts contain endorsement split-dollar life agreements. In these circumstances, the Bank accrues a reserve liability and related compensation expense for the expected future benefit payout.
Loan Commitments and Related Financial Instruments
Financial instruments include off-balance sheet credit instruments, such as unused lines of credit and commercial letters of credit issued to meet customer financing needs. The face amount of these items represents the exposure to loss before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
Reserve for Unfunded Commitments
Management maintains a reserve for unfunded commitments to absorb probable losses associated with our off-balance sheet commitments to lend funds such as unused lines of credit and the undisbursed portion of construction loans. Management determines the adequacy of the reserve based on reviews of individual exposures, current economic conditions, and other relevant
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factors. The reserve is based on estimates and ultimate losses may vary from the current estimates. The reserve is evaluated on a regular basis and necessary adjustments are reported in earnings during the period in which they become known. The reserve for unfunded commitments is included in the other liabilities section of the consolidated balance sheets.
Stock-Based Compensation
Compensation cost is recognized for stock options and restricted stock awards, based on the fair value of these awards at the grant date. A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of the Company’s common stock at the grant date is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.
Federal Income Taxes
The Company files a consolidated Federal income tax return and records its provision for income taxes under the asset and liability method. Deferred taxes result from temporary differences in the recognition of certain income and expense amounts between the Company’s financial statements and its tax return. The principal items giving rise to these differences include net operating losses, valuation adjustments on foreclosed properties, and allowance for credit losses. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Valuation allowances are established to reduce the net carrying amount of deferred tax assets if it is determined to be more likely than not that all or some portion of the potential deferred tax asset will not be realized. The Company’s policy is to recognize interest and penalties associated with income tax matters in income tax expense.
Employee Stock Ownership Plan
The cost of shares issued to the Employee Stock Ownership Plan (“ESOP”), but not yet allocated to participants, is shown as a reduction of stockholders’ equity. Compensation expense is based on the market price of shares as they are committed to be released to participant accounts. Dividends on allocated ESOP shares reduce retained earnings; dividends on unearned ESOP shares reduce debt and accrued interest.
Earnings Per Share
Nonvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents are participating securities and are included in the computation of earnings per share (“EPS”) pursuant to the two-class method. The two-class method is an earnings allocation formula that determines EPS for each class of common stock and participating security according to dividends declared or accumulated and participation rights in undistributed earnings. Certain shares of the Company’s nonvested restricted stock awards qualify as participating securities.
Net income is allocated between the common stock and participating securities pursuant to the two-class method, based on their rights to receive dividends, participate in earnings or absorb losses. Basic earnings per common share is computed by dividing net earnings available to common shareholders by the weighted average number of common shares outstanding during the period, excluding participating nonvested restricted shares. As ESOP shares are committed to be released, they are included in the outstanding shares used in the basic EPS calculation.
Diluted earnings per share is computed in a similar manner, except that first the denominator is increased to include the number of additional shares that would have been outstanding if potentially dilutive shares, excluding the participating securities, were issued using the treasury stock method. For all periods presented, stock options and certain restricted stock awards are potentially dilutive non-participating instruments issued by the Company.
Undistributed losses are not allocated to the nonvested share-based payment awards (the participating securities) under the two-class method as the holders are not contractually obligated to share in the losses of the Company.
Comprehensive Income
Comprehensive income consists of net income and unrealized gains and losses on investments available-for-sale and derivatives, which are also recognized as separate components of equity, net of tax.
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Advertising Expenses
Advertising costs are generally expensed as incurred and are not material.
Fair Value of Financial Instruments
Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.
Segment Information
The Company’s activities are considered to be a single industry segment for financial reporting purposes. The Company is engaged in the business of attracting deposits from the general public and providing lending services. Substantially all income is derived from a diverse base of investments and commercial, construction, mortgage, and consumer lending activities.
Reclassification
Certain amounts in the consolidated financial statements for prior years have been reclassified to conform to the current consolidated financial statement presentation. The results of the reclassifications are not considered material and have no effect on previously reported net income or stockholders’ equity.
Derivatives
The Company designates certain interest rate swap agreements as a cash flow hedge, and as such, reports the net fair value as an asset or liability. The hedge is utilized to mitigate the risk of variability in future interest payments. The fair value of the cash flow hedge is based on dealer quotes, pricing models, discounted cash flow methodologies or similar techniques for which the determination of fair value may require significant management judgment or estimation. The derivative is marked to its fair value, with the change in fair value recorded as other comprehensive income or loss. The gain or loss on the derivative is reclassified into earnings in the same income statement line item that is used to present the earnings effect of the hedged item.
Goodwill
Goodwill is recorded from a business combination as the difference in purchase price and fair value of the assets acquired and liabilities assumed. Goodwill has an indefinite useful life, and as such, is not amortized. The Company performs a goodwill impairment analysis on an annual basis as of December 31. Additionally, the Company performs an impairment analysis as needed when circumstances indicate impairment potentially exists. Any impairment will be recorded as a noninterest expense and corresponding reduction in intangible asset on the consolidated financial statements.
Core Deposit Intangible
A core deposit intangible (“CDI”) asset is recognized from the assumption of core deposit liabilities in connection with the acquisition of four branches from Opus Bank, a California state-chartered commercial bank (the “Branch Acquisition”). The asset was valued by a third party and is amortized into noninterest expense over ten years. The CDI is evaluated for impairment annually with any additional decline recorded as a noninterest expense on the Consolidated Income Statement.
Recent Accounting Pronouncements Adopted in 2019
In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-02, Leases (Topic 842). ASU No. 2016-02 requires lessees to recognize on the balance sheet the assets and liabilities arising from operating leases. In July 2018, FASB issued ASU No. 2018-11, Leases (Topic 842) to address the comparative reporting requirements when this ASU is adopted. In March 2019, FASB issued ASU 2019-01, Leases (Topic 842), Codification Improvements. Under these ASUs, a lessee should recognize a liability to make lease payments and a right-of-use asset representing its right to use the underlying asset for the lease term. A lessee should include payments to be made in an optional period only if the lessee is reasonably certain to exercise an option to extend the lease or not to exercise an option to terminate the lease. For a finance lease, interest payments should be recognized separately from amortization of the right-of-use asset in the statement of comprehensive income. For operating leases, the lease cost should be allocated over the lease term on a generally straight-line basis. The Company adopted this ASU on January 1, 2019, and according to ASU 2018-11, elected to recognize the related
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cumulative-effect adjustment as an adjustment to the opening balance of retained earnings. Adoption of ASU 2016-02 resulted in the addition of a right-of-use asset and lease liability related to certain banking offices under noncancelable operating lease agreements. The resulting increase did not have a material impact on the Company’s consolidated financial statements or regulatory capital ratios. For more information see Note 10 - Leases.
In March 2017, FASB issued ASU No. 2017-08, Receivables - Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. The ASU shortens the amortization period for certain callable debt securities held at a premium. The Company adopted this ASU as of January 1, 2019, with no material impact on the Company’s consolidated financial statements.
Recently Issued Accounting Pronouncements
ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326) as amended by ASU 2018-19, ASU 2019-04 and ASU 2019-05, was originally issued in June 2016. This ASU replaces the existing incurred loss impairment methodology that recognizes credit losses when a probable loss has been incurred with new methodology where loss estimates are based upon lifetime expected credit losses. The amendments in this ASU require a financial asset that is measured at amortized cost to be presented at the net amount expected to be collected. The income statement would then reflect the measurement of credit losses for newly recognized financial assets as well as changes to the expected credit losses that have taken place during the reporting period. The measurement of expected credit losses will be based on historical information, current conditions, and reasonable and supportable forecasts that impact the collectability of the reported amount. Available-for-sale securities will bifurcate the fair value mark and establish an allowance for credit losses through the income statement for the credit portion of that mark. The interest portion will continue to be recognized through accumulated other comprehensive income or loss. The change in allowance recognized as a result of adoption will occur through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the ASU is adopted. This ASU is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years, with early adoption permitted for smaller reporting companies, such as the Company. The Company is evaluating its current expected loss methodology on the loan and investment portfolios to identify the necessary modifications in accordance with this standard and expects a change in the processes and procedures to calculate the ALLL, including changes in assumptions and estimates to consider expected credit losses over the life of the loan versus the current accounting practice that utilizes the incurred loss model. A valuation adjustment to the ALLL or investment portfolio that is identified in this process will be reflected as a one-time adjustment in equity rather than earnings. ASU 2019-05 issued in April 2019 further provides that entities that have certain financial instruments measured at amortized cost that has credit losses, to irrevocably elect the fair value option in Subtopic 825-10, upon adoption of Topic 326. The fair value option applies to available-for-sale debt securities. This ASU is effective upon adoption of ASU 2016-13, and should be applied on a modified-retrospective basis as a cumulative-effect adjustment to the opening balance of retained earnings in the statement of financial condition as of the adoption date. The Company is in the process of compiling historical and industry data that will be used to calculate expected credit losses on the loan portfolio to ensure that it is fully compliant with the ASU at the adoption date and is evaluating the potential impact adoption of this ASU will have on its consolidated financial statements. The Company intends to adopt ASU 2016-13 in the first quarter of 2023, and as a result, the ALLL may increase. Until the evaluation is complete, however, the magnitude of the increase will not be known.
In August 2018, FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820) - Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement. The amendments in this ASU remove certain disclosure requirements regarding transfers between Level 1 and Level 2 of the fair value hierarchy and changes in unrealized gains and losses for recurring Level 3 fair value measurements. In addition, the amendments modified and added certain disclosure requirements for Level 3 fair value measurements. This ASU is effective for fiscal years beginning after December 15, 2019, and early adoption is permitted. Entities are permitted to early adopt any removed or modified disclosures and adopt the additional disclosures at the effective date. Adoption of ASU 2018-13 is not expected to have a material impact on the Company’s consolidated financial statements.
In April 2019, FASB issued ASU 2019-04, Codification Improvements to Topic 326, Financial Instruments--Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments. This ASU provides clarification and guidance on recently issued ASUs regarding recognition and measurement of financial assets, credit losses on financial instruments and accounting for derivatives and hedging activities. This ASU is effective for fiscal years beginning after December 15, 2019 for the portions related to topics 326 and 825. For the portion related to topic 815, this ASU is effective for concurrent adoption with ASU 2016-13. Adoption of ASU 2019-04 is not expected to have a material impact on the Company’s consolidated financial statements.
In April 2019, FASB issued ASU 2019-05, Financial Instruments--Credit Losses (Topic 326), Targeted Transition Relief. The amendments in this ASU provide entities that have certain financial instruments measured at amortized cost that have credit losses, to irrevocably elect the fair value option in Subtopic 825-10, upon adoption of Topic 326. The fair value option applies to
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available-for-sale debt securities. This ASU is effective when ASU 2016-13 is adopted, and will be applied on a modified-retrospective basis as a cumulative-effect adjustment to the opening balance of retained earnings in the statement of financial condition as of the adoption date. Adoption of ASU 2019-05 is not expected to have a material impact on the Company’s consolidated financial statements.
In December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes (ASU 2019-12). This ASU simplifies the accounting for income taxes by removing the exception to the incremental approach for intra-period tax allocation when there is a loss from continuing operations and income or a gain from other items, removing the requirement to recognize a deferred tax liability for equity method investments when a foreign subsidiary becomes an equity method investment, and removing the general methodology for calculating income taxes in an interim period when a year-to-date loss exceeds the anticipated loss for the year. This ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. The Company does not expect the adoption of ASU 2019-12 to have a material impact on its consolidated financial statements.
Note 2 - Investments
The following tables summarize the amortized cost and fair value of investments available-for-sale at December 31, 2019 and 2018, and the corresponding amounts of gross unrealized gains and losses.
There were no investments classified as held-to-maturity at December 31, 2019 or 2018.
The amortized cost and estimated fair value of investments available-for-sale at December 31, 2019, by expected maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or
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prepay obligations with or without call or prepayment penalties. Investments not due at a single maturity date, primarily mortgage-backed investments are shown separately.
Under Washington State law, in order to participate in the public funds program the Company is required to pledge eligible securities as collateral in an amount equal to 50% of the public deposits held. Investments with a carrying value of $19.0 million and $15.6 million were pledged as collateral for public deposits at December 31, 2019, and 2018, respectively, both of which exceeded the minimum collateral requirements established by the Washington Public Deposit Protection Commission. At December 31, 2019, and 2018, there were no investments pledged as collateral for FHLB advances.
Sales and other redemptions of available-for-sale investments were as follows:
The following tables summarize the aggregate fair value and gross unrealized loss by length of time those investments have been continuously in an unrealized loss position at December 31, 2019 and 2018.
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At December 31, 2019, and 2018, the Company had 37 and 51 securities, respectively, with a gross unrealized loss position. Management reviewed the financial condition of the entities underlying the securities at both December 31, 2019, and December 31, 2018, and determined that no OTTI was required. Management believes that, while actual fluctuation in unrealized losses will occur over the life of an investment security, the temporary impairment on the investment securities that were in an unrealized loss position at December 31, 2019 and 2018, will be incrementally relieved as the individual investment securities approach their respective contractual maturity dates. The unrealized losses relate principally to the general change in interest rate and illiquidity, and not credit quality. As management does not intend to sell the security, and it is likely that it will not be required to sell the security before its anticipated recovery, no declines are deemed to be other-than-temporary.
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Note 3 - Loans Receivable
Loans receivable net of loans in process (“LIP”) at December 31, 2019, and 2018 are summarized as follows:
____________
(1)
Included in the construction/land category are “rollover” loans, which are loans that will convert upon completion of the construction period to permanent loans. At that time, the loans will be classified according to the underlying collateral. In addition, raw land or buildable lots, where the Company does not intend to finance the construction are included in the construction/land category. At December 31, 2019, we classified $38.6 million of multifamily loans, $8.7 million of commercial land loans, $3.5 million of one-to-four family residential and $18.3 million of commercial real estate loans as construction/land loans to facilitate the review of the composition of our loan portfolio. At December 31, 2018, $25.2 million of multifamily loans, $6.2 million of commercial land loans, $602,000 one-to-four family residential and $10.0 million of commercial real estate loans were reclassified to the construction/land category.
At December 31, 2019, and 2018, there were no loans classified as held for sale.
Concentrations of credit. Most of the Bank’s lending activity occurs within the state of Washington. The primary market areas include King and to a lesser extent Pierce, Snohomish and Kitsap counties. At December 31, 2019, the Company’s loan portfolio consists of one-to-four family residential loans which comprised 33.2%, commercial real estate and multifamily loans were 35.2% and 15.4%, respectively, and construction/land loans were 10.1% of the total loan portfolio. Consumer and business loans accounted for the remaining 6.1% of the loan portfolio. Included in the one-to-four family residential, multifamily, and commercial real estate loan portfolios at December 31, 2019 were $432,000, $8.4 million, and $78.0 million, respectively, to the Company’s five largest borrowing relationships.
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The Company originates both adjustable and fixed interest rate loans. The composition of loans receivable at December 31, 2019, and 2018, was as follows:
Our adjustable-rate loans are tied to various indexes, including LIBOR, the prime rate as published in The Wall Street Journal, and the FHLB. Certain adjustable-rate loans have interest rate adjustment limitations and are generally indexed to the FHLB Long-Term Bullet advance rates published by the FHLB. Future market factors may affect the correlation of the interest rate adjustment with the rates paid on short-term deposits that have been primarily utilized to fund these loans.
Credit Quality Indicators. The Company assigns a risk rating to all credit exposures based on the risk rating system designed to define the basic characteristics and identified risk elements of each credit extension. The Company utilizes a nine-point risk rating system. A description of the general characteristics of the risk grades is as follows:
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Grades 1 through 5: These grades are considered to be “pass” credits. These include assets where there is virtually no credit risk, such as cash secured loans with funds on deposit with the Bank. Pass credits also include credits that are on the Company’s watch list, where the borrower exhibits potential weaknesses, which may, if not checked or corrected, negatively affect the borrower’s financial capacity and threaten their ability to fulfill debt obligations in the future.
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Grade 6: These credits, classified as ”special mention”, possess weaknesses that deserve management’s close attention. Special mention assets do not expose the Company to sufficient risk to warrant adverse classification in the substandard, doubtful or loss categories. If left uncorrected, these potential weaknesses may result in deterioration in the Company’s credit position at a future date.
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Grade 7: These credits, classified as “substandard”, present a distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. These credits have well defined weaknesses which jeopardize the orderly liquidation of the debt and are inadequately protected by the current net worth and payment capacity of the borrower or of any collateral pledged.
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Grade 8: These credits are classified as “doubtful” have well defined weaknesses which make the full collection or liquidation of the loan highly questionable and improbable. This classification is used where significant risk exposures are perceived but the exact amount of the loss cannot yet be determined due to pending events.
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•
Grade 9: Assets classified as “loss” are considered uncollectible and cannot be justified as a viable asset for the Company. There is little or no prospect of near term recovery and no realistic strengthening action of significance is pending.
As of December 31, 2019, and 2018, the Company had no loans rated as doubtful or loss. The following tables represent a summary of loans at December 31, 2019, and 2018 by type and risk category:
ALLL. When the Company classifies problem assets as either substandard or doubtful, pursuant to Federal regulations, it may establish a specific reserve in an amount deemed prudent to address the risk specifically or may allow the loss to be addressed in the general allowance. General allowances represent loss allowances which have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been specifically allocated to the particular problem assets. When an insured institution classifies problem assets as a loss, pursuant to Federal regulations, it is required to charge-off such assets in the period in which they are deemed uncollectible. The determination as to the classification of the Company’s assets and the amount of valuation allowances is subject to review by bank regulators, who can require the establishment of additional loss allowances.
Loan grades are used by the Company to identify and track potential problem loans which do not rise to the levels described for substandard, doubtful, or loss. The grades for watch and special mention are assigned to loans which have been criticized based upon known characteristics such as periodic payment delinquency or stale financial information from the borrower and/or guarantors. Loans identified as criticized (watch and special mention) or classified (substandard, doubtful or loss) are subject to problem loan reporting every three months.
The following tables summarize changes in the ALLL and loan portfolio by type of loan and reserve method for the periods indicated.
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____________
(1) Loans collectively evaluated for general reserves.
(2) Loans individually evaluated for specific reserves.
_____________
(1) Loans collectively evaluated for general reserves.
(2) Loans individually evaluated for specific reserves.
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Past Due Loans. At December 31, 2019, total past due loans comprised 0.19% of total loans as compared to 0.08% at December 31, 2018.
The following tables represent a summary at December 31, 2019, and 2018, of the aging of loans by type:
_________________________
(1) There were no loans 90 days past due and still accruing interest at December 31, 2019.
________________________
(1) There were no loans 90 days past due and still accruing interest at December 31, 2018.
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Nonaccrual Loans. The following table is a summary of nonaccrual loans at December 31, 2019, and 2018, by type of loan:
Nonperforming loans were $95,000 and $752,000 at December 31, 2019, and 2018, respectively. Foregone interest on nonaccrual loans for the years ended December 31, 2019, and 2018, were $12,000 and $18,000, respectively.
The following tables summarize the loan portfolio at December 31, 2019, and 2018, by type and payment activity:
____________
(1) There were $210.8 million of owner-occupied one-to-four family residential loans and $161.6 million of non-owner occupied one to-four family residential loans classified as performing.
(2) There were $95,000 of owner-occupied one-to-four family residential loans and no non-owner occupied one-to-four family residential loans classified as nonperforming.
_____________
(1) There were $193.8 million of owner-occupied one-to-four family residential loans and $147.8 million of non-owner occupied one-to-four family residential loans classified as performing.
(2) There were $382,000 of owner-occupied one-to-four family residential loans and no non-owner occupied one-to-four family residential loans classified as nonperforming.
Impaired loans. The loan portfolio is constantly being monitored by management for delinquent loans and changes in the financial condition of each borrower. When an issue is identified with a borrower and it is determined that the loan needs to be classified as nonperforming and/or impaired, an evaluation of the collateral is performed prior to the end of the financial reporting period and, if necessary, an appraisal is ordered in accordance with the Company’s appraisal policy guidelines. Based on this evaluation, any additional provision for loan loss or charge-offs that may be needed is recorded prior to the end of the financial reporting period.
At December 31, 2019, there was $3.1 million committed to be advanced on an impaired $12.5 million construction loan. At December 31, 2018, there were no commitments to advance funds related to impaired loans.
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The following tables present a summary of loans individually evaluated for impairment at December 31, 2019, and 2018, by the type of loan:
_________________
(1) Represents the loan balance less charge-offs.
(2) Contractual loan principal balance.
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_____________
(1) Represents the loan balance less charge-offs.
(2) Contractual loan principal balance.
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The following table presents a summary of the average recorded investment in impaired loans, and interest income recognized on impaired loans for the years ended December 31, 2019 and 2018, by the type of loan:
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Troubled Debt Restructurings. The following is a summary of information pertaining to TDRs:
The accrual status of a loan may change after it has been classified as a TDR. Management considers the following in determining the accrual status of restructured loans: (1) if the loan was on accrual status prior to the restructuring, the borrower has demonstrated performance under the previous terms, and a credit evaluation shows the borrower’s capacity to continue to perform under the restructured terms (both principal and interest payments), the loan will remain on accrual at the time of the restructuring; (2) if the loan was on nonaccrual status before the restructuring, and the Company’s credit evaluation shows the borrower’s capacity to meet the restructured terms, the loan would remain as nonaccrual for a minimum of six months until the borrower has demonstrated a reasonable period of sustained repayment performance (thereby providing reasonable assurance as to the ultimate collection of principal and interest in full under the modified terms).
The following table presents for the periods indicated TDRs and their recorded investment prior to the modification and after the modification:
At December 31, 2019 and 2018, the Company had no commitments to extend additional credit to borrowers whose loan terms have been modified in a TDR. All TDRs are also classified as impaired loans and are included in the loans individually evaluated for impairment in the calculation of the ALLL.
TDRs resulted in no charge-offs to the ALLL for the years ended December 31, 2019 and 2018. For the years ended December 31, 2019 and 2018, there were no payment defaults on loans modified as TDRs within the previous 12 months.
At December 31, 2019, and 2018, the Bank had no loans outstanding with executive officers or directors. The change in the aggregate dollar amount of these loans outstanding to related parties is summarized as follows:
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Note 4 - Other Real Estate Owned
The following table is a summary of OREO activity for the periods indicated:
OREO at December 31, 2019, consisted of $454,000 in commercial real estate properties. At December 31, 2019, there were no mortgage loans secured by residential real estate in the process of foreclosure.
Note 5 - Premises and Equipment
Premises and equipment consisted of the following at December 31, 2019, and 2018:
Depreciation and amortization expense was $1.8 million and $1.6 million for the years ended December 31, 2019 and 2018, respectively.
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Note 6 - Fair Value of Financial Instruments
The Company has adopted ASU 2016-01, and therefore, is measuring the fair value of loans receivable under the exit price notion. The methodology used to estimate the fair values of other financial instruments did not change from the adoption of ASU 2016-01. Under the exit price notion used at December 31, 2019, and 2018, the fair value estimate of loans receivable was based on similar techniques, with the addition of current origination spreads, liquidity premiums, or credit adjustments. The fair value of nonperforming loans is based on the underlying value of the collateral for periods prior to and after adoption of ASU 2016-01.
The Company determines the fair values of its financial instruments based on the fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair values. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect its estimate for market assumptions.
Valuation inputs refer to the assumptions market participants would use in pricing a given asset or liability using one of the three valuation techniques. Inputs can be observable or unobservable. Observable inputs are those assumptions that market participants would use in pricing the particular asset or liability. These inputs are based on market data and are obtained from an independent source. Unobservable inputs are assumptions based on the Company’s own information or estimate of assumptions used by market participants in pricing the asset or liability. Unobservable inputs are based on the best and most current information available on the measurement date.
All inputs, whether observable or unobservable, are ranked in accordance with a prescribed fair value hierarchy:
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Level 1 - Quoted prices for identical instruments in active markets.
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Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable.
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Level 3 - Instruments whose significant value drivers are unobservable.
The Company used the following methods to measure fair value on a recurring or nonrecurring basis.
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Investments available-for-sale: The fair value of all investments, excluding FHLB stock, was based upon quoted market prices for similar investments in active markets, identical or similar investments in markets that are not active, and model-derived valuations whose inputs are observable.
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OREO: The fair value of OREO properties is measured at the lower of the carrying amount or fair value, less costs to sell. Fair values are generally based on third party appraisals of the property, resulting in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.
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Derivatives: The fair value of derivatives is based on dealer quotes, pricing models, discounted cash flow methodologies or similar techniques for which the determination of fair value may require significant management judgment or estimation.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The tables below present the balances of assets and liabilities measured at fair value on a recurring basis (there were no transfers between Level 1, Level 2 and Level 3 recurring measurements during the periods presented):
The estimated fair value of Level 2 investments is based on quoted prices for similar investments in active markets, identical or similar investments in markets that are not active, and model-derived valuations whose inputs are observable.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The tables below present the balances of assets and liabilities measured at fair value on a nonrecurring basis at December 31, 2019, and 2018.
_______________
(1) Total value of impaired loans is net of $31,000 of specific reserves on performing TDRs.
________________
(1) Total value of impaired loans is net of $62,000 of specific reserves on performing TDRs.
The following tables present quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a nonrecurring basis at December 31, 2019 and 2018.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The fair value calculation of the Company’s financial instruments are an attempt to incorporate market conditions at a specific point in time. The underlying assumptions are generally subjective and involve uncertainties. Therefore, these fair value estimates are not intended to represent the underlying value of the Company as a whole.
The carrying amounts and estimated fair values of financial instruments at December 31, 2019, and 2018, were as follows:
Fair value estimates are based on existing balance sheet financial instruments without attempting to estimate the value of anticipated future business. The fair value has not been estimated for assets and liabilities that are not considered financial instruments.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 7 - Accrued Interest Receivable
Accrued interest receivable consisted of the following at December 31, 2019 and 2018:
Note 8 - Deposits
Deposit accounts consisted of the following at December 31, 2019 and 2018:
_______________
(1) Shown net of $28,000 and $58,000 fair value adjustment on December 31, 2019 and 2018, respectively.
At December 31, 2019, scheduled maturities of certificates of deposit were as follows:
Deposits included public funds of $34.0 million and $28.5 million at December 31, 2019 and 2018, respectively.
Certificates of deposit equal to or exceeding the FDIC insured amount of $250,000 included in deposits at December 31, 2019, and 2018, were $130.6 million and $129.3 million, respectively. Interest expense on certificates equal to or exceeding $250,000 totaled $2.9 million and $1.8 million for the years ended December 31, 2019 and 2018, respectively.
Included in total deposits are accounts of $2.1 million and $16.0 million at December 31, 2019, and 2018, respectively which are controlled by related parties.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Interest expense on deposits for the periods indicated was as follows:
Note 9 - Other Borrowings
At December 31, 2019, and 2018, the Bank maintained credit facilities with the FHLB totaling $588.7 million and $554.8 million, respectively. The credit facility was collateralized by $240.8 million of single-family residential mortgages, $186.9 million of commercial real estate loans and $79.0 million of multifamily loans under a blanket lien arrangement at December 31, 2019. At December 31, 2018, the credit facility was collateralized by $216.4 million of single-family residential mortgages, $180.8 million of commercial real estate loans, and $74.2 million of multifamily loans under a blanket lien arrangement. The Bank also had $115.1 million unused line-of-credit facilities with other financial institutions at December 31, 2019, with interest payable at the then stated rate.
Summary information related to outstanding advances at the FHLB during the years ended December 31, 2019, and 2018 consisted of the following:
Scheduled maturities of Federal Home Loan Bank outstanding advances at December 31, 2019, were as follows:
Note 10 - Leases
The Company adopted ASU 2016-02 and ASU 2018-11 using the modified retrospective approach with an effective date of January 1, 2019, and recognized on the consolidated balance sheets a right-of-use asset (“ROU”) included in prepaid expenses and other assets and lease liabilities included in other liabilities. As such, prior year financial statements were not restated under the new standard. At December 31, 2019, the Company had ten operating leases for retail branch locations. The remaining initial lease terms range from 8 months to 5.25 years, with most leases carrying optional extensions of 3-5 years. The Company will include optional lease term extensions in the ROU assets and lease liabilities when management believes it is reasonably certain that the term extension will be exercised, and will be determined based on indicators that the Company would have an economic incentive to extend the lease. The Company has elected to not apply ASU 2016-02 to short term leases, which are those that have
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
a term of one year or less. To calculate the present value of lease payments not yet paid, the Company uses the incremental borrowing rate, which is equal to the FHLB advance rate for the remaining term of the lease that was in place at January 1, 2019, or for leases added after that date, at the time of lease inception.
The minimum monthly lease payments are generally based on square footage of the leased premises, with escalating minimum rent over the lease term. At December 31, 2019, the Company was committed to paying $53,000 per month in minimum monthly lease payments. The minimum monthly lease payment over the initial lease term, including any free rent period, was used to calculate the ROU and lease liability. The Company’s current leases do not include any non-lease components.
Total lease expense included in the Company’s Consolidated Income Statement for the year ended December 31, 2019, was $752,000. Lease expense includes the amortized lease expense under ASU 2016-02 combined with variable lease expenses for maintenance or other expenses as defined in the individual lease agreements. At December 31, 2019, the Company’s consolidated balance sheet included a $2.2 million right-of-use asset and a $2.3 million lease liability. The lease liability is amortizing over a weighted-average remaining term of 6.1 years. The weighted-average discount rate used to calculate the present value of future minimum lease payments was 2.94% at December 31, 2019.
The following table provides a reconciliation between the undiscounted minimum lease payments at December 31, 2019 and the discounted lease liability at that date:
The Company has secured a lease for a new retail branch in University Place, Washington, which commenced in March 2020. The initial lease term is for 65 months and includes options to extend the lease. The minimum rent will be determined at commencement and will increase annually thereafter. This lease was not included in the calculation of discounted lease payments at December 31, 2019.
Note 11 - Derivatives
The Company uses derivative financial instruments in the form of interest rate swap agreements, which qualify as cash flow hedges, to manage the risk of changes in future cash flows due to interest rate fluctuations. The hedged items have a total notional amount of $75.0 million, and consist of rolling one-month or three-month FHLB advances that are renewed at the fixed interest rate at each renewal date. The hedging instruments have four to five years terms and stipulate that the counterparty will pay the Company interest at one-month or three-month LIBOR and the Company will pay fixed interest of 1.34% on a $50.0 million notional amount, 1.44% on a $15.0 million notional amount, and 1.585% on a $10.0 million notional amount. The Company pays or receives the net interest amount quarterly based on the respective hedge agreement and includes this amount as part of FHLB advances interest expense on the Consolidated Income Statement.
Quarterly, the effectiveness evaluation is based upon the fluctuation of the interest the Company pays to the FHLB for the debt as compared to the one-month or three-month LIBOR interest received from the counterparty. At December 31, 2019, the $426,000 fair value of the cash flow hedges was reported with other assets. The tax effected amount of $336,000 was included in Accumulated Other Comprehensive Income. There were no amounts recorded in the Consolidated Income Statements for the years ended December 31, 2019 or 2018, related to ineffectiveness.
Fair value for these derivative instruments, which generally changes as a result of changes in the level of market interest rates, is estimated based on dealer quotes and secondary market sources.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table presents the fair value of derivative instruments as of December 31, 2019 and 2018:
The following table presents the net unrealized gains (losses) on derivative instruments included on the Consolidated Statements of Comprehensive Income for the years ended December 31, 2019 and 2018:
Note 12 - Benefit Plans
Multi-employer Pension Plans
The Company participates in the Pentegra Defined Benefit Plan for Financial Institutions (“The Pentegra DB Plan”), a tax-qualified defined-benefit pension plan that covers substantially all employees after one year of continuous employment. Pension benefits vest over a period of five years of credited service. The Pentegra DB Plan’s Employer Identification Number is 13-5645888 and the Plan Number is 333. The Pentegra DB Plan operates as a multi-employer plan for accounting purposes and as a multiple-employer plan under the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code. There are no collective bargaining agreements in place that require contributions to the Pentegra DB Plan.
The Pentegra DB Plan is a single plan under Internal Revenue Code Section 413(c) and, as a result, all of the assets stand behind all of the liabilities. Accordingly, under the Pentegra DB Plan, contributions made by a participating employer may be used to provide benefits to participants of other participating employers.
As of March 31, 2013, the Pentegra DB Plan was frozen, eliminating all future benefit accruals for employees. Each employee’s accrued benefit was determined as of March 31, 2013.
The funding target is the present value of all benefits that have accrued as of the first day of the current plan year (July 1). Because interest rates used to calculate the present value of all benefits (5.51% for 2019 and 5.71% for 2018) is significantly higher than current market rates, the funding target does not represent the Company’s actual liability upon withdrawal from participation in the Pentegra DB Plan, which is significantly larger than the funding target. The table below presents the funded status (market value of plan assets divided by funding target) of the plan as of July 1:
_________________
(1) Market value of plan assets reflects any contributions received through June 30, 2019, or 2018, respectively.
Total contributions made to the Pentegra DB Plan, as reported on Form 5500, equal $164.6 million and $367.1 million for the plan years ended June 30, 2018 and June 30, 2017 respectively. The Company’s contributions to the Pentegra DB Plan are not more than 5% of the total contributions to the Pentegra DB Plan. The Company’s policy is to fund pension costs as accrued.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Total contributions during the years ended December 31, 2019 and 2018 were:
Supplemental Executive Retirement Plan
The Company has entered into post-employment agreements with certain key officers to provide supplemental retirement benefits. The Company recorded $74,000 and $18,000 of compensation expense for the years ended December 31, 2019, and 2018, respectively.
401(k) Plan
The Company has a savings plan under Section 401(k) of the Internal Revenue Code, covering substantially all employees after 90 days of continuous employment. Under the plan, employee contributions up to 6% will be matched 50% by the Company. Such matching becomes vested over a period of five years of credited service. Employees may make investments in various stock, money market, or fixed income plans. The Company contributed $333,000 and $312,000 to the plan for the years ended December 31, 2019, and 2018, respectively.
Employee Stock Ownership Plan
The Company provides an ESOP for the benefit of substantially all employees. The ESOP borrowed $16.9 million from First Financial Northwest and used those funds to acquire 1,692,800 shares of First Financial Northwest’s stock at the time of the initial public offering at a price of $10.00 per share. The loan matures on October 8, 2022 and has a fixed interest rate of 4.88%.
Shares purchased by the ESOP with the loan proceeds are held in a suspense account and are allocated to ESOP participants on a pro rata basis as principal and interest payments are made by the ESOP to First Financial Northwest. The loan is secured by shares purchased with the loan proceeds and will be repaid by the ESOP with funds from the Company’s discretionary contributions to the ESOP and earnings on the ESOP assets. Annual principal and interest payments of $1.6 million were made by the ESOP during 2019, and 2018.
As shares are committed to be released from collateral, the Company reports compensation expense equal to the daily average market prices of the shares and the shares become outstanding for EPS computations. The compensation expense is accrued throughout the year.
A summary of key transactions for the ESOP for the periods indicated follows:
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Shares held by the ESOP at December 31, 2019 and 2018, are as follows:
Stock-Based Compensation
In June 2016, First Financial Northwest’s shareholders approved the First Financial Northwest, Inc. 2016 Equity Incentive Plan (“2016 Plan”). This plan provides for the granting of incentive stock options (“ISO”), non-qualified stock options (“NQSO”), restricted stock and restricted stock units. The 2016 Plan expires in June 2026. The 2016 Plan established 1,400,000 shares available to grant with a maximum of 400,000 of these shares available to grant as restricted stock awards. Each share issued as a restricted stock award counts as two shares towards the total shares available to be awarded.
As a result of the approval of the 2016 Plan, the First Financial Northwest, Inc. 2008 Equity Incentive Plan (“2008 Plan”) was frozen and no additional awards will be made. Restricted stock awards and stock options that were granted under the 2008 Plan will continue to vest and be available for exercise, subject to the 2008 Plan provisions. At December 31, 2019, there were 1,240,114 total shares available for grant under the 2016 Plan, including 320,057 shares available to be granted as restricted stock.
Under the 2016 Plan, the vesting date for each option award or restricted stock award is determined by an award committee and specified in the award agreement. In the case of restricted stock awards granted in lieu of cash payments of directors’ fees, the grant date is used as the vesting date.
Total compensation expense for the both the 2008 Plan and 2016 Plan for the years ended December 31, 2019, and 2018, was $501,000 and $650,000, respectively. The related income tax benefit was $105,000 and $137,000 for the years ended December 31, 2019, and 2018, respectively.
Stock Options
Under the 2008 Plan, stock option awards were granted with an exercise price equal to the market price of First Financial Northwest's common stock at the grant date. These option awards have a vesting period of five years, with 20% vesting on the anniversary date of each grant date, and a contractual life of ten years. Any unexercised stock options will expire ten years after the grant date, or sooner in the event of the award recipient’s death, disability or termination of service with the Company.
Under the 2016 Plan, the exercise price and vesting period for stock options are determined by the award committee and specified in the award agreement, however, the exercise price shall not be less than the fair market value of a share as of the grant date. Any unexercised stock option will expire 10 years after the award date or sooner in the event of the award recipient’s death, disability, retirement, or termination of service.
A cashless exercise of vested stock options may occur by the option holder surrendering the number of options valued at the current stock price at the time of exercise to cover the total cost to exercise. The surrendered options are canceled and are unavailable for reissue.
The fair value of each option award is estimated on the grant date using a Black-Scholes model that uses the assumptions noted in the table below. The dividend yield is based on the current quarterly dividend in effect at the time of the grant. Historical employment data is used to estimate the forfeiture rate. The historical volatility of the Company’s stock price over a specified period of time is used for the expected volatility assumption. First Financial Northwest bases the risk-free interest rate on the U.S. Treasury Constant Maturity Indices in effect on the date of the grant. First Financial Northwest elected to use the “simplified” method permitted by the U.S. Securities and Exchange Commission to calculate the expected term. This method uses the vesting term of an option along with the contractual term, setting the expected life at the midpoint.
There were 50,000 stock options granted in 2019, however, these shares were forfeited later in the year. There were no stock options granted in 2018.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A summary of the Company’s stock option plan awards activity for the year ended December 31, 2019 follows:
As of December 31, 2019, there was $32,000 of total unrecognized compensation cost related to nonvested stock options. The cost is expected to be recognized over the remaining weighted-average vesting period of 11 months.
Restricted Stock Awards
A summary of changes in nonvested restricted stock awards for the year ended December 31, 2019, follows:
As of December 31, 2019, there was $46,000 of total unrecognized compensation costs related to nonvested shares granted as restricted stock awards. The cost is expected to be recognized over the remaining weighted-average vesting period of two months. The total fair value of shares vested during the years ended December 31, 2019, and 2018 were $459,000 and $238,000, respectively.
Note 13 - Federal Income Taxes
The components of income tax expense for the years indicated are as follows:
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A reconciliation of the tax provision based on the statutory corporate rate of 21% for the year ended December 31, 2019, and 2018, on pretax income is as follows:
The deferred tax assets and liabilities, included in the accompanying consolidated balance sheets, consisted of the following at the dates indicated:
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. These calculations are based on many complex factors including estimates of the timing of reversals of temporary differences, the interpretation of federal income tax laws, and a
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
determination of the differences between the tax and the financial reporting basis of assets and liabilities. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax assets and liabilities.
At December 31, 2019 and 2018, the Company had no net operating loss carryforward.
As a result of the bad debt deductions taken in years prior to 1988, retained earnings includes accumulated earnings of approximately $4.5 million, on which federal income taxes have not been provided. If, in the future, this portion of retained earnings is used for any purpose other than to absorb losses on loans or on property acquired through foreclosure, federal income taxes may be imposed at the then-prevailing corporate tax rates. The Bank does not contemplate that such amounts will be used for any purpose that would create a federal income tax liability; therefore no provision has been made.
Under GAAP, a valuation allowance is required to be recognized if it is “more likely than not” that a portion of the deferred tax asset will not be realized. In order to support a conclusion that a valuation allowance is not needed, management evaluates both positive and negative evidence under the “more likely than not” standard. The weight given to the potential effect of negative and positive evidence should be commensurate with the extent to which the strength of the evidence can be objectively verified. As of December 31, 2019, it was determined the full deferred tax asset would be realized in future periods and a valuation allowance would not be necessary.
The Company had no unrecognized tax benefits at December 31, 2019 or 2018, and recognized no interest or tax penalties. The Company has filed U.S. federal income tax returns as well as California state income tax returns. Income tax returns filed are subject to examination by the U.S. federal, state, and local income tax authorities. While no income tax returns are currently being examined, the Company is no longer subject to tax examination by tax authorities for years prior to 2016.
Note 14 - Regulatory Capital Requirements
Under Federal regulations, pre-conversion retained earnings are restricted for the protection of pre-conversion depositors.
The Company is a bank holding company under the supervision of the Federal Reserve Bank of San Francisco. Bank holding companies are subject to capital adequacy requirements of the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve Board, except that, pursuant to the Economic Growth, Regulatory Relief and Consumer Protection Act, effective August 30, 2018, a bank holding company with consolidated assets of less than $3 billion is generally not subject to the Federal Reserve’s capital regulations, which parallel the FDIC’s capital regulations. The Bank is a federally insured institution and thereby is subject to the capital requirements established by the FDIC. Failure to meet minimum capital requirements can initiate certain mandatory and, possibly, additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital regulations that involve quantitative measures of their assets, liabilities, and certain off-balance- sheet items as calculated under regulatory accounting practices, and until August 30, 2018, First Financial Northwest was subject to similar capital regulations. The Company was not subject to regulatory requirements for bank holding companies at December 31, 2019, and 2018, as its assets were less than the $3.0 billion threshold.
The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table that follows) of total and Tier 1 capital to risk-weighted assets (as defined in the regulations) and of Tier 1 capital to average assets.
As of December 31, 2019, according to the most recent notification from the FDIC, the Bank was categorized as well-capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since the notification that management believes have changed the Bank’s category.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
First Financial Northwest Bank’s actual capital amounts and ratios at December 31, 2019, and 2018, are presented in the following table.
In addition to the minimum CET1, Tier 1, total capital and leverage ratios, the Bank must maintain a capital conservation buffer consisting of additional CET1 capital greater than 2.5% of risk-weighted assets above the required minimum levels in order to avoid limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses based on percentages of eligible retained income that could be utilized for such actions. As of December 31, 2019, the Bank’s conservation buffer was 6.38%.
Note 15 - Commitments and Contingencies
Financial Instruments with Off-Balance-Sheet Risk. In the normal course of business, the Company makes loan commitments, typically unfunded loans and unused lines of credit, to accommodate the financial needs of its customers. These arrangements have credit risk essentially the same as that involved in extending loans to customers and are subject to the Company’s normal credit policies, including collateral requirements, where appropriate. Commitments to extend credit are agreements to lend to customers in accordance with predetermined contractual provisions. These commitments are for specific periods or, may contain termination clauses and may require the payment of a fee. The total amounts of unused commitments do not necessarily represent future credit exposure or cash requirements, in that commitments can expire without being drawn upon. Unfunded commitments to originate loans or extend credit totaled $129.7 million at December 31, 2019, and $126.1 million at December 31, 2018.
Lease Commitments. First Financial Northwest Bank has entered into lease commitments for its branches located in Mill Creek, Edmonds, Renton, Bellevue, Woodinville, Smokey Point, Lake Stevens, Bothell, Kent and Kirkland, all in Washington. For more information on the Company’s lease commitments, see Note 10 - Leases.
Legal Proceedings. The Company and its subsidiaries are from time to time defendants in and are threatened with various legal proceedings arising from their regular business activities. Management, after consulting with legal counsel, is of the opinion that the ultimate liability, if any, resulting from these pending or threatened actions and proceedings will not have a material effect on the consolidated financial statements of the Company.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Employment Contracts and Severance Agreements. The Company has change in control severance agreements with key officers that offer specified terms of salary coverage. In addition, the Company has employment contracts with certain executives that include specified terms of salary coverage as a result of involuntary termination due to change in control or other circumstances. At December 31, 2019, the Company had a $238,000 liability under a severance agreement that will be fully paid during 2020.
Note 16 - Parent Company Only Financial Statements
Presented below are the condensed balance sheets, income statements and statements of cash flows for First Financial Northwest.
FIRST FINANCIAL NORTHWEST, INC.
Condensed Balance Sheets
FIRST FINANCIAL NORTHWEST, INC.
Condensed Income Statements
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FIRST FINANCIAL NORTHWEST, INC.
Condensed Statements of Cash Flows
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 17 - Earnings Per Share
The following table presents a reconciliation of the components used to compute basic and diluted EPS for the periods indicated.
Potential dilutive shares are excluded from the computation of EPS if their effect is anti-dilutive. For the years ended December 31, 2019 and 2018 there were no anti-dilutive shares outstanding related to options to acquire common stock.
Note 18 - Revenue Recognition
In accordance with Topic 606, revenues are recognized when goods or services are transferred to the customer in exchange for the consideration the Company expects to be entitled to receive. To determine the appropriate recognition of revenue for transactions within the scope of Topic 606, the Company performs the following five steps: (i) identify the contract(s) with the customer; (ii) identify the separate performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the separate performance obligations in the contract; and (v) recognize revenue when the entity satisfies a performance obligation. A contract may not exist if there are doubts as to collectability of the amounts the Company is entitled to in exchange for the goods or services transferred. If a contract is determined to be within the scope of Topic 606, the Company recognizes revenue as it satisfies a performance obligation. The largest portion of the Company’s revenue is from net interest income which is not within the scope of Topic 606.
Disaggregation of Revenue
The following table includes the Company’s noninterest income disaggregated by type of service for the years ended December 31, 2019 and 2018:
____________
(1) Not in scope of Topic 606
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the year ended December 31, 2019, substantially all of the Company’s revenues under the scope of Topic 606 are for performance obligations satisfied at a specified date.
Revenues recognized within scope of Topic 606
Wealth management revenue: Our wealth management revenue consists of commissions received on the investment portfolio managed by Bank personnel but held by a third party. Commissions are earned on brokerage services and advisory services based on contract terms at the onset of a new customer’s investment agreement or quarterly for ongoing services. Commissions are paid by the third party to the Bank when the performance obligation has been completed by both entities.
Deposit related fees: Fees are earned on our deposit accounts for various products or services performed for our customers. Fees include business account fees, non-sufficient fund fees, stop payment fees, wire services, safe deposit box, and others. These fees are recognized on a daily, monthly or annual basis, depending on the type of service.
Debit card and ATM fees: Fees are earned when a debit card issued by the Bank is used or when other bank’s customers use our ATM services. Revenue is recognized at the time the fees are collected from the customer’s account or remitted by the VISA interchange network.
Loan related fees: Noninterest fee income is earned on our loans for servicing or annual fees on certain loan types. Fees are also earned on the prepayment of certain loans, and are recognized at the time the loan is paid off.
Loan interest swap fees: For loans participating in an interest rate swap agreement, servicing fees are earned at the onset of the agreement and are not contingent on any future performance or term length of the loan itself. The performance obligation is satisfied by entering into the contract and receipt of the fees from the counterparty.
Other: Fees earned on other services, such as merchant services or occasional non-recurring type services, are recognized at the time of the event or the applicable billing cycle.
Contract Balances
At December 31, 2019, the Company had no contract liabilities where the Company had an obligation to transfer goods or services for which the Company had already received consideration. In addition, the Company had no material performance obligations as of this date.
Note 19 - Subsequent Events
On January 6, 2020, the Company’s Board of Directors authorized the repurchase of up to five percent (5%) of the Company’s outstanding common stock, or approximately 513,000 shares beginning no earlier than January 27, 2020 and ending no later than July 27, 2020. The Company will purchase the shares from time to time in the open market or through privately negotiated depending on market conditions and other corporate considerations.
On January 10, 2020, the Company entered into new post-employment benefit agreements with certain key officers to provide supplemental retirement benefits. Under the terms of the agreement, total annuities of $2.4 million were purchased. These annuities will be reported as held-to-maturity investments on the Company’s balance sheet. In addition, a rider endorsement is attached to the annuity policy which provides continued benefit payments for the life of the annuitant. The annual cost of the rider will be offset against the annuity balance. Post-retirement benefits will be paid out of the annuity until the balance is exhausted. At that time, the rider endorsement continues payments for the life of the annuitant.
During the remaining service period of each officer covered by these agreements, a benefit liability will accrue and a compensation expense will be recognized. A deferred tax asset will also be recognized at 21% of the compensation expense. As post-retirement benefits are paid from the annuity, the benefit liability will amortize until it is fully depleted when the policy rider is activated. The deferred compensation recognized in the deferred tax asset will be recognized as a tax benefit during the post-retirement payment period.
On February 14, 2020, the Company announced that its Board of Directors has declared a quarterly cash dividend of $0.10 per share on the Company’s outstanding common stock, an increase of $0.01 per share from its previous quarterly payout. The payout results in an annualized dividend yield of approximately 2.63% based on the stock price as of February 13, 2020. The cash dividend will be payable on March 27, 2020, to shareholders of record on March 13, 2020.
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
On March 2, 2020, the Bank entered into three $15.0 million cash flow hedges wherein the Bank will pay a fixed rate and receive a floating rate based on one month LIBOR (or an alternative substitute if LIBOR becomes unavailable in the future.) Specific terms are as follows:
On March 10, 2020, the Bank entered into two forward starting cash flow hedges, totaling $25.0 million, that provide for the Bank to pay a fixed rate and received a floating rate based on one-month LIBOR (or alternative substitute if LIBOR becomes unavailable in the future.) These cash flow hedges have a start date of October 25, 2021 and will partially replace the $50.0 million notional cash flow hedge that matures on on that date, wherein we pay 1.34% and receive three-month LIBOR. Specific terms are as follows:
Management entered into the above agreements as part of its ongoing efforts to manage interest rate risk and lower the Bank’s cost of funds. However, no assurances can be made that these transactions will ultimately assist in these efforts.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
(i) Disclosure Controls and Procedures.
An evaluation of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) was carried out as of December 31, 2019 under the supervision and with the participation of our Chief Executive Officer (“CEO”), Chief Financial Officer (“CFO”), and several other members of our senior management. The CEO (Principal Executive Officer) and CFO (Principal Financial Officer) concluded that, as of December 31, 2019, First Financial Northwest’s disclosure controls and procedures were effective in ensuring that information we are required to disclose in the reports we file or submit under the Exchange Act is (1) recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and (2) accumulated and communicated to First Financial Northwest management, including its CEO and CFO, as appropriate to allow timely decisions regarding required disclosure, specified in the SEC’s rules and forms.
(a) Management’s report on internal control over financial reporting.
First Financial Northwest’s management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) of the Securities Exchange Act of 1934. First Financial Northwest’s internal control system is designed to provide reasonable assurance to our management and the Board of Directors regarding the preparation and fair presentation of published financial statements for external purposes in accordance with generally accepted accounting principles.
This process includes policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions of First Financial Northwest; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of First Financial Northwest are being made only in accordance with authorizations of management and directors of First Financial Northwest; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of First Financial Northwest’s assets that could have a material effect on the financial statements. A control procedure, no matter how well conceived and operated, can provide only reasonable, not
absolute, assurance that the objectives of the control system are met. Also, because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. Additionally, in designing disclosure controls and procedures, our management was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. As a result of these inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Furthermore, projections of any evaluation of effectiveness to future periods are subject to risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
First Financial Northwest’s management assessed the effectiveness of First Financial Northwest’s internal control over financial reporting as of December 31, 2019. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework (2013 Framework). Based on that assessment, First Financial Northwest’s management believes that, as of December 31, 2019, First Financial Northwest’s internal control over financial reporting is effective based on those criteria.
Moss Adams LLP, an independent registered public accounting firm, has audited the Company’s consolidated financial statements and the effectiveness of our internal control over financial reporting as of December 31, 2019, which is included in Item 8. Financial Statements and Supplementary Data.
(b) Attestation report of the registered public accounting firm.
The “Report of Independent Registered Public Accounting Firm” included in Item 8 of this Annual Report on Form 10-K is incorporated herein by reference.
(c) Changes in internal control over financial reporting.
There were no significant changes in First Financial Northwest’s internal control over financial reporting during First Financial Northwest’s most recent fiscal quarter that have materially affected or are reasonably likely to materially affect, First Financial Northwest’s internal control over financial reporting.
Item 9B.
Item 9B. Other Information
There was no information to be disclosed by us in a report on Form 8-K during the fourth quarter of fiscal 2019 that was not so disclosed.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
The information required under the section captioned “Proposal 1 - Election of Directors” in First Financial Northwest’s Definitive Proxy Statement for the 2019 Annual Meeting of Shareholders (“Proxy Statement”) is incorporated herein by reference.
For information regarding the executive officers of First Financial Northwest and the Bank, see the information contained herein under the section captioned “Item 1. Business - Personnel - Executive Officers of the Registrant.”
Audit Committee Financial Expert
At December 31, 2019 our Audit Committee was composed of Directors Joann E. Lee (Chairman), Richard M. Riccobono and Ralph C. Sabin. Each member of the Audit Committee is “independent” as defined in listing standards of The Nasdaq Stock Market LLC. Our Board of Directors has designated Directors Joann E. Lee, Richard M. Riccobono and Ralph C. Sabin as the Audit Committee financial experts, as defined in the SEC’s Regulation S-K. Directors Joann E. Lee, Richard M. Riccobono and Ralph C. Sabin are independent as that term is used in Item 407(d)(5)(i)(B) of SEC’s Regulation S-K.
Code of Business Conduct and Ethics
A copy of the Code of Business Conduct and Ethics is available on our website at www.ffnwb.com under Investor Relations - Corporate Overview - Governance Documents. Additionally, any material amendments to, or waiver from a provision of the Code of Business Conduct and Ethics will be posted to the same website.
Item 11.
Item 11. Executive Compensation
The information required by this item under the sections captioned “Executive Compensation” and “Directors’ Compensation” in the Proxy Statement are incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
(a)
Security Ownership of Certain Beneficial Owners and Management.
The information required by this item under the section captioned “Security Ownership of Certain Beneficial Owners and Management” in the Proxy Statement is incorporated herein by reference.
(b) Security Ownership of Management.
The information required by this item under the section captioned “Security Ownership of Certain Beneficial Owners and Management” in the Proxy Statement is incorporated herein by reference.
(c) Change In Control
First Financial Northwest is not aware of any arrangements, including any pledge by any person of securities of First Financial Northwest, the operation of which may at a subsequent date result in a change in control of First Financial Northwest.
(d) Equity Compensation Plan Information
The following table summarizes share and exercise price information about First Financial Northwest’s equity compensation plans as of December 31, 2019.
___________________
(1) The shares available for grant under the 2016 Equity Incentive Plan include 320,057 shares of restricted stock. Each share granted as restricted stock reduces the total available shares for grant by two shares.
Item 13.
Item 13. Certain Relationships and Related Transactions and Director Independence
The information required by this item under the sections captioned “Meetings and Committees of the Board of Directors and Corporate Governance Matters - Corporate Governance - Transactions with Related Persons,” and “Meetings and Committees
of the Board of Directors and Corporate Governance Matters - Corporate Governance - Director Independence” in the Proxy Statement are incorporated herein by reference.
Item 14.
Item 14. Principal Accounting Fees and Services
The information required by this item under the section captioned "Proposal 4- Ratification of the appointment of Moss Adams as our independent auditor for 2020” in the Proxy Statement is incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) Exhibits
______________
(1) Filed as an exhibit to First Financial Northwest’s Registration Statement on Form S-1 on June, 6, 2007 (333-143539)
(2) Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated December 3, 2019.
(3) Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated December 5, 2013.
(4) Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated September 9, 2014.
(5) Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated January 15, 2020.
(6) Filed as Appendix A to First Financial Northwest’s definitive proxy statement dated April 15, 2008.
(7) Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated June 15, 2016.
(8) Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated July 1, 2008.
(9) Filed as an exhibit to First Financial Northwest’s Quarterly Report on Form 10-Q for March 31, 2018 filed on
May 8, 2018.
(10) Filed as an exhibit to First Financial Northwest’s Registration Statement on Form S-8 on June 15, 2016 (333-212029).
(11) Filed as an exhibit to First Financial Northwest’s Quarterly Report on Form 10-Q for September 30, 2018 filed November 7, 2018.
(12) Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated December 20, 2018.
(13) Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated January 3, 2019.
(14) Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated January 15, 2020.
(15) Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated January 15, 2020.
“+” indicates management contract, compensatory plan, or arrangement.
Item 16. Form 10-K Summary.
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.