ITEM 1 - BUSINESS
Frontier Financial Corporation (“FFC” or “the Corporation”) is a Washington corporation which was incorporated in 1983 and is registered as a financial holding company under the Bank Holding Company Act of 1956. As part of a plan of reorganization consummated following the close of business September 30, 1983, FFC acquired all of the stock of Frontier Bank (the “Bank”), issuing its common stock in an exchange for the Bank’s common stock on a share-for-share basis. FFC has two subsidiaries: the Bank, which is engaged in a general banking business and in businesses related to banking, and FFP, Inc., a nonbank corporation which leases property to the Bank.
The Bank
Frontier Bank is a Washington state-chartered commercial bank that is a member of the Federal Reserve System, with its headquarters located in Everett, Snohomish County, Washington. It was founded in September 1978 by Robert J. Dickson and local business persons. The Bank is an “insured bank” as defined in the Federal Deposit Insurance Act.
Location of Principal Market Areas
The Bank engages in general banking business in the State of Washington, including the acceptance of demand, time and savings deposits and the making of loans. As of December 31, 2004, the Bank conducted its business operations out of 38 offices located in Clallam, Jefferson, King, Kitsap, Pierce, Skagit, Snohomish, and Whatcom counties, which is the Bank’s principal market area. Four offices are located in Everett, one office each is located in Arlington, Duvall, Snohomish, Smokey Point, Lake Stevens, Kirkland, Marysville, Lynnwood, Mill Creek, Mount Vernon, Edmonds, Stanwood, Bothell, Woodinville, Monroe, Lake City (Seattle), Totem Lake, Tacoma, Kent, Redmond, Burlington, Bellingham and four offices located in Pierce county in the cities of Sumner, Puyallup, Orting and Buckley. In addition, the following eight branches are located in Clallam, Jefferson and Kitsap counties; two branches in Poulsbo, and one each are in Bainbridge Island, Port Angeles, Port Townsend, Sequim and Silverdale. Acquired in the merger with Interbancorp, Inc. (InterBank) which was consummated in February 2001, were three branches located in King County in the cities of Duvall, Kirkland and Totem Lake.
Banking Services
The Bank provides a full range of consumer banking services including savings accounts, checking accounts, installments and commercial lending, safe deposit facilities, time deposits and other consumer and business related financial services. In addition to consumer-oriented activities, the Bank maintains a strong commercial lending program, servicing businesses headquartered in the Bank’s principal market area.
Frontier’s loan portfolio consists of primarily of loans secured by real estate, although emphasis is also placed on commercial and agriculture loans, consumer installment loans and bankcard loans. At December 31, 2004, real estate category loans comprised 82% of the portfolio, while commercial and agriculture loans made up 15% of the portfolio and installment and bankcard loans were 3%. Loans totaled $1.97 billion, and were 110% of deposits. Almost all of these loans were to borrowers within the Bank’s principal market areas. See page 15 for loan category amounts for the last five years.
Commercial and Agriculture Loans
This category of loans includes both commercial and agriculture loans used to provide working capital or for specific purposes, such as to finance the purchase of fixed assets, equipment or inventory. Commercial loans include lines of credit and term loans. Lines of credit are extended to businesses based on the financial strength and integrity of the borrower and generally (with some exceptions) are collateralized by short-term assets such as accounts receivable and have a maturity of one year or less. Such lines of credit bear an interest rate that floats with the base rate or another established index. Commercial term loans are typically made to finance the acquisition of fixed assets, refinance short-term debt originally used to purchase fixed assets or, in rare cases, to finance a businesses purchase. Commercial term loans generally mature within one to five years. They may be
collateralized by the asset being acquired or other available assets. These term loans will generally bear interest that either floats with the base rate or another established index or is fixed for the term of the loan. Agricultural loans consist of farm related credits used to finance operating expenses. These loans generally have terms of one year and bear interest that either floats with the base or is fixed for the term of the loan. These loans are generally collateralized by farm related assets including; land, equipment, crops or livestock.
Real Estate Loans
Real estate loans represent the largest share of our loan portfolio. These loans are comprised of construction loans, commercial term loans and home mortgages. The construction and land development loan portfolio is comprised of three types:
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Loans for construction of residential and commercial income-producing properties that generally have terms of less then two years and typically bear an interest rate that floats with the base rate.
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Loans for construction of single-family spec and owner-occupied properties that generally have terms of one year or less and typically bear an interest rate that floats with the base rate.
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Land development used for either residential or commercial purposes. These loans generally have terms of one year or less and typically bear an interest rate that floats with the base rate.
Our real estate commercial term loans finance the purchase and/or ownership of income producing properties. These loans are generally made with an amortization schedule ranging from 15 to 25 years with a lump sum balloon payment due in one to ten years. Interest rates will either be fixed or variable. Fixed rates loans typically reprice with one to five years.
Mortgages loans include various types of loans for which real property is held as collateral. These loans, collateralized by one to four family residences, will typically have maturities between one and five years with amortization schedules ranging from 10 to 20 years. Mortgage loans will be written with both fixed and variable rates.
In addition to home mortgages held in our portfolio the Bank is active in originating and selling mortgages into the secondary market. The Bank offers a variety of products for refinancing and purchases and is approved to originate FHA and VA loans. The majority of loans originated in 2004 were fixed rate single-family loans. Total loans sold in 2004 were approximately $65.8 million. Servicing is sold with the loan. Funding requirements for these loans is very minimal as few of these loans originated through this operation are retained for investment.
Installment Loans
We provide loans for personal use including: auto loans, boat loans, home improvement loans, revolving lines of credit, VISA credit cards and other loans typically made by banks to individual borrowers. These loans generally have terms ranging from one to five years, with up to 20-year amortizations and are written with both fixed and variable rates.
Investments
From time to time, the Bank acquires investment securities when funds acquired through deposit activities exceed loan demand. When excess funds are considered temporary in nature by management, they are typically placed in federal funds sold to correspondent banks, which are approved by the Board of Directors, on an overnight basis. This type of investment is not considered desirable, as the interest rate earned on these funds is minimal in nature. When funds are considered longer term, they are generally invested in securities purchased in the open market. At December 31, 2004 the Bank had investments totaling $148.2 million in amortized cost. U.S. Agency bonds comprised 34% of the portfolio and corporate bonds made up 29%. Please see Note 2, page 10 of our 2004 Annual Report for details on the makeup of the portfolio. The Bank has an investment policy that generally permits purchasing securities rated only in one of the four highest rating categories by a nationally recognized credit rating organization. The policy also provides for maturity patterns, diversification of investments and avoidance of concentrations within the portfolio.
Deposit Activities
The Bank’s primary source of funds has historically been customer deposits. The Bank offers a variety of accounts designed to attract both short-term and long-term deposits from its market area. These accounts include NOW, money market, sweep accounts, savings and certificates of deposit. Interest rates paid on these account vary from time to time and are based on competitive factors and liquidity needs. One of the goals of management is to maintain noninterest-bearing deposits at the highest level possible. These are low cost funds and help to increase the net interest margin. Over the last three years, noninterest-bearing accounts have grown from 15.2% of total deposits in 2002 to 17.4% of total deposits in 2004.
Other Funding Sources/FHLB Advances
The Bank has other funding sources such as FHLB advances, federal funds purchased and repurchase agreements. The major source of funds in this area is advances from the FHLB of Seattle. Although this source of funding can be more costly than deposit activities, large portions of funds are available very quickly for meeting loan commitments. The Bank’s line of credit with the FHLB is 15% of assets and is collateralized by qualifying first mortgage loans, qualifying commercial real estate and government agency securities. The Bank, as of December 31, 2004, has FHLB advances totaling $175.1 million (please refer to page 14 of the Annual Report to Shareowners for detail regarding these advances). These advances were collateralized with $144.3 million in qualifying first mortgages, other certain assets, a blanket filing on our commercial real estate portfolio and the remainder was secured by stock in FHLB. No commercial real estate or government securities were pledged at year-end. The unused portion of this credit line at December 31, 2004 was $157.0 million.
Other Banking Services
At the end of 1983, the Bank began to offer a discount brokerage service to its customers. In September of 1984, the Bank opened its Real Estate Division, offering a broad range of home, construction and commercial long-term financing. The Trust Department opened for business in March of 1985. This department offers a full array of trust services to its customers. In May 1988, the Bank opened a Private Banking Office to give personal service to high net worth customers. In August 1989, the Bank acquired, through a merger, three banking office of Citizens Bank of Snohomish County, and a real estate origination department. In January 1991, the Bank opened an office in Mill Creek, providing a full range of consumer banking services.
In March 1991, the Bank opened an Insurance and Investment Center that markets annuities, life insurance products, and mutual funds to Bank customers and the general public. In July 1992, the Bank opened its Stanwood Office. In November 1992, the Bank acquired through merger, Edmonds National Bank, which had one office. In July 1993, the Bank acquired through merger, The Bank of Northshore, which had two offices located in Bothell and Woodinville, King County, Washington. This merger marked the first time the Bank branched outside of Snohomish County. In October 1993, FFP, Inc. a bank premises holding company subsidiary, purchased land for construction of the Administrative offices which were relocated from the Evergreen Way Office. This building was placed in service in 1995. In June 1995, the Bank opened an office in Monroe, providing a full range of consumer banking services. In August 1996, the Bank opened the Lake City Office, (North Seattle) and in December 1996 opened its first office in Skagit County, in Burlington. In May 1997, the Bank opened an office in Redmond, Washington. This is the Bank’s first office in eastern King County.
In December 1998, the Bank acquired, through merger, the Bank of Sumner, with four offices, and a real estate origination department. These offices provide a full range of consumer and commercial banking services. In July 1999, the Bank opened its Bellingham office, which is the Bank’s first office in Whatcom County. In September 1999, the Bank opened its Mount Vernon office which is the Bank’s second office in Skagit County. In December 1999, FFP Inc., purchased property and a building two miles south of the current Administrative Building for the Bank’s Operations Center which began use in the second quarter of 2001. In July 2000, the Bank acquired, through merger, North Sound Bank, with eight offices, a real estate origination department and a financial services company. These offices provide a full range of consumer and commercial banking services. In May 2001, the Bank opened an office in Kent, Washington, which is south of Seattle.
In February 2001, the Bank acquired, through merger, Inter Bank, with two operating offices and one office approved but not yet opened, which has subsequently been opened for business. Additionally, Inter Bank had a real estate origination office. These offices provide a full range of consumer and commercial banking services.
In February of 2004, the Bank opened a full service banking office in downtown Seattle, its only office in the metropolitan area of Seattle. In April 2004, the Bank opened a Real Estate Office in Tacoma, Pierce County, which makes commercial and residential property loans. A second full service banking office in the city of Bellingham is scheduled for opening in March 2005.
Employees
At December 31, 2004, the Bank had 643 full time equivalent employees. The Bank considers its relations with employees to be good.
Competition
All phases of the Bank’s activities are highly competitive. Management believes that the principal competitive factors affecting the Corporation’s markets include interest rates paid on deposits and charged on loans, the range of banking products available, and customer service and support. The Bank competes actively with national and state banks, mutual savings banks, savings and loan associations, finance companies, credit unions, brokerage houses, and other financial institutions operating in its service area. Some of these financial institutions have greater resources than those of the Bank. On December 31, 2004, the Corporation had total assets of $2.243 billion and deposits of $1.796 billion.
REGULATION AND SUPERVISION
To the extent that the following information describes statutory and regulatory provisions, it is qualified in its entirety by reference to the full text of those provisions. Also, such statutes, regulations and policies are continually under review by Congress and state legislatures and federal and state regulatory agencies. A change in statutes, regulations or regulatory policies applicable to FFC could have a material effect on the business of FFC.
Introduction
FFC, its banking and nonbanking subsidiaries are subject to extensive regulation by federal and state agencies. The regulation of bank holding companies and their subsidiaries is intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole and not for the protection of security holders.
As discussed in more detail below, this regulatory environment, among other things, may restrict FFC’s ability to diversify into certain areas of financial services and pay dividends on its capital stock. It may also require FFC to provide financial support to its banking subsidiary, maintain capital balances in excess of those desired by management and pay higher deposit insurance premiums as a result of the deterioration in the financial condition of depository institutions in general.
Holding Company Structure
FFC is a Washington corporation which was incorporated in 1983 and is registered as a bank holding company under the Bank Holding Company Act of 1956 (the “Bank Holding Company Act”). As part of a plan of reorganization consummated following the close of business on September 30, 1983, FFC acquired all of the stock of Frontier Bank (the “Bank”), issuing its common stock in an exchange for the Bank’s common stock on a share-for-share basis. FFC has two subsidiaries: the Bank, which is engaged in a general banking business and in businesses related to banking, and FFP, Inc., a nonbank corporation which leases property to the Bank. Effective October 28, 2000, FFC became a financial holding company.
Source of Strength Doctrine. Under current FRB policy, FFC is expected to act as a source of financial and managerial strength to its subsidiary bank and, under appropriate circumstances, to commit resources to support such subsidiary bank.
Capital loans from FFC to its subsidiary bank are subordinate in right of payment to deposits and certain other indebtedness of the subsidiary bank. In the event of FFC’s bankruptcy, any commitment by FFC to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment.
Depositor Preference. The Federal Deposit Insurance Act (“FDI Act”) provides that, in the event of the “liquidation or other resolution” of an insured depository institution, the claims of depositors of the institution, including the claims of the FDIC as subrogate of insured depositors, and certain claims for administrative expenses of the FDIC as a receiver will have priority over other general unsecured claims against the institution. If an insured depository institution fails, insured and uninsured depositors, along with the FDIC, will have priority in payment ahead of unsecured, nondeposit creditors, including FFC, with respect to any extensions of credit they have made to such insured depository institution.
Regulatory Agencies
Bank Holding Company. FFC, as a bank holding company, is subject to regulation under the Bank Holding Company Act and to inspection, examination and supervision by the Board of Governors of the Federal Reserve System (Federal Reserve Board) (“FRB”) under the Bank Holding Company Act. As of October 28, 2000, FFC became a financial holding company under the Bank Holding Company Act.
Subsidiary Bank. FFC’s subsidiary bank, Frontier Bank, is a Washington state-chartered commercial bank. Effective October 7, 2002, Frontier Bank became a member bank of the Federal Reserve System. As a Federal Reserve System member, Frontier Bank is subject to supervision and examination by applicable federal and state bank agencies, primarily the Federal Reserve, but also the Federal Deposit Insurance Corporation (“FDIC”) and the Division of Banks of the Department of Financial Institutions for the State of Washington (the “Division”).
Bank Holding Company Activities
“Financial in Nature” Requirement. As a bank holding company that has elected also to become a financial holding company pursuant to the Bank Holding Company Act, FFC may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature or are incidental or complementary to activities that are financial in nature. “Financial in nature” activities include securities underwriting, dealing and market making, sponsoring mutual funds and investment companies, insurance underwriting and agency, merchant banking, and activities that the FRB determines from time to time to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. A bank holding company that is not also a financial holding company is limited to engaging in banking and such other activities as determined by the FRB to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.
FRB approval is not required for FFC to acquire a company (other than a bank holding company, bank or savings association) engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the FRB. Prior FRB approval is required before FFC may acquire the beneficial ownership or control of more than 5% of the voting shares or substantially all of the assets of a bank holding company, bank or savings association.
If the subsidiary bank of FFC receives a rating under the Community Reinvestment Act of 1977 of less than satisfactory, FFC will be prohibited from engaging in new activities or acquiring companies other than bank holding companies, banks or savings associations.
Regulatory Approval. In determining whether to approve a proposed bank acquisition, federal banking regulators will consider, among other factors, the effect of the acquisition on competition, the public benefits expected to be received from the acquisition, the projected capital ratios and levels on a post-acquisition basis, and the acquiring institution’s record of addressing the credit needs of the communities it serves, including the needs of low and moderate income neighborhoods, consistent with the safe and sound operation of the bank, under the Community Reinvestment Act of 1977.
Dividend Restrictions
FFC is a legal entity separate and distinct from its subsidiary bank. Its principal source of funds to pay dividends on its common stock and debt service on its debt is dividends from its subsidiary bank. The Bank, by statute, cannot declare or pay any dividend in an amount greater than its retained earnings without the approval of the Director of the Division of Banks for the State of Washington.
Deposit Insurance Assessments
Through the Bank Insurance Fund (BIF), the FDIC insures the deposits of FFC’s depository institution subsidiaries up to prescribed limits for each depositor. The amount of FDIC assessments paid by each BIF member institution is based on its relative risk of default as measured by regulatory capital ratios and other factors. Specifically, the assessment rate is based on the institution’s capitalization risk category and supervisory subgroup category. An institution’s capitalization risk category is based on the FDIC’s determination of whether the institution is well capitalized, adequately capitalized or less than adequately capitalized. An institution’s supervisory subgroup category is based on the FDIC’s assessment of the financial condition of the institution and the probability that FDIC intervention or other corrective action will be required.
The BIF assessment rate currently ranges from zero to 27 cents per $100 of domestic deposits. The FDIC may increase or decrease the assessment rate schedule on a semi-annual basis. An increase in the BIF assessment rate could have a material adverse effect on FFC’s earnings, depending on the amount of the increase. The FDIC is authorized to terminate a depository institution’s deposit insurance upon a finding by the FDIC that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the institution’s regulatory agency.
All FDIC-insured depository institutions must pay an annual assessment to provide funds for the payment of interest on bonds issued by the Financing Corporation, a federal corporation chartered under the authority of the Federal Housing Finance Board. The bonds, commonly referred to as FICO bonds, were issued to capitalize the Federal Savings and Loan Insurance Corporation. The FDIC established the FICO assessment rates effective for the first quarter of 2002 at approximately $.0154 per $100 annually for BIF-assessable deposits. The FICO assessments are adjusted quarterly to reflect changes in the assessment bases of the FDIC’s insurance funds and do not vary depending on a depository institution’s capitalization or supervisory evaluations.
FDIC-insured depository institutions pay an assessment rate equal to the rate assessed on deposits insured by the Savings Association Insurance Fund.
Securities Registration and Reporting
FFC common stock is registered with the SEC under Section 12(g) of the Securities Exchange Act of 1934 and thus is subject to the periodic reporting and proxy solicitation requirements and the insider-trading restrictions of that Act. The periodic reports, proxy statements and other information filed by FFC under that Act can be inspected and copied at or obtained from the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. FFC is an electronic filer with the SEC, and the FFC filings may be obtained at the SEC website (http://www.sec.gov). In addition, the securities issued by FFC are subject to the registration requirements of the Securities Act of 1933 and applicable state securities laws unless exemptions are available.
NASD
FFC common stock is traded on the Nasdaq market under the symbol FTBK. The National Association of Securities Dealers (“NASD”) is the self-regulatory organization of the Nasdaq Market. FFC is subject to the rules of the NASD.
The NASD may implement rules from time to time that are required by the SEC. The NASD implemented rules under the Sarbanes-Oxley Act of 2002 regarding certain required disclosures to shareholders, and independence requirements for directors. In order for FFC common stock to continue to be traded on the Nasdaq market, FFC is required to comply with these listing rules, as amended from time to time.
Fiscal and Monetary Policies
FFC’s business and earnings are affected significantly by the fiscal and monetary policies of the federal government and its agencies. FFC is particularly affected by the policies of the FRB, which regulates the supply of money and credit in the United States. Among the instruments of monetary policy available to the Federal Reserve are (a) conducting open market operations in United States government securities, (b) changing the discount rates of borrowings of depository institutions, (c) imposing or changing reserve requirements against depository institutions’ deposits, and (d) imposing or changing reserve requirements against certain borrowing by banks and their affiliates. These methods are used in varying degrees and combinations to directly affect the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits. For that reason alone, the policies of the FRB have a material effect on the earnings of FFC.
Privacy Provisions of Gramm-Leach-Biley Act
Under the Gramm-Leach-Biley Act (“GLB Act”), federal banking regulators adopted rules limiting the ability of banks and other financial institutions to disclose nonpublic information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, will allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party.
Disclosure Controls and Procedures
The Sarbanes-Oxley Act of 2002 and related rulemaking by the SEC, which effect sweeping corporate disclosure and financial reporting reform, generally require public companies to focus on their disclosure controls and procedures. As a result, public companies such as FFC now must have disclosure controls and procedures in place and make certain disclosures about them in their periodic SEC reports (i.e., Forms 10-K and 10-Q) and their chief executive and chief financial officers must certify in these filings that they are responsible for developing and evaluating disclosure controls and procedures and disclose the results of an evaluation conducted by them within the 90-day period preceding the filing of the relevant report, among other things.
Future Legislation
Various legislation, including proposals to substantially change the financial institution regulatory system and to expand or contract the powers of banking institutions and bank holding companies, is from time to time introduced in the Congress. This legislation may change banking statutes and the operating environment of FFC and its subsidiaries in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. FFC cannot predict whether any of this potential legislation will be enacted, and if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of FFC or any of its subsidiaries.
THE BANK
GENERAL. Applicable federal and state statutes and regulations governing a bank’s operations relate, among other matters, to capital requirements, required reserves against deposits, investments, loans, legal lending limits, certain interest rates payable, mergers and consolidations, borrowings, issuance of securities, payment of dividends (see “Restrictions on Capital Distributions” below), establishment of branches, and dealings with affiliated persons. The FDIC has authority to prohibit banks under their supervision from engaging in what they consider to be an unsafe and unsound practice in conducting their business.
FFC’s subsidiary bank, Frontier Bank, is a Washington state-chartered commercial bank that is a member bank of the Federal Reserve System. All member banks of the Federal Reserve are required to purchase Federal Reserve stock, and to comply with the safety and soundness regulations. As a Federal Reserve System member, Frontier Bank is subject to supervision and examination by applicable federal and state banking agencies, primarily the Federal Reserve, but also the FDIC and the Division. The Bank is also subject to regulation and examination by the FDIC which insures the deposits of the Bank to the maximum extent permitted by law and by requirements established by the FRB. The federal laws that apply to the Bank regulate, among other things, the scope of its business, investments, reserves against deposits, the timing of the availability of deposited funds and the nature and amount of and collateral for loans. The laws and regulations governing the Bank generally have been promulgated to protect depositors and not to protect shareowners of such institutions or their holding companies.
The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) requires federal banking regulators to adopt regulations or guidelines in a number of areas to ensure bank safety and soundness including: internal controls, credit underwriting, asset growth, management compensation, ratios of classified assets to capital, and earnings. FDICIA also contains provisions which are intended to change independent auditing requirements; restrict the activities of “undercapitalized banks” to borrow from the FRB’s discount window; and require regulators to perform annual on-site bank examinations and set standards for real estate lending.
LOANS TO ONE BORROWER. The Bank is subject to limitations on the aggregate amount of loans that it can make to any one borrower, including related entities. Applicable regulations generally limit loans-to-one borrower to 20 percent of capital. As of December 31, 2004 the Bank was in compliance with applicable loans-to-one borrower requirements.
FDIC INSURANCE. Generally, customer deposit accounts in banks are insured by the FDIC for up to a maximum amount of $100,000. The FDIC has adopted a risk-based insurance assessment system under which depository institutions contribute funds to the Bank Insurance Fund (“BIF”), based on their risk.
On September 30, 1996, the Deposit Insurance Fund Act of 1996 (“Funds Act”) was enacted. The Funds Act provides, among other things, for the recapitalization of the SAIF through a special assessment on all depository institutions that hold SAIF insured deposits. The one-time assessment was designed to place the SAIF at its 1.25 reserve ratio goal.
The Funds Act, for the three-year period beginning in 1997, subjects BIF insured deposits to a Financing Corporation (“FICO”) premium assessment on domestic deposits at one-fifth the premium rate (approximately 1.3 basis points) imposed on SAIF insured deposits (approximately 6.5 basis points).
Beginning in the year 2000, BIF insured institutions were required to pay the FICO obligations on a pro-rata basis with all thrift institutions; annual assessments are expected to equal approximately 2.4 basis points until 2017, to be phased out completely by 2019. Until further action by the FDIC, BIF premiums will be maintained at their current level.
Banking regulations are empowered under the Funds Act to prohibit insured institutions and their holding companies from facilitating or encouraging the shifting of deposits from the SAIF to the BIF in order to avoid higher assessment rates. It is expected that Congress will continue to address comprehensive legislation on the merger of the funds and elimination of the thrift charter.
The FDIC may terminate the deposit insurance of any insured depository institution if it determined after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law. The insurance may be terminated permanently, if the institution has no tangible capital. If deposit insurance is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, will continue to be insured for a period of six months to two years, as determined by the FDIC.
CAPITAL ADEQUACY REQUIREMENTS. The FRB and the FDIC (collectively, the “Agencies”) have adopted risk-based capital guidelines for banks and bank holding companies that are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies and account for off-balance sheet items. The guidelines are minimums, and the federal regulators have noted that banks and bank holding companies contemplating significant expansion programs should not allow expansion to diminish their capital ratios and should maintain ratios in excess of the minimums. Failure to achieve and maintain adequate capital levels may give rise to supervisory action through the issuance of a capital directive to ensure the maintenance of required capital levels.
The current guidelines require all federally regulated banks to maintain a minimum risk-based total ratio equal to 8 percent, of which at least 4 percent must be Tier 1 capital. Tier 1 capital includes common shareowners’ equity, qualifying perpetual preferred stock, and minority interest in equity accounts of consolidated subsidiaries, but excludes goodwill and most other intangibles, gains or losses on available for sale securities and the allowance for losses on loans. Total capital includes the excess of any preferred stock not included in Tier 1 capital, mandatory convertible securities, hybrid capital instruments, subordinated debts and intermediate term preferred stock and the allowance for losses on loans up to 1.25 percent of risk-weighted assets. The Bank has not received notice indicating that it will be subject to higher capital requirements.
PROMPT CORRECTIVE ACTION. Regulations adopted by the Agencies as required by FDICIA impose even more stringent capital requirements. The regulators require the FDIC and other Federal Banking Agencies to take certain “prompt corrective action” when a bank fails to meet certain capital requirements. The regulations establish and define five capital levels: (1) “well-capitalized”, (2) “adequately capitalized”, (3) “undercapitalized”, (4) “significantly undercapitalized”, and (5) “critically undercapitalized.” To qualify as “well capitalized” an institution must maintain at least 10 percent total risk-based capital, 6 percent Tier 1 risk-based capital, and a leverage ratio of no less than 5 percent. Increasingly severe restrictions are imposed on the payment of dividends and management fees, asset growth and other aspects of the operations of institutions that fall below the category of being “adequately capitalized” (which requires at least 8 percent total risk-based capital, 4 percent Tier 1 risk-based capital, and a leverage ratio of at least 4 percent). Undercapitalized institutions are required to develop and implement capital plans acceptable to the appropriate federal regulatory agency. Such plans must require that any company that controls the undercapitalized institution must provide certain guarantees that the institution will comply with the plan until it is adequately capitalized. As of December 31, 2004, the Bank was well capitalized and maintained a leverage ratio of 10.03 percent, a risk-based Tier 1 capital ratio of 9.72 percent, and a risk-based total capital ratio of 10.97 percent.
RESTRICTIONS ON CAPITAL DISTRIBUTIONS. Dividends paid to FFC by the Bank are a material source of FFC’s cash flow. Various federal and state statutory provisions limit the amount of dividends the Bank is permitted to pay to FFC without regulatory approval.
FRB policy further limits the circumstances under which bank holding companies may declare dividends. For example, a bank holding company should not continue its existing rate of cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality, and overall financial condition.
If, in the opinion of the applicable federal banking agency, a depository institution under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which depending on the financial condition of the institution, could include the payment of dividends), the agency may require, after notice and hearing, that such institution cease and desist from such practice. In addition, the FRB and the FDIC have issued policy statements which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings.
According to Washington law, the Bank may not declare or pay a cash dividend in an amount greater than its retained earnings, without the approval of the Director of the Division of Financial Institutions.
INTERSTATE BANKING AND BRANCHING. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“Interstate Act”) generally permits nationwide interstate banking and branching by relaxing federal law restrictions on interstate banking and providing general authorization for interstate branching. Subject to certain state laws, such as age and contingency laws, the Interstate Act allows adequately capitalized and adequately managed bank holding companies to purchase the assets of out-of-state banks. Additionally, since June 1, 1997, the Interstate Act permits interstate bank mergers subject to these state laws, unless the home state of either merging bank has “opted-out” of these provisions by enacting “opt-out” legislation. The Interstate Act does allow states to impose certain conditions on interstate bank mergers within their borders; for example, states may require that the in-state merging bank exist for up to five years before the interstate merger. Under the Interstate Act, states may also “opt-in” to de novo branching, allowing out-of-state banks to establish de novo branches within the state.
In 1996, Washington enacted “opting-in” legislation authorizing interstate mergers pursuant to the Interstate Act. Accordingly, as of June 6, 1996, an out-of-state bank holding company may now acquire more than 5 percent of the voting shares of a Washington-based bank, regardless of reciprocity, provided such bank or its predecessor has been doing business for at least five years prior to the acquisition. Further, an out-of-state bank may engage in banking in Washington if the requirement of Washington’s interstate banking statute are met, and either: (1) was lawfully engaged in banking in Washington on June 6, 1996, (2) resulted from an interstate combination pursuant to Washington law, (3) resulted from a relocation of a head office of a state bank or a main office of a national bank pursuant to federal law, or (4) resulted from the establishment of a savings bank branch in compliance with applicable Washington law. Additionally, the Director of the Division of Financial Institutions may approve interstate combinations if the basis for such approval does not discriminate against out-of-state banks, out-of-state holding companies, or their subsidiaries.
The agencies recently adopted regulations, under which banks are prohibited from using their interstate branches primarily for deposit production. The Agencies have accordingly implemented a loan-to-deposit ratio screen to ensure compliance with this prohibition.
REGULATORY IMPROVEMENT. In 1994, Congress enacted the Community Development and Regulatory Improvement Act (“Regulatory Improvement Act”), with the intent of, among other things, reducing the regulatory burden on financial institutions. This Act is intended to streamline certain regulatory procedures and relax certain regulatory compliance requirements. In addition, the Regulatory Improvement Act specifically directs each federal banking agency to review and streamline its regulations and written supervisory policies.
Effect of Governmental Policies. The Bank is affected not only by general economic conditions, but also by the monetary and fiscal policies of the United States Government and various agencies, particularly the Federal Reserve System. In its role of implementing its monetary policy, the Federal Reserve Board has the power to regulate the national supply of bank credit through such methods as open market operations in the United States Government securities markets, control of the discount rate on member bank borrowings, and establishment of reserve requirements against bank deposits. These means are used in varying combinations and have an influence over the growth of bank loans, investments, and deposits. They may also affect interest rates charged on loans or paid on deposits. The nature and timing of future changes in monetary policies and their impact on the Bank are not predictable. As a consequence of extensive regulation of commercial banking activities in the United States, the Bank’s business is particularly susceptible to being affected by Federal legislation and regulations which may have the effect of increasing the cost of doing business or limiting permissible activities.
Equity Compensation Plans
The following table sets forth information regarding outstanding options and shares reserved for issuance under the Corporation’s plans:
(A) Consists of FFC Incentive Stock Option Plan.
(B) Consists of FFC 1999 Employee Stock Award Plan and 2001 Stock Award Plan.
FFP, Inc.
On April 4, 1988, the Corporation formed a new subsidiary corporation called FFP, Inc. The purpose of this corporation is to purchase and lease improved real property to the Bank. For further details, please see page 24 of this Form 10-K Report, “Properties.” It is intended that future purchases of real property will be made by FFP, Inc. At this time, it is not anticipated that FFP, Inc. will engage in any other type of business.
Recent Stock Purchase
In December 2004, the Corporation purchased 4.95% of the common stock of Skagit State Bank, located in Burlington, Washington, which is approximately 44 miles north of Everett in Skagit County. Subsequent to this investment, the Corporation applied to the Board of Governors of the Federal Reserve System to purchase up to 20% of Skagit State. Approval was received in February 2005 and the Corporation has since purchased an additional 3.2% for a total ownership of 8.13%. In accordance with the terms of an agreement entered into with the private investor, the Corporation will purchase an additional 22,500 shares in July 2005, representing an additional 3.2%, for a cumulative total ownership of 11.3%. Additional shares may be purchased from time to time up to the 20% authorized.
Share Repurchase Program
In January 2001 the Board announced the adoption of a stock repurchase program authorizing the Corporation to repurchase up to 5% of its outstanding stock in the open market. On October 17, 2001 the Board of Directors authorized to repurchase an additional 5% of outstanding common stock under the plan. On October 17, 2002 the Board of Directors authorized to repurchase an additional 5% of outstanding common stock under the plan. The plan expired October 2004 and a fourth plan to repurchase up to 5% of outstanding common stock was approved by the Board of Directors on September 16, 2004, for a period not to exceed two years. The Corporation has repurchased 361,800 and 473,500 shares in 2003 and 2002. There have been no shares repurchased since 2003 and there were 932,270 shares remaining under the current plan at December 31, 2004.
Treatment of Goodwill
The Corporation has goodwill which was recorded in connection with acquisitions over the years. Prior to January 1, 2002, the Corporation amortized goodwill over 20 years. Upon the implementation of Statement of Financial Standards No. 142 (SFAS No. 142), Goodwill and Other Intangible Assets, on January 1, 2002 the Company ceased amortization of goodwill. SFAS 142 requires the Corporation to test the goodwill for impairment at least annually. The Corporation tested its goodwill and found no impairment during 2004. The Corporation uses the fair market value approach to determine if there has been any impairment.
Availability of Filings
You may access, free of charge, copies of the following reports of FFC on its investor relations page at www.frontierbank.com or on the SEC’s website at www.sec.gov (except for the Code of Ethics Policy):
1) Annual Reports on Form 10-K; and
2) Quarterly Reports on Form 10-Q.
3) Code of Ethics Policy
These documents are posted on the SEC’s website, generally within twenty-four hours after FFC files these documents electronically with the Securities and Exchange Commission.
Forward-Looking Statement
The Annual Report on Form 10-K contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, the Corporation may make certain statements in future SEC filings, in press releases, and in oral and written statements made with the Corporation’s approval that are not statements of historical fact and may constitute forward-looking statements. Forward-looking statements may relate to, without limitation the Corporation’s financial condition, results of operations, plans, objectives, future performance or business.
Forward-looking statements are identified by the fact that they do not relate only to historical or current facts. Sentences containing words such as “may”, “will”, “expect”, “anticipate”, “believe”, “estimate”, “should”, “projected”, or similar words may constitute forward-looking statements, but are not the only means to identify these statements. The Corporation may have used these statements to describe expectations and estimates in various areas, including, but not limited to: changes in the economy of the markets in which it operates; interest rate movements; future acquisition and growth strategies; system conversions and integration activities; the impact of competitive products, services and pricing; and legislative, regulatory and accounting changes affecting the banking and financial service industry.
Forward-looking statements are subject to risks and uncertainties that may cause actual future results to differ materially from estimated or projected results. Factors that could cause this difference-many of which are beyond the Corporation’s control-include the following, without limitation: interest rate trends may differ than expected; loan delinquency rates may be significantly higher than expected; the general state of the economy in Washington state and the United States as a whole could be worse than expected; competitive pressures among financial institutions could increase significantly; and changes in laws and regulations could adversely affect the Corporation.
STATISTICAL DISCLOSURE INDEX
The schedules listed below set forth the statistical information relating to Frontier Financial Corporation and subsidiaries (unless otherwise stated) in accordance with Guide 3. This information should be read in conjunction with the consolidated financial statements.
Analysis of Investment Securities
The aggregate amortized recorded values of investment securities at December 31 are as follows:
Maturity Distribution of Investment Securities
The following table sets forth the maturities of investment securities at December 31, 2004. Taxable equivalent values are used in calculating yields assuming a tax rate of 35%.
As of December 31, 2004 and 2003, the Corporation held FHLB bonds that had a book value of $34.0 million and $47.0 million and a market value of $33.8 million and $46.9 million, respectively. The FHLB announced in December 2004 that it would not repurchase any stock until further notice.
Types of Loans
Major classifications of loans, net of deferred loan fees, at December 31 are as follows:
Loan Maturities and Sensitivity to Changes in Interest Rates
The following table shows the amounts and maturity analysis of loans outstanding as of December 31, 2004. Also, the amounts are classified as to fixed and variable rate sensitivity for amounts due after one year.
Loans maturing after one year with:
It is not uncommon to rollover loans at the maturity period, provided that the rate and terms of the loan conform to the current policy.
Loan Administration
The credit approval process at the Bank provides for the prompt and thorough underwriting and approval or decline of loan requests. The method used is a step process based on assigned lending limits. Approval process includes authority assigned to individual officers and an internal loan committee. Lending authority is also assigned to the Bank’s Directors’ Loan Committee to approve the Bank’s largest credit relationships up to the legal lending limit of the Bank.
Credit Review personnel conduct continuous reviews to ensure the loan portfolio remains in compliance with our lending policies and safe and sound practices. They provide ongoing reporting to management regarding credit weakness and policy exceptions. Quarterly reports are prepared for submission to Senior Management, and the Director’s Audit Committee, which detail levels of exceptions and follow-up corrective actions.
Certain problem loans are placed on a nonaccrual basis in conformance with defined policy. The Loan Committee and other administrative personnel regularly review information reports on adversely classified and delinquent
loans. Comparative summaries of delinquent loans are also provided on a regular basis to senior management and to the Board of Directors.
Management closely monitors the adequacy of the loan loss reserve and an analysis is performed four times a year. The allowance is maintained at a level deemed sufficient to meet potential losses.
The reviews, examinations and actions described above are in addition to the periodic examinations by federal and state regulatory agencies, as well as the Bank’s internal audit department and the Bank’s outside public accounting firm.
RISK ELEMENTS - IMPAIRED ASSETS
Nonaccruing Loans
Loans are placed in a nonaccrual status when, in the opinion of management, the collection of additional interest is doubtful or when the loan becomes ninety (90) days past due. When a loan is placed on nonaccrual status, all interest previously accrued, but not collected, is reversed and charged against interest income. Income on nonaccrual loans is then recognized only to the extent cash is received and where the future collection of principal is probable. Accruals are resumed only when the loan is brought current, and when, in the opinion of management, the borrower has demonstrated the ability to resume payments of principal and interest on a regular basis. As a consequence, some of these loans are current in their payments at this time.
Impaired Loans
A loan is considered impaired when management determines it is probable that all contractual amounts of principal and interest will not be paid as scheduled in the loan agreement. These loans include all loans in nonaccrual, loans restructured, and other loans that management considers to be impaired.
This assessment for impairment occurs when and while such loans are on nonaccrual, or the loan has been restructured. When a loan with unique risk characteristics has been identified as being impaired, the amount of impairment will be measured by the Corporation. If the measurement of the impaired loan is less than the recorded investment in the loan an impairment is recognized by creating or adjusting an existing allocation of the allowance for loan losses.
Restructured Loans
In cases where a borrower experiences financial difficulties and the Corporation makes certain concessionary modifications to the contractual terms, the loan is classified as a restructured (accruing) loan. Loans restructured at a rate equal to or greater than that of a new loan with comparable risk at the time of the contract is modified may be excluded from the impairment assessment and may cease to be considered impaired.
Delinquent and Problem Loans
Delinquent and problem loans are a part of any lending enterprise. When a borrower fails to make payments, the Bank implements collection activities commencing with simple past due notices. This then progresses to phone calls and letters, followed by legal activity when and if necessary. At one month past due, the loan is tracked and reported as a delinquency.
It is the Bank’s practice to discontinue accruing interest on virtually all loans that are delinquent in excess of 90 days regardless of risk of loss, collateral, etc. Some problem loans which are less than 90 days delinquent are also placed into nonaccrual status if the success of collecting full principal and interest in a timely manner is in doubt and some loans will remain in nonaccrual even after improved performance until a consistent timely payment pattern is exhibited and/or timely performance is considered to be reliable.
Levels of, and Trends in, Delinquencies and Nonaccruals
Nonperforming loans and other real estate increased in 2004 to $14.1 million, from $10.9 million in 2003. Management monitors delinquencies monthly and reports are prepared for the Board of Directors review. Delinquencies for the commercial, personal, real estate and credit lines categories are charted separately when presented to the Board. The current level of nonperforming assets represents a 30% increase by dollar amount from the previous year.
On the following table the dollar amount of loans past due 90 days or more whether accruing or not, past due, and other real estate owned as a percentage of total loans was .71%, .61%, and 1.14%, for year-end 2004, 2003 and 2002, respectively. These loans have a variety of situations, some of which may lead to foreclosure or involve a bankruptcy case and while some of these loans are in active legal collection processes, others are under active repayment plans and may continue payment as the borrower’s financial situation improves.
The Bank ended the year holding six nonaccruing loans with a combined balance of $14.1 million. This compares to previous year-end balance of $6.7 million consisting of 13 loans. Two loans, totaling $11.1 million, make up 79% of our year-end balance. One of these two loans, totaling $5.1 million, has resumed repayment and will likely be shifted to restructured loans in 2005. All of the nonaccrual loans are secured by real estate. Aggressive collection efforts are underway.
Loans past due 90 days or more and still accruing, nonaccruing, restructured and other real estate owned (OREO) on which the accrual of interest has been discontinued as of December 31st are as follows:
(1) For consistency with prior years filings, percentage calculated includes RE loans held for resale in total loans.
There are certain amounts of interest collected on the loans that is included in income, and amounts that have not been accrued which are indicated in the following table:
Loan Charge Off’s
It is the bank’s policy to aggressively review questionable loans for charge-off. The Bank adheres to all regulatory, accounting, and legal requirements regarding the writing off of loans.
Other Real Estate Owned
OREO is carried at the lesser of book value or market value. The costs related to completion, repair, maintenance, or other costs of such properties, are generally expensed with any gains or inadvertent shortfalls from the ultimate sale of OREO being shown as other income or expense.
The Bank had no OREO total to report at year-end December 31, 2004. Previous year-end OREO balance total $4.2 million or .2% of total assets. The change in OREO total is a reflection of our aggressive collection efforts resulting in an orderly transition of assets from acquisition, through foreclosure, and sale.
Certain other loans, currently in nonaccrual, are in the process of foreclosure and there is a likelihood these foreclosures will be completed and the loans will then become OREO. This is viewed as an ordinary part of the collection process and efforts are constantly underway to reduce and minimize such nonperforming assets.
The table below shows the carrying value of OREO at December 31st:
Allowance For Loan Losses - Qualitative Factors
The allowance for loan losses was $32.7 million, or 1.65% of loans at December 31, 2004. This compares to $29.6 million, or 1.67% at December 31, 2003, and $28.2 million, or 1.70% at December 31,2002. Net charge-offs’s as a percentage of average loans improved to .02% in 2004, from .17% in 2003 and .28% in 2002. The allowance for loans as a percentage of nonperforming loans decreased to 232% in 2004 from 272% in 2003. An improving economy, and positive credit performance trends, is reflected in year-end 2004 reserves of 1.65% and net charge off’s of $328 thousand. An uncertain economic environment and increasing delinquencies supported the higher loan loss reserve for year-end 2003 and 2002.
The allowance for loan losses is the amount, which, in the opinion of management, provides adequate protection in the event of loan losses. This analysis is performed quarterly and reviewed by senior management to determine the adequacy of the reserve. The analysis takes into consideration current economic trends both on a national and
local level. It includes careful consideration of delinquency rates and trends for special loan categories including commercial, personal and real estate related loans by geographic location.
Management and the Board review policies and procedures annually, or more often, and changes are made to reflect the current operating environment integrated with regulatory requirements. Partly out of these policies has evolved an internal credit risk review process. During this process the quality grade of loans are reviewed and loans are assigned a dollar value of the loan loss reserve by degree of risk. This analysis is performed quarterly and reviewed by senior management who makes the determination if the risk is reasonable, and if the reserve is adequate.
Taken into consideration when the analysis is performed is the national and local economic trends and conditions. The analysis also takes into consideration the level of, or trends in, delinquencies and non-accruing loans. Management monitors delinquencies monthly and reports are prepared for the Board of Directors to review. Delinquencies for commercial, personal and real estate loans are charted separately by their types and by portfolio geographic locations.
Another consideration is the volume and terms of loans. Management reviews the growth and terms of loans so that the allowance can be adjusted for current and anticipated future needs.
Quantitative Factors
The allowance for loan losses is the amount which, in the opinion of management, is necessary to absorb loan losses. Management’s evaluation of the adequacy of the allowance is based on the market area served, local and national economic conditions, the growth and composition of the loan portfolio and the related risk characteristics, by continual review by management of the quality of the portfolio.
The Corporation has an active ongoing credit review function. When a loan has degradation in quality as evidenced by an internal watch rating its internal rating is downgraded. An assessment of these loans is performed to determine whether it is appropriate to establish a specific allocation reserve or write down as directed by FAS 114, Accounting by Creditors for Impairment of a Loan. If appropriate, such allocation reserve or write down is made. For the remainder of these loans that which no specific allocation reserve or write down is necessary we establish a background reserve. The background reserves are reviewed quarterly to determine if these background reserve percentages are appropriate.
All other loans which have not been identified with degradation in quality have background reserves based upon our experience and information concerning actual industry losses by loan types.
Every quarter certain qualitative facts are evaluated to determine if certain adjustments are indicated for any of the background reserves established. This is accomplished through an internal narrative and the tracking of statistics including but not limited to unemployment rates, historical charge offs, job growth, effects of changing interest rates, housing starts, trends in volume and terms of loans, levels of, and trends in, delinquencies and nonaccruals, and other real estate owned trends.
Loan concentrations, quality, terms and basic underlying assumptions remained substantially unchanged during the period. The actual loan loss reserve as a percentage of total loans has declined over the last two years, mainly due to loan portfolio quality.
Summary of Loan Loss Experience
The following table provides an analysis of net losses by loan type for the last five years at December 31:
(1) For consistency with prior years filings, percentage calculated includes RE loans held for resale in total loans.
Allocation of Allowance for Loan Losses
Based on certain characteristics of the portfolio, potential losses can be anticipated for major loan categories. In the following table, the allowance for loan losses at year-end, for the last five years, has been allocated among major loan categories based primarily on their historical net charge-off experience, along with consideration of factors such as quality, volume, anticipated economic conditions and other business considerations.
Historical net charge-offs are not necessarily accurate indicators of future losses since net charge-offs vary from period to period due to economic conditions and other factors that cannot be accurately predicted. Thus, an evaluation based on historical loss experience within individual loan categories is only one of many factors considered by management in evaluating the adequacy of the overall allocation.
In addition, regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may require the Bank to change the allowance based upon their judgment at the time of their examination. It is the Bank’s policy to be in compliance with all accounting and regulatory standards related to loan loss reserves and all accounting policies promulgated by GAAP.
Loan concentrations, quality, terms and basic underlying assumptions remained substantially unchanged during the period. The actual loan loss reserve as a percentage of total loans has declined over the last five years, mainly due to mergers with institutions which had a lower reserve comparably, and due to loan portfolio quality.
Effects of Changing Interest Rates
A review of the past 12 months shows that the tax equivalent net interest margin began the year 2004 at 5.12% (quarter ended December 31, 2003). The margin then declined to 5.02% for the first quarter but increased to 5.05% in the second quarter, increased in the third quarter to 5.15% and 5.32% for the fourth quarter. The Corporation increased its key lending index 25 basis points in August, September, November and December. However, the improvement in the net interest margin was more attributed to continued decline in the cost of funds during the first three quarters of the year. The Corporation dropped its key lending index 25 basis points in the third quarter 2003 and the FRB dropped interest rates three times during the year 2002 in February, April and November. The impact of these movements contributed to the narrowing of the margin in all but the fourth quarter 2003 and the second, third, and fourth quarters of 2004. In the two years previous to 2003 we saw the net interest margin increase from 4.90% to 5.38% in 2002.
Concentrations of Credit
The most significant portion of the loan portfolio consists of commercial real estate. The portfolio consists of a wide cross-section of retail, small office, warehouse, and industrial type properties. These loans are secured by first trust deeds with maturities from 3 to 10 years and original loan to value ratios generally from 65% to 75%. A substantial number of these properties are owner-occupied. While the Bank has significant balances within this lending category, management believes that its lending policies and underwriting standards are sufficient to minimize risk even during these uncertain economic times. Management closely monitors the effects of current and expected market conditions and other factors that may influence the repayment of these loans.
The following chart indicates the amount of those loans, and as a percent of total loans for the period:
(1) For consistency with prior years filings, percentage calculated includes RE loans held for resale in total loans.
Trends in Volume and Terms of Loans
Average loans for the year 2004 were $1.887 billion, representing an increase of $196.5 million, or 11.6% over the average balance for 2003. Average loans for 2003 totaled $1.691 billion representing an increase of $90.0 million, or a 5.6% increase over 2002 average loans outstanding. Loans did show favorable increases throughout 2004. Growth substantially increased over prior years increases mainly due additional lending staff. Terms of loans have remained competitive and within policy guidelines.
Conclusion of Qualitative Factors
The allowance for loan losses is the amount, which, in the opinion of management, is necessary to absorb inherent loan losses regardless of source. Management’s evaluation of the adequacy of the allowance is based on the market area served, local economic conditions, the growth and mix of the portfolio and their related risk characteristics. Based upon actual historical loan loss rates the loan loss reserve may appear to be somewhat larger than might be necessary, however our analysis included subjective factors that cause us to believe the reserve is adequate, but not unduly conservative.
Off Balance Sheet Arrangements
In the ordinary course of business, Frontier has entered into off-balance sheet financial instruments consisting of commitments for the extension of credit, credit card commitments, letter of credit commitments, home equity lines and standby letters of credit. These instruments are recorded in the financial statements when they are funded or related fees are incurred or received. The following table summarizes the amount of commitments as of December 31, 2004:
Commitments to extend credit and letters of credit are written for one year, or have a call in one year. The fair value of these commitments is not material since they are for a short period of time and subject to customary credit terms. A fee is charged for all commitments to lend. Due to the Bank’s underwriting policies, there have been no losses associated with these commitments.
Deposits
For the average amount of deposits and rates paid on such deposits for years ended December 31, 2004, 2003, and 2002 please refer to page 42 of 2004 Annual Report to Shareowners.
Maturities of time certificates of deposit $100,000 and over at year-end 2004 are shown below:
The following table represents the noninterest and interest-bearing deposit accounts that will mature or reprice in one year or less as compared to the past year:
Although 65% of our time deposit portfolio will mature within the next year, we feel that cash flows are sufficient to support operations for the foreseeable future. Over the past year, we have had the ability to retain and grow each category of our deposit accounts. If liquidity was needed going forward, sources would consist of maturing securities, increased customer deposits or loan maturities. If need be, lines of credit are available or we could issue additional capital stock. Cash flows from operations also contribute significantly to liquidity needs.
Borrowings
Short-Term Borrowings
For information regarding average balances and yields, please refer to page 42 of 2004 Annual Report to Shareowners.
ITEM 2
ITEM 2 - PROPERTIES
At December 31, 2004 the Bank had 38 offices, including the main office, all of which are located in the State of Washington. These offices are located in Arlington, Bainbridge Island, Bellingham, Bothell, Buckley, Duvall, Edmonds, Everett (4), Kent, Kirkland, Lake City, Lake Stevens, Lynnwood, Marysville, Puyallup, Mill Creek, Milton, Monroe, Mount Vernon, Orting, Port Angeles, Port Hadlock, Port Townsend, Poulsbo (2), Redmond, Seattle (2), Sequim, Silverdale, Smokey Point, Snohomish, Stanwood, Sumner, Tacoma, Totem Lake and Woodinville. All of its branches are located in properties owned by FFP, Inc., a real estate holding subsidiary, except for the offices located in Edmonds (lease expires July 2009), one office in Everett (lease expires October 2014), Lake Stevens (lease expires May 2006), Mill Creek (lease expires November 2010), Puyallup (building is owned, land lease expires 2009), Mount Vernon (building owned, land lease expires March 2023), Bainbridge Island (lease expires July 2012) Poulsbo (lease expires on October 2006 on one of the two branches there), Port Angeles (lease expires January 2019), Port Hadlock, (lease expires January 2006), Seattle Metro (lease expires October 2013), Tacoma (lease expires September 2011), Totem Lake (lease expires June 2010) and Milton lease expires March 2006). FFP, Inc. also owns the building and land in South Everett and Sumner where Frontier Bank data processing and operations departments are located. The Bank’s new location in Bellingham was opened in April 2004 and is owned by FFP. Work is currently underway on a second office in Bellingham that is scheduled to open in March 2005 (lease expires October 2009). The Port Hadlock Office was closed in June 2004 and the building is leased until December 2006.
ITEM 3
ITEM 3 - LEGAL PROCEEDINGS
The Corporation is involved in ordinary routine litigation arising in the normal course of business. In the opinion of management, liabilities (if any) arising from such claims will not have a material effect on the business, results of operations or financial condition of the Corporation.
ITEM 4
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SHAREOWNERS
No matters were submitted to shareowners during the fourth quarter of 2004.
PART II
ITEM 5
ITEM 5 - MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED SHAREOWNER MATTERS
(a) Frontier Financial Corporation’s common stock is traded on the Nasdaq market under the symbol FTBK. The table below indicates the high/low trading range of Frontier stock over the last eight quarters:
(b) Frontier Financial Corporation has only one class of stock outstanding, which is common stock. At February 28, 2005 there were 18,837,713 shares outstanding.
(c) The table below indicates the cash dividends paid on each share of its common stock over the last two years:
Issuer Purchases of Equity Securities
Plan No.
Date Announced
Number of Shares
(Units) Approved
Expiration Date
Date Plan expired
during period covered
by above date
Date Plan was
terminated if prior to
expiration
9/16/2004
932,270
9/15/2006
N/A
N/A
ITEM 6
ITEM 6 - SELECTED FINANCIAL DATA
FINANCIAL HIGHLIGHTS
ITEM 7
ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Please see 2004 Annual Report to Shareowners, page 26 through 43.
ITEM 7A
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Please see 2004 Annual Report to Shareowners, pages 31-34.
Please see this Form 10-K, 18-22.
ITEM 8
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
ITEM 9
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A
ITEM 9A - C ONTROLS AND PROCEDURES
The Corporation’s management, including the Corporation’s Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of its disclosure controls and procedures as of December 31, 2004. Based on this evaluation, the Chief Executive Officer and the Chief Financial Officer each concludes that as of December 31, 2004, the Corporation maintained effective disclosure controls and procedures in all material respects, including those to ensure that information required to be disclosed in reports filed or submitted with the SEC is recorded, processed, and reported within the time periods specified by the SEC, and is accumulated and communicated to management, including the Chief Executive Officer and the Chief Financial Officer, as appropriate to allow for timely decisions regarding required disclosure.
There has been no change in the Corporation’s internal control over financial reporting in the period covered by this report that have materially affected, or are reasonably likely to affect, the Corporation’s internal control over financial reporting.
PART III
ITEM 10
ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF FRONTIER FINANCIAL CORPORATION
Please see pages 3 - 5 of 2005 Proxy Statement.
ITEM 11
ITEM 11 - EXECUTIVE COMPENSATION
Please see pages 10 - 11 of 2005 Proxy Statement.
ITEM 12
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREOWNER MATTERS
Please see pages 8 - 9 of 2005 Proxy Statement.
ITEM 13
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Please see page 15 of 2005 Proxy Statement; and,
Note 13, page 20 of 2004 Annual Report to Shareowners.
ITEM 14
ITEM 14 - PRINCIPAL ACCOUNTANT FEES AND SERVICES
Please see page 15 - 16 of 2005 Proxy Statement.
PART IV
ITEM 15
ITEM 15 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of the report:
1. Financial Statements
Financial statements required by Item 8 of this report are incorporated by reference, from the 2004 Annual Report to Shareowners.
3. Exhibits
(b) Reports on Form 8-K:
On October 19, 2004, Form 8-K under Item 2.02 was filed announcing third quarter earnings.
On December 7, 2004, Form 8-K was filed under Item 8.01 announcing that the Corporation will purchase up to 80,000 shares of the common stock of Skagit State Bank.
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: