Item 1 - Business General
Banner Corporation (BANR or the Company) is a bank holding company incorporated in the State of Washington. The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly owned subsidiary, Banner Bank (BB or the Bank). The Bank is a Washington-chartered commercial bank that conducts business from its main office in Walla Walla, Washington and its 49 branch offices and 12 loan production offices located in 23 counties in Washington, Oregon and Idaho. The Company is subject to regulation by the Federal Reserve Board (FRB). The Bank is subject to regulation by the State of Washington Department of Financial Institutions, Division of Banks (Division) and the Federal Deposit Insurance Corporation (FDIC). The Company had total assets of $2.897 billion and total stockholders' equity of $215.2 million at December 31, 2004.
The operating results of the Company depend primarily on its net interest income, which is the difference between interest income on interest-earning assets, consisting of loans and investment securities, and interest expense on interest-bearing liabilities, composed primarily of checking and savings deposits and Federal Home Loan Bank (FHLB) advances. The Company's net income is also significantly affected by provisions for loan losses and the level of its other income, including deposit service charges, loan origination and servicing fees, and gains and losses on the sale of loans and securities, as well as its non-interest operating expenses and income tax provisions. Net income for the year ended December 31, 2004 was $19.3 million, or $1.65 per share on a fully diluted basis. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for more detailed information about the Company's financial performance.
Banner Bank is a regional bank which offers a wide variety of commercial banking services and financial products to both businesses and individuals in its primary market areas. The Bank's primary business is that of a traditional banking institution, accepting deposits and originating loans in locations surrounding its offices in portions of Washington, Oregon and Idaho. The Bank is also an active participant in the secondary market, engaging in mortgage banking operations largely through the origination and sale of one- to four-family residential loans. Lending activities include commercial business and commercial real estate loans, agriculture business loans, construction and land development loans, one- to four-family residential loans and consumer loans. A portion of the Bank's construction and mortgage lending activities are conducted through its subsidiary, Community Financial Corporation (CFC), which is located in the Lake Oswego area of Portland, Oregon. In addition to loans, the Bank maintains a significant portion of its assets in marketable securities. The securities portfolio is heavily weighted toward mortgage-backed securities secured by one- to four-family residential properties. This portfolio also includes a significant amount of U.S. Government agency (including government-sponsored entities) securities, as well as investment grade corporate debt securities and tax-exempt municipal securities primarily issued by entities located in the State of Washington.
Lending Activities
General: All of the Company's lending activities are conducted through the Bank and its subsidiaries. The Bank offers a wide range of loan products to meet the demands of its customers. The Bank originates loans for its own loan portfolio and for sale in the secondary market. Management's strategy has been to maintain a significant percentage of assets in the loan portfolio with more frequent interest rate repricing terms or shorter maturities than traditional long-term fixed-rate mortgage loans. As part of this effort, the Bank has developed a variety of floating or adjustable interest rate products that correlate more closely with the Bank's cost of funds. However, in response to customer demand, the Bank continues to originate fixed-rate loans, including fixed interest rate mortgage loans with terms of up to 30 years. The relative amount of fixed-rate loans and adjustable-rate loans that can be originated at any time is largely determined by the demand for each in a competitive environment.
Historically, lending activities have been primarily directed toward the origination of real estate and commercial loans. Real estate lending activities have been significantly focused on residential construction and first mortgages on owner occupied, one- to four-family residential properties. To an increasing extent in recent years, lending activities have also included the origination of multifamily and commercial real estate loans. Commercial lending has been directed toward meeting the credit and related deposit needs of various small- to medium-sized business and agri-business borrowers operating in the Bank's primary market areas. During the past two and one-half years, the Bank has significantly added to its resources engaged in commercial lending, including senior credit administration personnel and experienced officers focused on middle market corporate lending opportunities. The Bank has also recently increased its emphasis on consumer lending. While continuing its commitment to construction and residential lending, management expects commercial lending, including commercial real estate, agricultural and consumer lending to become increasingly important activities for the Bank.
At December 31, 2004, the Bank's net loan portfolio totaled $2.063 billion. For additional information concerning the Bank's loan portfolio, see Item 7, "Management's Discussion and Analysis of Financial Condition-Comparison of Financial Condition at December 31, 2004 and 2003-Loans/Lending." See also Table 5 contained therein, which sets forth the composition of the Company's loan portfolio, and Tables 6 and 6(a), which contain information regarding the loans maturing in the Company's portfolio.
One- to Four-Family Residential Real Estate Lending: The Bank originates loans secured by first mortgages on one- to four-family residences and loans for the construction of one- to four-family residences in the communities where it has full service branches. In addition, the Bank operates real estate loan production offices in Bellevue, Puyallup, Kennewick, Moses Lake, Burlington and Oak Harbor, Washington. The Bank's mortgage lending subsidiary, CFC, provides residential and construction lending primarily in the Bend and Portland, Oregon and Pasco and Vancouver, Washington market areas. At December 31, 2004, $308.0 million, or 14.7% of the Company's loan portfolio, consisted of permanent loans on one- to four-family residences.
The Bank and CFC offer fixed- and adjustable-rate mortgages (ARMs) at rates and terms competitive with market conditions. Most ARM products offered adjust annually after an initial period ranging from one to five years, subject to a limitation on the annual change of 1.0% to 2.0% and a
<PAGE>
lifetime limitation of 5.0% to 6.0%. Generally, these ARM products adjust based upon the weekly average yield on U.S. Treasury securities adjusted to a constant maturity of one year plus a margin of 2.75% to 3.25%. ARM loans held in the Bank's portfolio do not permit negative amortization of principal and carry no prepayment restrictions. The retention of ARM loans in the Bank's loan portfolio can help reduce the Company's exposure to changes in interest rates. However, borrower demand for ARM loans versus fixed-rate mortgage loans is a function of the level of interest rates, the expectations of changes in the level of interest rates and the difference between the initial interest rates and fees charged for each type of loan. In recent years, borrower demand for ARM loans has been limited and the Bank has chosen not to aggressively pursue ARM loans by offering minimally profitable deeply discounted teaser rates. As a result, ARM loans have represented only a small portion of loans originated during this period. However, during the year ended December 31, 2004, the Bank did experience an increase in the origination of hybrid-ARM loans. Hybrid-ARM loans generally adjust annually following an initial fixed-rate period ranging from three to ten years using indices, margins and adjustment limitations similar to other ARM products. Fixed rate loans generally are offered on a fully amortizing basis for terms ranging from 15 to 30 years at interest rates and fees that reflect current secondary market pricing.
The Bank's residential loans are generally underwritten and documented in accordance with the guidelines established by the Federal Home Loan Mortgage Corporation (Freddie Mac or FHLMC) and the Federal National Mortgage Corporation (Fannie Mae or FNMA). Government insured loans are generally underwritten and documented in accordance with the guidelines established by the Department of Housing and Urban Development (HUD) and the Veterans Administration (VA). In the loan approval process, the Bank assesses the borrower's ability to repay the loan, the adequacy of the proposed security, the employment stability of the borrower and the credit worthiness of the borrower. Generally, the Bank lends up to 95% of the lesser of the appraised value of the property or purchase price of the property on conventional loans, although higher loan-to-value ratios are available on certain government insured programs. The Bank usually requires private mortgage insurance on residential loans with a loan-to-value ratio at origination exceeding 80%.
The Bank and CFC sell residential loans on either a servicing-retained or servicing-released basis. The decision to hold or sell loans is based on asset/liability management goals and policies and market conditions. During the past three years, the Bank has sold a significant portion of its conventional residential mortgage originations and nearly all of its government insured loans into the secondary market.
Construction and Land Lending: The Bank invests a significant portion of its loan portfolio in residential construction loans to professional home builders. To a lesser extent, the Bank also originates land loans and construction loans for commercial and multifamily real estate. At December 31, 2004, construction and land loans totaled $506.1 million (including $175.9 million of land or land development loans and $68.1 million of commercial and multifamily real estate construction loans), or 24.2% of total loans of the Company. Residential construction lending is a primary focus of the Bank's subsidiary, CFC, and the Company's largest concentration of construction and development loans is in the Portland/Vancouver market area. The Bank also has a significant amount of construction loans for properties in the Puget Sound region and in the Tri-Cities market in Washington State.
Construction and land lending afford the Bank the opportunity to achieve higher interest rates and fees with shorter terms to maturity than does one- to four-family permanent mortgage lending. Construction and land lending, however, are generally considered to involve a higher degree of risk than one- to four-family permanent mortgage lending because of the inherent difficulty in estimating both a property's value at completion of the project and the estimated cost of the project. If the estimate of construction cost proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to permit completion of the project. If the estimate of value upon completion proves to be inaccurate, the Bank may be confronted at, or prior to, the maturity of the loan with a project the value of which is insufficient to assure full repayment. Disagreements between borrowers and builders and the failure of builders to pay subcontractors may also jeopardize projects. Loans to builders to construct homes for which no purchaser has been identified carry additional risk because the payoff for the loan is dependent on the builder's ability to sell the property before the construction loan is due. The Bank addresses these risks by adhering to strict underwriting policies, disbursement procedures and monitoring practices.
Construction loans made by the Bank include those with a sale contract or permanent loan in place for the finished homes and those for which purchasers for the finished homes may be identified either during or following the construction period. The Bank monitors the number of unsold homes in its construction loan portfolio and generally maintains the portfolio so that approximately 25% of its construction loans are secured by homes with a sale contract in place. The maximum number of speculative loans approved for each builder is based on a combination of factors, including the financial capacity of the builder, the market demand for the finished product and the ratio of sold to unsold inventory the builder maintains. The Bank has chosen to diversify the risk associated with speculative construction lending by doing business with a large number of small and mid-sized builders spread over a relatively large geographic area.
Loans for the construction of one- to four-family residences are generally made for a term of twelve months. The Bank's loan policies include maximum loan-to-value ratios of up to 80% for speculative loans. Individual speculative loan requests are supported by an independent appraisal of the property, a set of plans, a cost breakdown and a completed specifications form. All speculative construction loans must be approved by senior loan officers.
To a lesser extent, the Bank makes land loans to developers, builders and individuals to finance the acquisition and/or development of improved lots or unimproved land. In making land loans, the Bank follows underwriting policies and disbursement and monitoring procedures similar to those for construction loans. The initial term on land loans is typically one to three years with interest only payments, payable monthly, and provisions for principal reduction as lots are sold and released from the lien of the mortgage.
The Bank regularly monitors the construction and land loan portfolios and the economic conditions and housing inventory in each of its markets and will decrease this type of lending if it perceives unfavorable market conditions. The Bank believes that the underwriting policies and internal monitoring systems it has in place mitigate many of the risks inherent in construction and land lending.
<PAGE>
Commercial and Multifamily Real Estate Lending: The Bank also originates loans secured by multifamily and commercial real estate including, as noted above, loans for construction of multifamily and commercial real estate projects. At December 31, 2004, the Company's loan portfolio included $107.7 million in multifamily and $547.6 million in commercial real estate loans. Multifamily and commercial real estate lending affords the Bank an opportunity to receive interest at rates higher than those generally available from one- to four-family residential lending. However, loans secured by multifamily and commercial properties are generally greater in amount, more difficult to evaluate and monitor and, therefore, riskier than one- to four-family residential mortgage loans. Because payments on loans secured by multifamily and commercial properties are often dependent on the successful operation and management of the properties, repayment of these loans may be affected by adverse conditions in the real estate market or the economy. In all multifamily and commercial real estate lending, the Bank considers the location, marketability and overall attractiveness of the properties. The Bank's current underwriting guidelines for multifamily and commercial real estate loans require an appraisal from a qualified independent appraiser and an economic analysis of each property with regard to the annual revenue and expenses, debt service coverage and fair value to determine the maximum loan amount. In the approval process the Bank assesses the borrowers' willingness and ability to repay the loan and the adequacy of the collateral in relation to the loan amount.
Multifamily and commercial real estate loans originated by the Bank are both fixed- and adjustable-rate loans generally with intermediate terms of five to ten years. Most multifamily and commercial real estate loans originated in the past five years are linked to various U.S. Treasury indices or certain prime rates. Rates on these adjustable-rate loans generally adjust with a frequency of one to five years after an initial fixed-rate period ranging from one to ten years. Rate adjustments for some of the more seasoned adjustable-rate loans in the portfolio predominantly reflect changes in the FHLB National Monthly Median Cost of Funds index. The Bank's commercial real estate portfolio consists of loans on a variety of property types with no large concentrations by property type or location. At December 31, 2004, multifamily and commercial real estate loans comprised 31.3% of the Company's total loans.
Commercial Business Lending: The Bank is active in small- to medium-sized business lending, including origination of loans guaranteed by the Small Business Administration (SBA), and has engaged to a lesser extent in agricultural lending primarily by providing crop production loans. Bank officers have devoted a great deal of effort to developing customer relationships and the ability to serve these types of borrowers. Management believes that many large banks have neglected these lending markets, which has contributed to the Bank's success. Also, during the past two and one-half years, the Bank has added experienced officers and staff focused on middle market corporate lending opportunities for borrowers with credit needs generally in the $3 million to $15 million range. Management intends to leverage the past success of these officers with local decision making ability to continue to expand this market niche. In addition to providing earning assets, it is anticipated that this type of lending will increase the Bank's deposit base. Expanding commercial lending and related commercial banking services is currently an area of significant effort at the Bank and staffing has been increased in the areas of credit administration, business development, and loan and deposit operations.
Commercial business loans may entail greater risk than residential mortgage loans. Commercial business loans may be unsecured or secured by special purpose or rapidly depreciating assets, such as equipment, inventory and receivables, which may not provide an adequate source of repayment on defaulted loans. In addition, commercial business loans are dependent on the borrower's continuing financial strength and management ability, as well as market conditions for various products, services and commodities. For these reasons, commercial business loans generally provide higher yields than residential loans but also require more administrative and management attention. Loan terms, including the fixed or adjustable interest rate, the loan maturity and the collateral considerations, vary significantly and are negotiated on an individual loan basis.
The Bank underwrites its commercial business loans on the basis of the borrower's cash flow and ability to service the debt from earnings rather than on the basis of the underlying collateral value. The Bank seeks to structure these loans so that they have more than one source of repayment. The borrower is required to provide the Bank with sufficient information to allow the Bank to make its lending determination. In most instances, this information consists of at least three years of financial statements, tax returns, a statement of projected cash flows, current financial information on any guarantor and information about the collateral. Loans to closely held businesses typically require personal guarantees by the principals. The Bank's commercial loan portfolio is geographically dispersed across the market areas serviced by its branch network and there are no significant concentrations by industry or products.
The Bank's commercial business loans may be structured as term loans or as lines of credit. Commercial business term loans are generally made to finance the purchase of fixed assets and have maturities of five years or less. Commercial business lines of credit are typically made for the purpose of providing working capital and are usually approved with a term of one year. Adjustable- or floating-rate loans are generally tied to various prime rate and LIBOR indices. At December 31, 2004, commercial loans totaled $395.2 million, or 18.9% of the Company's total loans.
Agricultural Lending: Agriculture is a major industry in many eastern Washington, eastern Oregon and southern Idaho locations. While agricultural loans are not a large part of the portfolio, the Bank intends to continue to make agricultural loans to borrowers with a strong capital base, sufficient management depth, proven ability to operate through agricultural cycles, reliable cash flows and adequate financial reporting. Payments on agricultural loans depend, to a large degree, on the results of operations of the related farm entity. The repayment is also subject to other economic and weather conditions as well as market prices for agricultural products, which can be highly volatile. At December 31, 2004, agricultural business loans, including collateral secured loans to purchase farm land and equipment, totaled $148.3 million, or 7.1% of the loan portfolio.
Agricultural operating loans generally are made as a percentage of the borrower's anticipated income to support budgeted operating expenses. These loans generally are secured by a blanket lien on all crops, livestock, equipment, accounts and products and proceeds thereof. In the case of crops, consideration is given to projected yields and prices from each commodity. The interest rate is normally floating based on the prime rate as published in The Wall Street Journal, plus a negotiated margin. Because these loans are made to finance a farm or ranch's annual operations, they
<PAGE>
are written on a one-year review and renewable basis. The renewal is dependent upon the prior year's performance and the forthcoming year's projections as well as the overall financial strength of the borrower. The Bank carefully monitors these loans and related variance reports on income and expenses compared to budget estimates. To meet the seasonal operating needs of a farm, borrowers may qualify for single payment notes, revolving lines of credit and/or non-revolving lines of credit.
In underwriting agricultural operating loans, the Bank considers the cash flow of the borrower based upon the expected operating results as well as the value of collateral used to secure the loans. Collateral generally consists of cash crops produced by the farm, such as grains, fruit, grass seed, peas, sugar beets, mint, onions, potatoes, corn and alfalfa or livestock. In addition to considering cash flow and obtaining a blanket security interest in the farm's cash crop, the Bank may also collateralize an operating loan with the farm's operating equipment, breeding stock, real estate and federal agricultural program payments to the borrower.
The Bank also originates loans to finance the purchase of farm equipment. Loans to purchase farm equipment are made for terms of up to seven years. The Bank also originates agricultural real estate loans secured primarily by first liens on farmland and improvements thereon located in the Bank's market area, and generally only made to service the needs of the Bank's existing customers. Loans are written in amounts up to 50% to 75% of the tax assessed or appraised value of the property at terms ranging from five to 20 years. These loans have interest rates that generally adjust at least every five years based typically upon a U.S. Treasury index plus a negotiated margin. Fixed-rate loans are granted on terms generally not to exceed five years with rates established at inception based on margins set above the current five-year U.S. Treasury Note or another generally accepted index. In originating agricultural real estate loans, the Bank considers the debt service coverage of the borrower's cash flow, the appraised value of the underlying property, the experience and knowledge of the borrower, and the borrower's past performance with the Bank and/or market area. These loans normally are not made to start-up businesses but are generally reserved for existing customers with substantial equity and a proven history.
Among the more common risks to agricultural lending can be weather conditions and disease. These risks can be mitigated through multi-peril crop insurance. Commodity prices also present a risk, which may be reduced by the use of set price contracts. Normally, required beginning and projected operating margins provide for reasonable reserves to offset unexpected yield and price deficiencies. In addition to these risks, the Bank also considers management succession, life insurance and business continuation plans when evaluating agricultural loans.
Consumer and Other Lending: The Bank originates a variety of consumer loans, including home equity lines of credit, automobile loans and loans secured by deposit accounts. While consumer lending has traditionally been a small part of the Bank's business, with loans made primarily to accommodate its existing customer base, it has received renewed emphasis in 2003 and 2004 and management anticipates increased activity in future periods. Despite increased marketing efforts and strong borrower demand, consumer loans increased only modestly in the past year, largely as a result of accelerated prepayments in the current very low interest rate environment. At December 31, 2004, the Company had $79.8 million, or 3.8% of its loans receivable, in outstanding consumer related loans, an increase of $12.7 million or 18.8% from December 31, 2003.
Similar to commercial loans, consumer loans often entail greater risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans. These loans may also give rise to claims and defenses by a consumer loan borrower against an assignee of such loans such as the Bank, and a borrower may be able to assert against the assignee claims and defenses that it has against the seller of the underlying collateral.
Loan Solicitation and Processing: The Bank originates real estate loans by direct solicitation of real estate brokers, builders, depositors and walk-in customers. Loan applications are taken by the Bank's loan officers and are processed in each branch location. Most underwriting and loan administration functions are performed by loan personnel at central locations.
Loan officers solicit commercial and agricultural business loans through call programs focused on local businesses and farmers. While commercial loan officers are delegated reasonable commitment authority based upon their qualifications, credit decisions on significant commercial and agricultural loans are made by senior loan officers or in certain instances by the Board of Directors of the Bank or the Company.
Consumer loans are originated through various marketing efforts directed primarily toward existing deposit and loan customers of the Bank. Consumer loan applications may be processed at branch locations or by administrative personnel at the Bank's main office.
Loan Originations, Sales and Purchases
While the Bank originates a variety of loans, its ability to originate each type of loan is dependent upon the relative customer demand and competition in each market it serves. For the years ended December 31, 2004, 2003 and 2002, the Bank originated loans, net of repayments, of $696.3 million, $721.5 million and $368.6 million, respectively.
In recent years, the Bank generally has sold most of its newly originated fixed-rate one- to four-family residential mortgage loans and a portion of its SBA guaranteed loans to secondary market purchasers as part of its interest rate risk management strategy. Proceeds from sales of loans by the Company for the years ended December 31, 2004, 2003 and 2002, totaled $338.4 million, $572.2 million and $457.7 million, respectively. Sales of
<PAGE>
loans generally are beneficial to the Bank because these sales may generate income at the time of sale, provide funds for additional lending and other investments and increase liquidity. The Company sells loans on both a servicing-retained and a servicing-released basis. All loans are sold without recourse. See "Loan Servicing." At December 31, 2004, the Company had $2.1 million in loans held for sale.
The Bank purchases whole loans and loan participation interests primarily during periods of reduced loan demand in its primary market area. Any such purchases are made consistent with the Bank's underwriting standards; however, the loans may be located outside of the Bank's normal lending area. During the years ended December 31, 2004, 2003 and 2002, the Bank purchased $18.2 million, $34.5 million and $52.0 million, respectively, of loans and loan participation interests.
Loan Servicing
The Bank receives fees from a variety of institutional owners in return for performing the traditional services of collecting individual payments and managing portfolios of sold loans. At December 31, 2004, the Bank was servicing $250.7 million of loans for others. Loan servicing includes processing payments, accounting for loan funds and collecting and paying real estate taxes, hazard insurance and other loan-related items such as private mortgage insurance. In addition to earning fee income, the Bank retains certain amounts in escrow for the benefit of the lender for which the Bank incurs no interest expense but is able to invest the funds into earning assets. At December 31, 2004, the Bank held $2.6 million in escrow for its portfolio of loans serviced for others. The loan servicing portfolio at December 31, 2004 was composed primarily of $185.6 million of Freddie Mac mortgage loans, $3.3 million of Fannie Mae mortgage loans and $16.5 million of Oregon Housing Division loans. The remaining balance of the loan servicing portfolio at December 31, 2004 consisted of loans serviced for a variety of private investors. The portfolio included loans secured by property located primarily in the states of Washington and Oregon. For the year ended December 31, 2004, $1.7 million of loan servicing fees, net of $489,000 of servicing rights amortization, was recognized in operations.
Mortgage Servicing Rights: The Bank records mortgage servicing rights (MSRs) with respect to loans it originates and sells in the secondary market on a servicing-retained basis. The cost of MSRs is capitalized and amortized in proportion to, and over the period of, the estimated future net servicing income. For the years ended December 31, 2004, 2003 and 2002, the Company capitalized $78,000, $1,576,000, and $1,046,000, respectively, of MSRs relating to loans sold with servicing retained. No MSRs were purchased in those periods. Amortization of MSRs for the years ended December 31, 2004, 2003 and 2002, was $489,000, $1,021,000, and $686,000, respectively. Management periodically evaluates the estimates and assumptions used to determine the carrying values of MSRs and the amortization of MSRs. These carrying values are adjusted when the valuation indicates the carrying value is impaired. MSRs generally are adversely affected by current and anticipated prepayments resulting from decreasing interest rates. At December 31, 2004, MSRs were carried at a value of $1,565,000, net of amortization.
Asset Quality
Classified Assets: State and federal regulations require that the Bank review and classify its problem assets on a regular basis. In addition, in connection with examinations of insured institutions, state and federal examiners have authority to identify problem assets and, if appropriate, require them to be classified. The Bank's Credit Policy Division reviews detailed information with respect to the composition and performance of the loan portfolio, including information on risk concentrations, delinquencies and classified assets. The Credit Policy Division approves all recommendations for new classified assets or changes in classifications, and develops and monitors action plans to resolve the problems associated with the assets. The Credit Policy Division also approves recommendations for establishing the appropriate level of the allowance for loan losses. Significant problem loans are transferred to the Bank's Special Assets Department for resolution or collection activities. The Board of Directors is given a detailed report on classified assets and asset quality at least quarterly.
For additional information with respect to asset quality and non-performing loans, see Item 7, "Management's Discussion and Analysis of Financial Condition-Comparison of Financial Condition at December 31, 2004 and 2003-Asset Quality," and Table 10 contained therein.
Allowance for Loan Losses: In originating loans, the Company recognizes that losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the credit worthiness of the borrower over the term of the loan, general economic conditions and, in the case of a secured loan, the quality of the security for the loan. As a result, the Company maintains an allowance for loan losses consistent with the generally acceptable accounting principles (GAAP) guidelines. The Company increases its allowance for loan losses by charging provisions for possible loan losses against the Company's income. The allowance for losses on loans is maintained at a level which, in management's judgment, is sufficient to provide for estimated losses based on evaluating known and inherent risks in the loan portfolio and upon continuing analysis of the factors underlying the quality of the loan portfolio.
At December 31, 2004, the Company had an allowance for loan losses of $29.6 million, which represented 1.41% of net loans and 186% of non-performing loans compared to 1.51% and 92%, respectively, at December 31, 2003. For additional information concerning the Company's allowance for loan losses, see Item 7, "Management's Discussion and Analysis of Financial Condition-Comparison of Results of Operations for the Years Ended December 31, 2004 and 2003-Provision and Allowance for Loan Losses," and Tables 11 and 12 contained therein.
Investment Activities
Under Washington state law, banks are permitted to invest in various types of marketable securities. Authorized securities include but are not limited to U.S. Treasury obligations, securities of various federal agencies (including government-sponsored entities), mortgage-backed securities,
<PAGE>
certain certificates of deposit of insured banks and savings institutions, bankers' acceptances, repurchase agreements, federal funds, commercial paper, corporate debt and equity securities and obligations of states and their political subdivisions. The Bank's investment policies are designed to provide and maintain adequate liquidity and to generate favorable rates of return without incurring undue interest rate or credit risk. The Bank's policies generally limit investments to U.S. Government and government agency (including government-sponsored entities) securities, municipal bonds, certificates of deposit, marketable corporate debt obligations and mortgage-backed securities. Investment in mortgage-backed securities includes those issued or guaranteed by Freddie Mac, Fannie Mae, Government National Mortgage Association (Ginnie Mae or GNMA) and privately-issued mortgage-backed securities that have an AA credit rating or higher, as well as collateralized mortgage obligations (CMOs). A high credit rating indicates only that the rating agency believes there is a low risk of loss or default. However, all of the Bank's investment securities, including those that have high credit ratings, are subject to market risk in so far as a change in market rates of interest or other conditions may cause a change in an investment's earning performance and/or market value.
At December 31, 2004, the Company's consolidated investment portfolio totaled $597.7 million and consisted principally of U.S. Government agency obligations, mortgage-backed securities, municipal bonds, corporate debt obligations, and stock of Fannie Mae and Freddie Mac. From time to time, investment levels may be increased or decreased depending upon yields available on investment alternatives, and management's projections as to the demand for funds to be used in the Bank's loan originations, deposits and other activities. During the year ended December 31, 2004, investments and securities decreased by $104.4 million. Holdings of mortgage-backed securities decreased $83.0 million to $332.2 million, and U.S. Treasury and agency obligations decreased $21.4 million to $139.9 million. Ownership of corporate and other securities decreased $8.3 million to $73.7 million, while municipal bonds increased $8.3 million to $52.0 million.
The Company invests significantly in mortgage-backed securities. The Company's mortgage-backed securities investments generally are collateralized by loans on one- to four-family residential real estate. The average life of a mortgage-backed security is usually less than its stated maturity due to principal amortization and prepayments of the underlying mortgages. Prepayments that are faster than anticipated may shorten the life of the security and may result in rapid amortization of premiums or discounts and thereby affect the net yield on these securities. Although prepayments of underlying mortgages depend on many factors, including the type of mortgages, the coupon rate, the age of mortgages, the geographical location of the underlying real estate collateralizing the mortgages and general levels of market interest rates, the difference between the interest rates on the underlying mortgages and the prevailing mortgage interest rates generally is the most significant determinant of the rate of prepayments. During periods of declining mortgage interest rates, if the coupon rate of the underlying mortgage loans exceeds the prevailing market interest rates offered for mortgage loans, refinancing generally increases and accelerates the prepayment of the underlying mortgage loans and the related security. Under such circumstances, the Company may be subject to reinvestment risk because, to the extent that the Company's mortgage-backed securities amortize or prepay faster than anticipated, the Company may not be able to reinvest the proceeds of the repayments and prepayments at a comparable rate. In contrast to mortgage-backed securities in which cash flow is received (and hence, prepayment risk is shared) pro rata by all securities holders, the cash flow from the mortgage loans or mortgage-backed securities underlying CMOs is segmented and paid in accordance with a predetermined priority to investors holding various tranches of the securities or obligations. A particular tranche of a CMO may therefore carry prepayment risk that differs from that of both the underlying collateral and other tranches. At December 31, 2004, the Company held CMOs with a net carrying value of $163.5 million, including $51.9 million of privately-issued CMOs.
For detailed information on the Company's investment securities, see Item 7, "Management's Discussion and Analysis of Financial Condition-Comparison of Financial Condition at December 31, 2004 and 2003-Investments," and Tables 1, 2, 3 and 4 contained therein.
Off-Balance-Sheet Derivatives: Derivatives include "off-balance-sheet" financial products whose value is dependent on the value of an underlying financial asset, such as a stock, bond, foreign currency, or a reference rate or index. Such derivatives include "forwards," "futures," "options" or "swaps." The Company and the Bank generally have not invested in "off-balance-sheet" derivative instruments, although investment policies authorize such investments. However, as a part of mortgage banking activities, the Bank issues "rate lock" commitments to borrowers and obtains offsetting "best efforts" delivery commitments from purchasers of loans. While not providing any trading or net settlement mechanisms, these off-balance-sheet commitments do have many of the prescribed characteristics of derivatives and as a result are accounted for as such in accordance with Statement of Financial Accounting Standards (SFAS) No. 133, as amended. Accordingly, on December 31, 2004, the Company recorded an asset of $50,000 and a liability of $50,000, representing the estimated market value of those commitments. On December 31, 2004, the Company and the Bank had no other investment related off-balance-sheet derivatives.
Deposit Activities and Other Sources of Funds
General: Deposits, FHLB advances (or borrowings) and loan repayments are the major sources of the Bank's funds for lending and other investment purposes. Scheduled loan repayments are a relatively stable source of funds, while deposit inflows and outflows and loan prepayments are influenced by general economic, interest rate and money market conditions and may vary significantly. Borrowings may be used on a short-term basis to compensate for reductions in the availability of funds from other sources. Borrowings may also be used on a longer-term basis for general business purposes, including funding loans and investments.
The Bank competes with other financial institutions and financial intermediaries in attracting deposits. There is strong competition for transaction balances and savings deposits from commercial banks, credit unions and nonbank corporations, such as securities brokerage companies, mutual funds and other diversified companies, some of which have nationwide networks of offices. Much of the focus of the Bank's recent branch expansion, relocations and renovation has been directed toward attracting additional deposit customer relationships and balances.
<PAGE>
Deposit Accounts: The Bank generally attracts deposits from within its primary market areas by offering a broad selection of deposit instruments, including demand checking accounts, negotiable order of withdrawal (NOW) accounts, money market deposit accounts, regular savings accounts, certificates of deposit, cash management services and retirement savings plans. Deposit account terms vary according to the minimum balance required, the time periods the funds must remain on deposit and the interest rate, among other factors. In determining the terms of deposit accounts, the Bank considers current market interest rates, profitability to the Bank, matching deposit and loan products and customer preferences and concerns. At December 31, 2004, the Bank had $1.926 billion of deposits, including $870.7 million of transaction and savings accounts and $1.055 billion in time deposits. For additional information concerning the Bank's deposit accounts, see Item 7, "Management's Discussion and Analysis of Financial Condition-Comparison of Financial Condition at December 31, 2004 and 2003-Deposit Accounts." See also Table 7 contained therein, which sets forth the balances of deposits in the various types of accounts offered by the Bank, and Table 8, which sets forth the amount of the Bank's certificates of deposit greater than $100,000 by time remaining until maturity as of December 31, 2004.
Borrowings: While deposits are the primary source of funds for the Bank's lending and investment activities and for its general business purposes, the Bank also uses borrowings to supplement its supply of lendable funds, to meet deposit withdrawal requirements and to more efficiently leverage its capital position. The FHLB-Seattle serves as the Bank's primary borrowing source. The FHLB-Seattle provides credit for member financial institutions. As a member, the Bank is required to own capital stock in the FHLB-Seattle and is authorized to apply for advances on the security of that stock and certain of its mortgage loans and securities provided certain credit worthiness standards have been met. Limitations on the amount of advances are based on the financial condition of the member institution and the adequacy of collateral pledged to secure the credit. At December 31, 2004, the Bank had $583.6 million of combined borrowings from the FHLB-Seattle at a weighted average rate of 3.77%. At that date, the Bank had been authorized by the FHLB-Seattle to borrow up to $870.2 million under a blanket floating lien security agreement. The Bank also has access to additional short-term funds through a $26.0 million commercial bank credit line. At December 31, 2004, the Bank had no short-term funds borrowed on this commercial banking credit line. For additional information concerning the Company's borrowings from the FHLB-Seattle, see Item 7, "Management's Discussion and Analysis of Financial Condition-Comparison of Financial Condition at December 31, 2004 and 2003-Borrowings," Table 9 contained therein, and Note 12 of the Notes to the Consolidated Financial Statements.
The Bank issues retail repurchase agreements, generally due within 90 days, as an additional source of funds. At December 31, 2004, the Bank had issued retail repurchase agreements totaling $38.4 million, with a weighted average interest rate of 1.49%, which were secured by a pledge of certain Fannie Mae, Ginnie Mae and Freddie Mac mortgage-backed securities with a market value of $41.5 million.
The Bank also borrows funds through the use of secured wholesale repurchase agreements with securities brokers. The broker holds Bank securities while the Bank continues to receive the principal and interest payments from the security. The Bank's outstanding borrowings at December 31, 2004 under wholesale repurchase agreements totaled $29.8 million, with a weighted average rate of 2.38%, and were collateralized by mortgage-backed securities with a fair value of $31.1 million.
In addition to borrowings at the Bank, the Company has generated funding by issuing $70 million of trust preferred securities (TPS). The TPS were issued in 2002, 2003 and 2004 by special purpose business trusts owned by the Company and were sold to pooled investment vehicles sponsored and marketed by investment banking firms. The junior subordinated debentures associated with the TPS have been recorded as liabilities on the Company's statement of financial condition, but the TPS qualify as Tier 1 capital for regulatory capital purposes. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations-Recent Developments and Significant Events," and Note 13 of the Notes to the Consolidated Financial Statements for additional information with respect to the TPS.
For additional information about deposits and other sources of funds, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources," and Notes 11, 12 and 13 of the Notes to the Consolidated Financial Statements contained in Item 8.
Personnel
As of December 31, 2004, the Bank and its subsidiaries had 735 full-time and 69 part-time employees. The Company has no employees except for those who are also employees of the Bank and its subsidiaries. The employees are not represented by a collective bargaining unit. The Company believes its relationship with its employees is good.
Taxation
Federal Taxation
General: For tax reporting purposes, the Company and the Bank report their income on a calendar year basis using the accrual method of accounting and file consolidated income tax returns. The Company and the Bank are subject to federal income taxation in the same manner as other corporations with some exceptions, including particularly the reserve for bad debts discussed below. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to the Company and the Bank. Reference is made to Note 14 of the Notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K for additional information concerning the income taxes payable by the Company.
Provisions of the Small Business Job Protection Act of 1996 (the Job Protection Act) significantly altered the Company's tax bad debt deduction method and the circumstances that would require a tax bad debt reserve recapture. Prior to enactment of the Job Protection Act, savings institutions (the Bank was previously chartered as a savings institution) were permitted to compute their tax bad debt deduction through use of
<PAGE>
either the reserve method or the percentage of taxable income method. The Job Protection Act repealed both of these methods for large savings institutions and allows bad debt deductions based only on actual current losses. While repealing the reserve method for computing tax bad debt deductions, the Job Protection Act allows savings institutions to retain their existing base year bad debt reserves but requires that reserves in excess of the balance at December 31, 1987, be recaptured into taxable income over six years. As of December 31, 2003, the reserves in excess of the base year (December 31, 1987) had been fully recaptured into taxable income.
The base year reserve is recaptured into taxable income only in limited situations, such as in the event of certain excess distributions, complete liquidation or disqualification as a bank. None of the limited circumstances requiring recapture are contemplated by the Company. The amount of the Company's tax bad debt reserves subject to recapture in these circumstances was approximately $5.3 million at December 31, 2004. As a result of the remote nature of events that may trigger the recapture provisions, no tax liability has been established in the accompanying Consolidated Financial Statements.
In addition, as a result of certain acquisitions, the Company is required to recapture certain tax bad debt reserves of the acquired business. The Company has elected to recapture these reserves into income over a four-year period using the deferral method. The recapture does not result in a charge to earnings as the Company provided for this liability on the acquisition date.
Dividends-Received Deduction and Other Matters: The Company may exclude from its income 100% of dividends received from the Bank as a member of the same affiliated group of corporations. The corporate dividends-received deduction is generally 70% in the case of dividends received from unaffiliated corporations with which the Company and the Bank will not file a consolidated tax return, except that if the Company or the Bank own more than 20% of the stock of a corporation distributing a dividend, then 80% of any dividends received may be deducted.
There have not been any Internal Revenue Service audits of the Company's or the Bank's federal income tax returns during the past five years.
State Taxation
Washington Taxation: The Company and the Bank are subject to a Business and Occupation (B&O) tax which is imposed under Washington law at the rate of 1.50% of gross receipts; however, interest received on loans secured by mortgages or deeds of trust on residential properties, residential mortgage-backed securities, and certain U.S. Government and agency securities is not subject to such tax. The Company's B&O tax expense was $1.1 million, $1.0 million and $943,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
Oregon and Idaho Taxation: Corporations with nexus in the states of Oregon and Idaho are subject to a corporate level income tax. The Company's operations in those states resulted in corporate income taxes of approximately $497,000, $223,000 and $108,000 (net of federal tax benefit) for the years ended December 31, 2004, 2003 and 2002, respectively. As the Company's operations in these states increase, the state income tax provision will have an increasing effect on the Company's effective tax rate and results of operations.
Environmental Regulation
The business of the Company is affected from time to time by federal and state laws and regulations relating to hazardous substances. Under the federal Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), owners and operators of properties containing hazardous substances may be liable for the costs of cleaning up the substances. CERCLA and similar state laws can affect the Bank both as an owner of branches and other properties used in its business and as a lender holding a security interest in property which is found to contain hazardous substances. While CERCLA contains an exemption for holders of security interests, the exemption is not available if the holder participates in the management of a property, and some courts have broadly defined what constitutes participation in management of property. Moreover, CERCLA and similar state statutes can affect the Bank's decision whether or not to foreclose on a property. Before foreclosing on commercial real estate, the Bank's general policy is to obtain an environmental report, thereby increasing the costs of foreclosure. In addition, the existence of hazardous substances on a property securing a troubled loan may cause the Bank to elect not to foreclose on the property, thereby reducing the Bank's flexibility in handling the loan.
Competition
The Bank encounters significant competition both in attracting deposits and in originating loans. The Bank's most direct competition for deposits has come historically from other commercial and savings banks, savings associations and credit unions in its market areas. The Bank also experiences competition from securities firms, insurance companies, money market and mutual funds, and other investment vehicles. The Bank expects continued strong competition from such financial institutions and investment vehicles in the foreseeable future. The ability of the Bank to attract and retain deposits depends on its ability to provide transaction services and investment opportunities that satisfy the requirements of depositors. The Bank competes for deposits by offering a variety of accounts and financial services with competitive rates and terms, at convenient locations and business hours, and delivered with a high level of personal service and expertise.
Competition for loans comes principally from other commercial banks, loan brokers, mortgage banking companies, savings banks and credit unions. The competition for loans is intense as a result of the large number of institutions competing in the Bank's market areas. The Bank competes for loans primarily through offering competitive rates and fees and providing timely decisions and excellent service to borrowers.
<PAGE>
Regulation
The Bank
General: As a state-chartered, federally insured commercial bank, the Bank is subject to extensive regulation and must comply with various statutory and regulatory requirements, including prescribed minimum capital standards. The Bank is regularly examined by the FDIC and state banking regulators and files periodic reports concerning its activities and financial condition with its regulators. The Bank's relationship with depositors and borrowers also is regulated to a great extent by both federal and state law, especially in such matters as the ownership of deposit accounts and the form and content of mortgage and other loan documents.
Federal and state banking laws and regulations govern all areas of the operation of the Bank, including reserves, loans, investments, deposits, capital, issuance of securities, payment of dividends and establishment of branches. Federal and state bank regulatory agencies also have the general authority to limit the dividends paid by insured banks and bank holding companies if such payments should be deemed to constitute an unsafe and unsound practice. The respective primary federal regulators of the Company and the Bank have authority to impose penalties, initiate civil and administrative actions and take other steps intended to prevent banks from engaging in unsafe or unsound practices.
State Regulation and Supervision: As a Washington state-chartered commercial bank with branches in the States of Oregon and Idaho, the Bank is subject to the applicable provisions of Washington, Oregon and Idaho law and regulations. State law and regulations govern the Bank's ability to take deposits and pay interest thereon, to make loans on or invest in residential and other real estate, to make consumer loans, to invest in securities, to offer various banking services to its customers and to establish branch offices.
Deposit Insurance: The FDIC is an independent federal agency that insures the deposits, up to applicable limits, of depository institutions. The FDIC currently maintains two separate insurance funds: the BIF and the SAIF. Banner Bank's accounts are insured by both the BIF and the SAIF to the maximum extent permitted by law. As insurer of the Bank's deposits, the FDIC has examination, supervisory and enforcement authority over the Bank.
The Bank pays deposit insurance premiums based on a risk-based system established by the FDIC. Under this system, an institution's insurance assessment varies according to the level of capital the institution holds, the balance of insured deposits during the preceding two quarters, and the degree to which it is the subject of supervisory concern. In addition, regardless of the potential risk to the insurance fund, federal law requires the ratio of reserves to insured deposits at $1.25 per $100. Both funds currently meet this reserve ratio.
Since 1997, the premium schedule for BIF and SAIF insured institutions has ranged from zero to 27 basis points. In recent years, the Bank has not been required to make any premium payments to the FDIC. However, SAIF insured institutions and BIF insured institutions are required to pay a Financing Corporation (FICO) assessment in order to fund the interest on bonds issued to resolve thrift failures in the 1980s. For the fourth quarter of 2004, the annualized rate was 1.46 basis points for each $100 in domestic deposits. These assessments, which may be revised based upon the level of BIF and SAIF deposits, will continue until the bonds mature in the year 2015.
The FDIC may terminate the deposit insurance of any insured depository institution if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of termination, less subsequent withdrawals, will continue to be insured for a period of six months to two years, as determined by the FDIC. Management is not aware of any existing circumstances that could result in termination of the deposit insurance of the Bank.
Prompt Corrective Action: Federal statutes establish a supervisory framework based on five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. An institution's category depends upon where its capital levels are in relation to relevant capital measures, which include a risk-based capital measure, a leverage ratio capital measure and certain other factors. The federal banking agencies have adopted regulations that implement this statutory framework. Under these regulations, an institution is treated as well capitalized if its ratio of total capital to risk-weighted assets is 10% or more, its ratio of core capital to risk-weighted assets is 6% or more, its ratio of core capital to adjusted total assets (leverage ratio) is 5% or more, and it is not subject to any federal supervisory order or directive to meet a specific capital level. In order to be adequately capitalized, an institution must have a total risk-based capital ratio of not less than 8%, a Tier 1 risk-based capital ratio of not less than 4%, and a leverage ratio of not less than 4%. Any institution which is neither well capitalized nor adequately capitalized is considered undercapitalized.
Undercapitalized institutions are subject to certain prompt corrective action requirements, regulatory controls and restrictions which become more extensive as an institution becomes more severely undercapitalized. Failure by the Bank to comply with applicable capital requirements would, if unremedied, result in restrictions on its activities and lead to enforcement actions, including, but not limited to, the issuance of a capital directive to ensure the maintenance of required capital levels. Banking regulators will take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. Additionally, approval of any regulatory application filed for their review may be dependent on compliance with capital requirements.
At December 31, 2004, the Bank was categorized as "well capitalized" under the prompt corrective action regulations of the FDIC.
<PAGE>
Capital Requirements: Federally insured financial savings institutions, such as the Bank, are required to maintain a minimum level of regulatory capital. FDIC regulations recognize two types, or tiers, of capital: core (Tier 1) capital and supplementary (Tier 2) capital. Tier 1 capital generally includes common stockholders' equity and noncumulative perpetual preferred stock, less most intangible assets. Tier 2 capital, which is limited to 100% of Tier 1 capital, includes such items as qualifying general loan loss reserves, cumulative perpetual preferred stock, mandatory convertible debt, term subordinated debt and limited life preferred stock; however, the amount of term subordinated debt and intermediate term preferred stock (original maturity of at least five years but less than 20 years) that may in included in Tier 2 capital is limited to 50% of Tier 1 capital.
The FDIC currently measures an institution's capital using a leverage limit together with certain risk-based ratios. The FDIC's minimum leverage capital requirement specifies a minimum ratio of Tier 1 capital to average total assets. Most banks are required to maintain a minimum leverage ratio of at least 4% to 5% of total assets. At December 31, 2004, the Bank had a Tier 1 leverage capital ratio of 8.13%. The FDIC retains the right to require a particular institution to maintain a higher capital level based on an institution's particular risk profile.
FDIC regulations also establish a measure of capital adequacy based on ratios of qualifying capital to risk-weighted assets. Assets are placed in one of four categories and given a percentage weight based on the relative risk of the category. In addition, certain off-balance-sheet items are converted to balance-sheet credit equivalent amounts, and each amount is then assigned to one of the four categories. Under the guidelines, the ratio of total capital (Tier 1 capital plus Tier 2 capital) to risk-weighted assets must be at least 8%, and the ratio of Tier 1 capital to risk-weighted assets must be at least 4%. In evaluating the adequacy of a bank's capital, the FDIC may also consider other factors that may affect the bank's financial condition. Such factors may include interest rate risk exposure, liquidity, funding and market risks, the quality and level of earnings, concentration of credit risk, risks arising from nontraditional activities, loan and investment quality, the effectiveness of loan and investment policies, and management's ability to monitor and control financial operating risks. At December 31, 2004, the Bank had a Tier 1 risk-based capital ratio of 9.98% and a total risk-based capital ratio of 11.26%.
FDIC capital requirements are designated as the minimum acceptable standards for banks whose overall financial condition is fundamentally sound, which are well-managed and have no material or significant financial weaknesses. The FDIC capital regulations state that, where the FDIC determines that the financial history or condition, including off-balance-sheet risk, managerial resources and/or the future earnings prospects of a bank are not adequate and/or a bank has a significant volume of assets classified substandard, doubtful or loss or otherwise criticized, the FDIC may determine that the minimum adequate amount of capital for the bank is greater than the minimum standards established in the regulation.
The Company believes that, under the current regulations, the Bank exceeds its minimum capital requirements. However, events beyond the control of the Bank, such as weak or depressed economic conditions in areas where the Bank has most of its loans, could adversely affect future earnings and, consequently, the ability of the Bank to meet is capital requirements. For additional information concerning the Bank's capital, see Note 18 of the Notes to the Consolidated Financial Statements.
Standards for Safety and Soundness: The federal banking regulatory agencies have prescribed, by regulation, guidelines for all insured depository institutions relating to internal controls, information systems and internal audit systems; loan documentation; credit underwriting; interest rate risk exposure; asset growth; asset quality; earnings; and compensation, fees and benefits. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If the FDIC determines that the Bank fails to meet any of these guidelines, it may require the Bank to submit to the FDIC an acceptable plan to achieve compliance with the guideline. The Company believes that at December 31, 2004, the Bank meets all of the FDIC guidelines.
Federal Reserve System: The Federal Reserve Board requires, under Regulation D, reserves on all depository institutions that maintain transaction accounts or nonpersonal time deposits. These reserves may be in the form of cash or non-interest-bearing deposits with the regional Federal Reserve Bank. NOW accounts and other types of accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to Regulation D reserve requirements, as are any nonpersonal time deposits at a bank. Under Regulation D, for 2005, a bank must establish reserves equal to 3% of the first $47.6 million of transaction accounts, of which the first $7.0 million is exempt, and 10% of the remainder. Currently there is no reserve requirement on nonpersonal time deposits. As of December 31, 2004, the Bank met its reserve requirements.
Affiliate Transactions: The Company and the Bank are separate and distinct legal entities. Various legal limitations restrict the Bank from lending or otherwise supplying funds to the Company (an "affiliate"), generally limiting such transactions with the affiliate to 10% of the Bank's capital and surplus and limiting all such transactions to 20% of the Bank's capital and surplus. Such transactions, including extensions of credit, sales of securities or assets and provision of services, also must be on terms and conditions consistent with safe and sound banking practices, including credit standards that are substantially the same or at least as favorable to the Bank as those prevailing at the time for transactions with unaffiliated companies.
Federally insured banks are subject, with certain exceptions, to certain restrictions on extensions of credit to their parent holding companies or other affiliates, on investments in the stock or other securities of affiliates and on the taking of such stock or securities as collateral from any borrower. In addition, such banks are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or the providing of any property or service.
<PAGE>
Community Reinvestment Act: The Bank is also subject to the provisions of the Community Reinvestment Act of 1977, which requires the appropriate federal bank regulatory agency to assess the bank's record in meeting the credit needs of the community serviced by the bank, including low and moderate income neighborhoods. The regulatory agency's assessment of the bank's record is made available to the public. Further, such assessment is required of any bank which has applied, among other things, to establish a new branch office that will accept deposits, relocate an existing office or merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution. The Bank received a "satisfactory" rating during its most recent examination.
Dividends: Dividends from the Bank constitute the major source of funds for dividends paid by the Company to shareholders The amount of dividends payable by the Bank to the Company will depend upon the Bank's earnings and capital position, and is limited by federal and state laws, regulations and policies. Federal law further provides that no insured depository institution may make any capital distribution (which includes a cash dividend) if, after making the distribution, the institution would be "undercapitalized," as defined in the prompt corrective action regulations. Moreover, the federal bank regulatory agencies also have the general authority to limit the dividends paid by insured banks if such payments should be deemed to constitute an unsafe and unsound practice.
The Company
General: The Company, as sole shareholder of the Bank, is a bank holding company registered with the Federal Reserve. Bank holding companies are subject to comprehensive regulation by the Federal Reserve under the Bank Holding Company Act of 1956, as amended (BHCA), and the regulations of the Federal Reserve. The Company is required to file quarterly reports with the Federal Reserve and such additional information as the Federal Reserve may require and is subject to regular examinations by the Federal Reserve. The Federal Reserve also has extensive enforcement authority over bank holding companies, including, among other things, the ability to assess civil money penalties, to issue cease and desist or removal orders and to require that a holding company divest subsidiaries (including its bank subsidiaries). In general, enforcement actions may be initiated for violations of law and regulations and unsafe or unsound practices.
Financial Services Modernization Act: On November 12, 1999, the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 was signed into law. The purpose of this legislation is to modernize the financial services industry by establishing a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms and other financial service providers. Generally, the Gramm-Leach-Bliley Act:
repealed the historical restrictions and eliminated many federal and state law barriers to affiliations among banks, securities firms, insurance companies and other financial service providers;
provided a uniform framework for the functional regulation of the activities of banks, savings institutions and their holding companies;
broadened the activities that may be conducted by national banks, banking subsidiaries of bank holding companies and their financial subsidiaries;
provided an enhanced framework for protecting the privacy of consumer information; and
addressed a variety of other legal and regulatory issues affecting operations and activities of financial institutions.
The enactment of the Gramm-Leach-Bliley Act expanded the structural options available to bank holding companies, such as the Company, and other financial institutions, to permit them to engage in banking and other financial activities. Specifically, the Gramm-Leach-Bliley Act provides for the establishment of a new financial holding company. The Gramm-Leach-Bliley Act permits qualifying financial holding companies to own companies that engage in securities underwriting and dealing, insurance agency and underwriting, merchant banking or venture capital activities, the distribution of mutual funds, and securities lending. Financial holding companies may hold any type of deposit-taking subsidiary, including a national bank, a state-chartered bank, or a thrift or savings bank. To qualify as a financial holding company, however, each of the company's deposit-taking subsidiaries must be well capitalized, well managed, and have at least a "satisfactory" rating under the Community Reinvestment Act. The Company has not elected to become a financial holding company.
The Bank Holding Company Act: Under the BHCA, the Company is supervised by the Federal Reserve. The Federal Reserve has a policy that a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, the Federal Reserve provides that bank holding companies should serve as a source of strength to its subsidiary banks by being prepared to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity, and should maintain the financial flexibility and capital raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company's failure to meet its obligation to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve to be an unsafe and unsound banking practice or a violation of the Federal Reserve's regulations or both.
<PAGE>
The Company is required to file quarterly and periodic reports with the Federal Reserve and provide additional information as the Federal Reserve may require. The Federal Reserve may examine the Company, and any of its subsidiaries, and charge the Company for the cost of the examination.
The Company and any subsidiaries that it may control are considered "affiliates" within the meaning of the Federal Reserve Act, and transactions between the Bank and affiliates are subject to numerous restrictions. With some exceptions, the Company, and its subsidiaries, are prohibited from tying the provision of various services, such as extensions of credit, to other services offered by the Company, or by the Company's affiliates.
Acquisitions: The BHCA prohibits a bank holding company, with certain exceptions, from acquiring ownership or control of more than 5% of the voting shares of any company that is not a bank or bank holding company and from engaging in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. Under the BHCA, the Federal Reserve may approve the ownership of shares by a bank holding company in any company, the activities of which the Federal Reserve has determined to be so closely related to the business of banking or managing or controlling banks as to be a proper incident thereto. These activities include: operating a savings institution, mortgage company, finance company, credit card company or factoring company; performing certain data processing operations; providing certain investment and financial advice; underwriting and acting as an insurance agent for certain types of credit-related insurance; leasing property on a full-payout, non-operating basis; selling money orders, travelers' checks and U.S. Savings Bonds; real estate and personal property appraising; providing tax planning and preparation services; and, subject to certain limitations, providing securities brokerage services for customers.
The USA Patriot Act: In response to the terrorist events of September 11, 2001, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the USA Patriot Act, was signed into law on October 26, 2001. The USA Patriot Act gives the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. Title III of the USA Patriot Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions.
Among other requirements, Title III of the USA Patriot Act imposes the following requirements:
(a)
Financial institutions must establish anti-money laundering programs that include: (i) internal policies, procedures, and controls, (ii) specific designation of an anti-money laundering compliance officer, (iii) ongoing employee training programs, and (iv) an independent audit function to test the anti-money laundering program.
(b)
Financial institutions must implement a risk-based customer identification program in connection with opening new accounts. The program must contain requirements for identity verification, record-keeping, comparison of information to government-maintained lists and notice to customers.
(c)
Financial institutions that establish, maintain, administer, or manage private banking accounts or correspondent accounts in the United States for non-United States persons or their representatives (including foreign individuals visiting the United States) must establish appropriate, specific, and, where necessary, enhanced due diligence policies, procedures, and controls designed to detect and report money laundering.
(d)
Financial institutions are prohibited from establishing, maintaining, administering or managing correspondent accounts for foreign shell banks (foreign banks that do not have a physical presence in any country), and are subject to certain record-keeping obligations with respect to correspondent accounts of foreign banks.
(e)
Bank regulators must consider a holding company's effectiveness in combating money laundering when ruling on Federal Reserve Act and Bank Merger Act applications.
The Bank's policies and procedures have been updated to reflect the requirements of the USA Patriot Act. No significant changes in the Bank's business or customer practices were required as a result of the implementation of these requirements.
Sarbanes-Oxley Act of 2002: The Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley Act) was signed into law on July 30, 2002 in response to public concerns regarding corporate accountability in connection with the recent accounting scandals. The stated goals of the Sarbanes-Oxley Act are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws.
The Sarbanes-Oxley Act generally applies to all companies, both U.S. non-U.S., that file or are required to file periodic reports with the Securities and Exchange Commission (SEC), under the Securities Exchange Act of 1934 (Exchange Act).
The Sarbanes-Oxley Act includes very specific additional disclosure requirements and new corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules. The Sarbanes-Oxley Act represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees.
<PAGE>
The Sarbanes-Oxley Act addresses, among other matters:
(a)
audit committees;
(b)
certification of financial statements by the chief executive officer and the chief financial officer;
(c)
the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer's securities by directors and senior officer in the twelve-month period following initial publication of any financial statements that later require restatement;
(d)
a prohibition on insider trading during pension plan black out periods;
(e)
disclosure of off-balance-sheet transactions;
(f)
a prohibition on personal loans to directors and officers;
(g)
expedited filing requirements for Form 4s;
(h)
disclosure of a code of ethics and filing a Form 8-K for a change or waiver of such code;
(i)
"real time" filing of periodic reports;
(j)
the formation of a public accounting oversight board;
(k)
auditor independence; and
(l)
various increased criminal penalties for violations of securities laws.
Interstate Banking and Branching:
The Federal Reserve must approve an application of a bank holding company to acquire control of, or acquire all or substantially all of the assets of, a bank located in a state other than the holding company's home state, without regard to whether the transaction is prohibited by the laws of any state. The Federal Reserve may not approve the acquisition of a bank that has not been in existence for the minimum time period (not exceeding five years) specified by the statutory law of the host state. Nor may the Federal Reserve approve an application if the applicant (and its depository institution affiliates) controls or would control more than 10% of the insured deposits in the United States or 30% or more of the deposits in the target bank's home state or in any state in which the target bank maintains a branch. Federal law does not affect the authority of states to limit the percentage of total insured deposits in the state which may be held or controlled by a bank holding company to the extent such limitation does not discriminate against out-of-state banks or bank holding companies. Individual states may also waive the 30% state-wide concentration limit contained in the federal law.
The federal banking agencies are authorized to approve interstate merger transactions without regard to whether the transaction is prohibited by the law of any state, unless the home state of one of the banks adopted a law prior to June 1, 1997 which applies equally to all out-of-state banks and expressly prohibits merger transactions involving out-of-state banks. Interstate acquisitions of branches will be permitted only if the law of the state in which the branch is located permits such acquisitions. Interstate mergers and branch acquisitions will also be subject to the nationwide and statewide insured deposit concentration amounts described above.
Dividends: The Federal Reserve has issued a policy statement on the payment of cash dividends by bank holding companies, which expresses its view that although there are no specific regulations restricting dividend payments by bank holding companies other than state corporate laws, a bank holding company must maintain an adequate capital position and generally should not pay cash dividends unless the company's net income for the past year is sufficient to fully fund the cash dividends and that the prospective rate of earnings appears consistent with the company's capital needs, asset quality, and overall financial condition. The Federal Reserve policy statement also indicates that it would be inappropriate for a company experiencing serious financial problems to borrow funds to pay dividends.
Capital Requirements: The Federal Reserve has established capital adequacy guidelines for bank holding companies that generally parallel the capital requirements of the FDIC for the Bank, although the Federal Reserve regulations provide for the inclusion of certain trust preferred securities for up to 25% of Tier 1 capital in determining compliance with the guidelines. The Federal Reserve regulations provide that capital standards will be applied on a consolidated basis in the case of a bank holding company with $150 million or more in total consolidated assets. The guidelines require that a company's total risk-based capital must equal 8% of risk-weighted assets and one half of the 8% (4%) must consist of Tier 1 (core) capital. As of December 31, 2004, the Company's total risk-based capital was 12.24% of risk-weighted assets and its Tier 1 (core) capital was 10.94% of risk-weighted assets.
Stock Repurchases: A bank holding company, except for certain "well-capitalized" and highly rated bank holding companies, is required to give the Federal Reserve prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding twelve months, is equal to 10% or more of its consolidated net worth The Federal Reserve may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe or unsound practice or would violate any law, regulation, Federal Reserve order or any
<PAGE>
condition imposed by, or written agreement with, the Federal Reserve. For information concerning the Company's repurchase activities during the 2004 fiscal year and for the quarter ended December 31, 2004, see Item 5 hereof.
Management Personnel
Executive Officers
The following table sets forth information with respect to the executive officers of the Company and the Bank as of December 31, 2004.
Name
Age
Position with Company
Position with Bank
D. Michael Jones
President, Chief Executive
President, Chief Executive Officer,
Officer, Director
Director
Gary Sirmon
Chairman of the Board, Director
Chairman of the Board, Director
Lloyd W. Baker
Executive Vice President,
Executive Vice President,
Chief Financial Officer
Chief Financial Officer
Michael K. Larsen
Executive Vice President,
Real Estate Lending
Cynthia D. Purcell
Executive Vice President,
Bank Operations
Richard B. Barton
Executive Vice President,
Chief Credit Officer
Paul E. Folz
Executive Vice President,
Community Banking
John R. Neill
Executive Vice President,
Corporate Lending
Douglas M. Bennett
Executive Vice President,
Real Estate Lending Operations
Biographical Information
Set forth below is certain information regarding the executive officers of the Company and the Bank. There are no family relationships among or between the directors or executive officers.
D. Michael Jones joined Banner Bank in 2002 following an extensive career in banking, finance and accounting. Mr. Jones served as President and Chief Executive Officer from 1996 to 2001 for Source Capital Corporation, a lending company in Spokane, Washington. From 1987 to 1995, Mr. Jones served as President of West One Bancorp, a large regional banking franchise based in Boise, Idaho.
Gary Sirmon joined First Savings Bank of Washington, Banner Bank's predecessor, in 1980 as an Executive Vice President and served as its Chief Executive Officer from 1982 until 2002.
Lloyd W. Baker joined First Savings Bank of Washington (now Banner Bank) in 1995 as Asset/Liability Manager and has served as its Chief Financial Officer since 2000. His banking career began in 1972.
Michael K. Larsen joined First Savings Bank of Washington (now Banner Bank) in 1981 and has been the Bank's senior real estate lending officer since 1982.
Cynthia D. Purcell was formerly the Chief Financial Officer of Inland Empire Bank (now Banner Bank), which she joined in 1981.
Richard B. Barton joined Banner Bank in 2002. Mr. Barton's banking career began in 1972 with Seafirst Bank and Bank of America, where he served in a variety of commercial lending and credit risk management positions. In his last positions before joining Banner, he served as the senior real estate risk management executive for the Pacific Northwest and as the credit risk management executive for the west coast home builder divisions.
<PAGE>
Paul E. Folz joined Banner Bank in 2002. Mr. Folz, who has 27 years of commercial lending experience, served in his last position before joining Banner Bank as Washington Mutual's Senior Vice President for new market planning and development, where he spearheaded the expansion of business banking into new markets. Prior to that position, he served from 1989 as Washington Mutual's Senior Vice President in charge of commercial banking operations in the State of Oregon.
John R. Neill joined Banner Bank in 2002. Mr. Neill, who has over 26 years of commercial banking and community development experience, began his banking career with Seafirst Bank in 1975. From 1995 until he joined Banner Bank, he served as Senior Vice President and Senior Client Manager for Bank of America's central Washington commercial banking division.
Douglas M. Bennett, who joined Banner Bank in 1974, has over 30 years of experience in real estate lending.
Available Information
The Company's website is www.bannerbank.com. The website contains a link to the Company's filings with the Securities and Exchange Commission, including Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments. Copies of these filing are available as soon as reasonably practicable.
Item 2
Item 2 - Properties
The Company's home office, which is owned by the Company, is located in Walla Walla, Washington. As of December 31, 2004 the Bank has, in total, 49 branch offices located in Washington, Oregon and Idaho. These offices are located in the cities of Walla Walla (5), Kennewick (2), Richland, Pasco, Clarkston, Sunnyside, Yakima (4), Selah, Wenatchee, Dayton, Bellingham, Ferndale, Lynden, Blaine, Point Roberts, Spokane (2), Woodinville, Bothell, Everett (2), Kirkland, Bellevue, Redmond, Renton, Kent, Edmonds and Seattle (2), Washington; Hermiston, Pendleton (2), Umatilla, Boardman, Stanfield, Lake Oswego and Hillsboro, Oregon; and Lewiston (2), Twin Falls and Boise, Idaho. Of these offices, 23 are owned by the Company and 26 are leased. The leases expire from 2005 through 2023. In addition to these branch offices, the Bank has eleven leased loan production offices in Bellevue, Puyallup, Kennewick, Spokane, Moses Lake, Bellingham, Oak Harbor, Burlington, Seattle and Federal Way, Washington and Lake Oswego, Oregon, and it leases administrative offices in Walla Walla, Bothell and Woodinville, Washington. Community Financial Corporation (CFC), the wholly owned subsidiary of the Bank, located in Lake Oswego, Oregon, leases space to operate its two loan production offices in Lake Oswego, Oregon and Vancouver, Washington. The leases expire from 2006 through 2010. The Company's net investment in its offices, premises, equipment and leaseholds was $39.3 million at December 31, 2004.
Item 3
Item 3 - Legal Proceedings
In the normal course of business, the Company and the Bank have various legal proceedings and other contingent matters outstanding. These proceedings and the associated legal claims are often contested and the outcome of individual matters is not always predictable. These claims and counter-claims typically arise during the course of collection efforts on problem loans or with respect to action to enforce liens on properties in which the Bank holds a security interest. The Company and the Bank are not a party to any pending legal proceedings that they believe would have a material adverse effect on the financial condition or operations of the Company.
Item 4
Item 4 - Submission of Matters to a Vote of Security Holders
None.
<PAGE>
Part II
Item 5
Item 5 - Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Stock Listing
The Company's common stock is traded over-the-counter on The Nasdaq Stock Market® under the symbol "BANR" and newspaper stock tables list the Company as "Banner Corp." Stockholders of record at December 31, 2004 totaled 951. This total does not reflect the number of persons or entities who hold stock in nominee or "street" name through various brokerage firms. The following tables show the reported high and low closing sale prices of the Company's common stock for the years ended December 31, 2004, 2003 and 2002.
Year Ended December 31, 2004
High
Low
Cash Dividend Declared
First quarter
$
29.29
$
24.80
$
0.16
Second quarter
30.89
25.60
0.16
Third quarter
31.16
26.08
0.16
Fourth quarter
34.25
27.73
0.17
Year Ended December 31, 2003
High
Low
Cash Dividend Declared
First quarter
$
18.94
$
15.27
$
0.15
Second quarter
21.99
15.37
0.15
Third quarter
21.79
19.60
0.15
Fourth quarter
25.67
20.90
0.16
Year Ended December 31, 2002
High
Low
Cash Dividend Declared
First quarter
$
22.01
$
16.96
$
0.15
Second quarter
24.75
21.28
0.15
Third quarter
23.55
15.32
0.15
Fourth quarter
20.60
16.85
0.15
Issuer Purchases of Equity Securities
(1) Shares indicated as purchased during the periods presented were acquired at current market values as consideration for the exercise of certain fully vested options.
(2) On July 22, 2004, the Company's Board of Directors authorized the repurchase of up to 100,000 shares of the Company's outstanding common stock over the next twelve months. As of December 31, 2004, no shares had been repurchased under this program.
<PAGE>
Item 6
Item 6 - Selected Consolidated Financial and Other Data
These tables set forth selected consolidated financial and other data of the Company at the dates and for the periods indicated. This information is derived from and is qualified in its entirety by reference to the detailed information and Consolidated Financial Statements and Notes thereto presented elsewhere in this or prior filings.
<PAGE>
KEY FINANCIAL RATIOS:
(4)
(1)
Includes securities available for sale and held to maturity.
(2)
Per share data have been adjusted for the 10% stock dividend paid in November 2000.
(3)
Calculated using shares outstanding excluding unearned restricted shares held in ESOP.
(4)
Ratios are annualized
(5)
Net income divided by average assets
(6)
Net income divided by average equity
(7)
Difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.
(8)
Net interest income before provision for loan losses as a percent of average interest-earning assets.
(9)
Other operating expenses divided by the total of net interest income before loan losses and other operating income (non-interest income).
(10)
Non-performing loans consist of nonaccrual and 90 days past due loans.
<PAGE>
Item 7
Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations
Special Note Regarding Forward-Looking Statements
Management's Discussion and Analysis (MD&A) and other portions of this report contain certain "forward-looking statements" concerning the future operations of the Company. Management desires to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 and is including this statement for the express purpose of availing the Company of the protections of the safe harbor with respect to all "forward-looking statements" contained in this Annual Report on Form 10-K and the Annual Report to Stockholders. Management has used "forward-looking statements" to describe future plans and strategies, including expectations of the Company's future financial results. Management's ability to predict results or the effect of future plans or strategies is inherently uncertain. Factors which could cause actual results to differ materially include, but are not limited to, regional and general economic conditions, changes in interest rates, deposit flows, demand for mortgages and other loans, real estate values, agricultural commodity prices and production conditions, competition, loan delinquency rates, changes in accounting principles, practices, policies or guidelines, changes in legislation or regulation, other economic, competitive, governmental, regulatory and technological factors affecting operations, pricing, products and services and the Company's ability to successfully resolve the outstanding credit issues and recover check kiting losses. Accordingly, these factors should be considered in evaluating the "forward-looking statements," and undue reliance should not be placed on such statements. The Company undertakes no responsibility to update or revise any "forward-looking statements."
General
Banner Corporation, a Washington corporation, is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly owned subsidiary, Banner Bank. The Bank is a Washington-chartered commercial bank that conducts business from its main office in Walla Walla, Washington, and, as of December 31, 2004, its 49 branch offices and 12 loan production offices located in 23 counties in Washington, Idaho and Oregon. At December 31, 2004, the Company had grown to nearly $2.9 billion in total assets, including more than $2.0 billion in loans, while customer deposits had increased to $1.9 billion.
The operating results of the Company depend primarily on its net interest income, which is the difference between interest income on interest-earning assets, consisting of loans and investment securities, and interest expense on interest-bearing liabilities, composed primarily of customer deposits and Federal Home Loan Bank (FHLB) advances. Net interest income is primarily a function of the Company's interest rate spread, which is the difference between the yield earned on interest-earning assets and the rate paid on interest-bearing liabilities, as well as a function of the average balance of interest-earning assets as compared to the average balance of interest-bearing liabilities. As more fully explained below, the Company's net interest income before provision for loan losses increased $15.7 million for the year ended December 31, 2004 compared to the prior year, reflecting significant growth in interest-bearing assets and liabilities as well as an increase of 18 basis points in the net interest rate spread. The Company's net income also is significantly affected by provisions for loan losses and the level of its other income, including deposit service charges, loan origination and servicing fees, and mortgage banking operations, as well as its non-interest operating expenses and income tax provisions. Importantly, the provision for loan losses decreased by $1.7 million for the year ended December 31, 2004, compared to the prior year. As explained more fully below, this decrease reflects the meaningful continued reduction in non-performing loans in the current year compared to the prior year. The lower provision for loan losses in 2004 is important not only in comparison to the prior year, but also in comparison to the much higher provision recorded in the year ended December 31, 2002. This reduction in credit costs has been a significant reason for the Company's improved performance for the past two years. Other operating income decreased $2.6 million for the year ended December 31, 2004, largely due to a decrease in the level of mortgage banking activity and the resulting gain on the sale of loans, partially offset by increased loan servicing fees as well as increased deposit fees and service charges. Other operating expenses increased $9.8 million for the year ended December 31, 2004, compared to the prior year, reflecting the continued growth of the Company, as detailed below in the Comparison of Financial Condition and Results of Operations sections of this report. Net income increased by $3.2 million to $19.3 million for the year ended December 31, 2004.
Management's discussion and analysis of results of operations is intended to assist in understanding the financial condition and results of operations of the Company. The information contained in this section should be read in conjunction with the Consolidated Financial Statements and accompanying Notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K.
Recent Developments and Significant Events
Idaho Expansion: On March 4, 2004, the Company announced its intention to enter the southwestern Idaho market, including Boise and Twin Falls. The Company planned initially to operate commercial lending centers in the area and hired a group of eleven well known, experienced Idaho commercial bankers to lead the Company's expansion efforts. Subsequently, the Company announced plans to open three full service branch facilities in support of this expansion. The Bank has negotiated leases and announced plans for two facilities in the greater Boise area and has acquired a site in Twin Falls with architectural design work for a new branch facility currently in progress. Further, the Bank has signed a letter of intent on three additional facilities in the greater Boise area.
Puget Sound Expansion: During the third quarter of 2004, the Company announced the acquisition of three branch facilities and a parcel of vacant land in the greater Puget Sound market area. These three facilities were subsequently remodeled and opened as Banner Bank branches late in the fourth quarter of 2004. More recently, Banner Bank completed negotiations to lease two additional branch locations, also in the
<PAGE>
greater Puget Sound area. Regulatory approval for all of these branches has been granted and all five new locations are now open for business. Banner Bank is currently pursuing additional Puget Sound locations.
Junior Subordinated Debentures, Mandatorily Redeemable Trust Preferred Securities and Adoption of FIN 46: At December 31, 2003, three wholly-owned subsidiary grantor trusts, Banner Capital Trust I, II and III (collectively, Trusts), established by the Company had issued $55 million of pooled trust preferred securities. In addition, as noted below, in March 2004 the Company established a fourth wholly-owned subsidiary grantor trust called Banner Capital Trust IV to facilitate the issuance of an additional $15 million of trust preferred securities. Trust preferred securities accrue and pay distributions periodically at specified annual rates as provided in the related indentures. The Trusts used the net proceeds from the offerings to purchase a like amount of junior subordinated debentures (Debentures) of the Company. The Debentures are the sole assets of the Trusts. The Company's obligations under the Debentures and related documents, taken together, constitute a full and unconditional guarantee by the Company of the obligations of the Trusts. The trust preferred securities are mandatorily redeemable upon the maturity of the Debentures, or may be redeemed earlier as provided in the indentures. The Company has the right to redeem the Debentures in whole (but not in part) on or after specific dates, at a redemption price specified in the indentures plus any accrued but unpaid interest to the redemption date.
In January 2003, the Financial Accounting Standards Board (FASB) issued Financial Interpretation No. (FIN) 46, Consolidation of Certain Variable Interest Entities-An Interpretation of ARB No. 51, to clarify when an entity should consolidate another entity known as a Variable Interest Entity (VIE), more commonly referred to as a special purpose entity or SPE. Prior to adoption of FIN 46, the Trusts were considered consolidated subsidiaries of the Company. At December 31, 2002, $40 million of trust preferred securities were included in the Company's consolidated Statement of Financial Condition in the liabilities section, under the caption, "Trust preferred securities," and the $1.2 million common capital securities of the issuer retained by the Company were eliminated against the Company's investment in the Trusts. Distributions on these trust preferred securities were recorded as interest expense on the consolidated statements of income.
As a result of the adoption of FIN 46, the Company deconsolidated all three Trusts as of December 31, 2003. As a result, the Debentures issued by the Company to the Trusts, totaling $56.7 million, were reflected in the Company's consolidated balance sheet in the liabilities section at December 31, 2003 under the caption, "Junior subordinated debentures." At December 31, 2004, Debentures totaling $72.2 million were reflected in the Company's consolidated balance sheet, as discussed in more detail below. Beginning January 1, 2004, the Company has recorded interest expense for the corresponding junior subordinated debentures in its consolidated statements of income. The Company recorded $1.7 million of the common capital securities issued by the Trusts in the securities held-to-maturity in its consolidated balance sheet at December 31, 2003. Effective July 1, 2004, the $1.7 million investment in the Trusts' common capital securities was reclassified from securities held-to-maturity to other assets.
Sale of $15 Million of Trust Preferred Securities: In March 2004, the Company completed the issuance of an additional $15.5 million of Debentures in connection with a private placement of pooled trust preferred securities called Banner Capital Trust IV. The trust preferred securities were issued by a special purpose business trust owned by the Company and sold to pooled investment vehicles sponsored and marketed by investment banking firms. The Debentures have been recorded as a liability on the statement of financial condition but, subject to limitations under current Federal Reserve guidelines, qualify as Tier 1 capital for regulatory capital purposes. The proceeds from this offering are expected to be used primarily to support growth, including acquisitions, by augmenting the Bank's regulatory capital. Under the terms of the transaction, the trust preferred securities and Debentures have a maturity of 30 years and are redeemable after five years with certain exceptions. The holders of the trust preferred securities and Debentures are entitled to receive cumulative cash distributions at a variable annual rate. The interest rate is reset quarterly to equal three-month LIBOR plus 2.85%.
Critical Accounting Policies
Various elements of the Company's accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. In particular, management has identified several accounting policies that, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of the financial statements of the Company. These policies relate to the methodology for the determination of the allowance for loan and lease losses and the valuation of goodwill, mortgage servicing rights and real estate held for sale. These policies and the judgments, estimates and assumptions are described in greater detail in subsequent sections of Management's Discussion and Analysis of Financial Condition and Results of Operations and in Note 1 of the Notes to the Consolidated Financial Statements. Management believes that the judgments, estimates and assumptions used in the preparation of the financial statements are appropriate based on the factual circumstances at the time. However, because of the sensitivity of the financial statements to these critical accounting policies, the use of other judgments, estimates and assumptions could result in material differences in the results of operations or financial condition.
Comparison of Financial Condition at December 31, 2004 and 2003
General: Total assets increased $261.8 million, or 9.9%, from $2.635 billion at December 31, 2003, to $2.897 billion at December 31, 2004. The increase largely resulted from growth in the loan portfolio and was funded primarily by deposit growth. This asset growth reflects strong loan demand and solid deposit growth in the market areas where the Company operates, as well as the additional locations and production staff added in the past two years. Net loans receivable (gross loans less loans in process, deferred fees and discounts, and allowance for loan losses) increased $362.4 million, or 21.3%, from $1.701 billion at December 31, 2003, to $2.063 billion at December 31, 2004. Loan portfolio growth was broad-based and included increases of $91.6 million in commercial real estate loans, $18.7 million in multifamily real estate loans, $107.2 million in construction and land loans and $103.1 million in non-mortgage commercial and agricultural loans. These increases reflect the Company's continuing effort to increase the portion of its loans invested in commercial, construction and land development real estate loans,
<PAGE>
and non-mortgage commercial business and agricultural loans. The Company also had increases of $32.8 million in one- to four-family residential real estate loans and $12.7 million in consumer loans. Securities available for sale and held to maturity decreased $104.4 million, or 14.9%, from $702.2 million at December 31, 2003, to $597.7 million at December 31, 2004, primarily as a result of maturities and principal repayments on mortgage-related securities, although the decrease also reflected the sale of $49.3 million of securities and a modest decline in the fair value of the portion of the portfolio designated as available for sale as a result of changes in the level of market interest rates. As noted in the Consolidated Statements of Financial Condition, higher market interest rates resulted in an unrealized holding gain of $887,000 for the Company's available for sale securities at December 31, 2004, compared to an unrealized gain of $4.9 million at December 31, 2003. This change in the unrealized gain was also primarily responsible for the $3.9 million increase in deferred income tax asset, as well as for the $4.1 million decrease in accumulated other comprehensive income (loss) included in the stockholders' equity section of the Consolidated Statements of Financial Condition. FHLB stock increased $1.0 million as a result of dividends paid by the FHLB in the form of additional shares of stock. The Company also had an increase of $1.7 million in bank-owned life insurance from the growth of cash surrender values on existing policies.
Property and equipment increased by $16.5 million to $39.3 million at December 31, 2004, from $22.8 million at December 31, 2003. In the second quarter of 2004, the Bank purchased three branch properties and a piece of undeveloped land from a major bank that recently completed an acquisition of another competing bank. This facilities purchase is part of a strategy to grow deposits by expanding retail distribution in important markets in Washington, Oregon and Idaho. The properties purchased, located in Edmonds, Kent, Everett and Bellingham, Washington, are all part of the Puget Sound region, the most highly populated area in the Pacific Northwest with the most significant business activity. Earlier in the year the Bank opened new offices in Hillsboro, Oregon, Walla Walla, Washington and Boise and Twin Falls, Idaho. The increase in property and equipment also reflects completion of a new operations facility in Walla Walla, a major rebuild of a branch office in Yakima, Washington, and construction in progress for new branch facilities in Walla Walla and Vancouver, Washington and Twin Falls, Idaho.
The majority of the increase in assets was funded by a growth in deposits. Additional funding was also provided by the issuance of junior subordinated debentures and net income from operations. Total deposits grew $255.0 million, or 15.3%, from $1.671 billion at December 31, 2003, to $1.926 billion at December 31, 2004. Non-interest-bearing deposits increased $29.1 million, or 14.2%, while interest-bearing deposits increased significantly, growing by $225.9 million, or 15.4%, from the December 31, 2003 amounts. While FHLB advances decreased $29.0 million from $612.6 million at December 31, 2003, to $583.6 million at December 31, 2004, junior subordinated debentures issued in connection with trust preferred securities increased $15.5 million to $72.2 million. Other borrowings decreased $1.3 million to $68.1 million at December 31, 2004. The change in other borrowings reflects a $21.0 million increase in retail repurchase agreements which are primarily related to customer cash management accounts and a decrease of $22.3 million of repurchase agreement borrowings from securities dealers.
Investments: At December 31, 2004, the Company's consolidated investment portfolio totaled $597.7 million and consisted principally of U.S. Government and agency obligations, mortgage-backed securities, municipal bonds, corporate debt obligations, and Freddie Mac stock. From time to time, investment levels may be increased or decreased depending upon yields available on investment alternatives and management's projections as to the demand for funds to be used in the Bank's loan origination, deposit and other activities. During the year ended December 31, 2004, investments and securities decreased by $104.4 million as management chose to redeploy cash flow from securities to fund loan growth. Holdings of mortgage-backed securities decreased $83.0 million and U.S. Treasury and agency obligations decreased $21.4 million. Ownership of corporate and other securities decreased $8.3 million, while municipal bonds increased $8.3 million.
Mortgage-Backed Obligations: At December 31, 2004, the Company's net mortgage-backed securities including CMOs totaled $332.2 million, or 55.6% of the consolidated investment portfolio and 11.5% of total assets. The Company held CMOs with a net carrying value of $163.5 million. The estimated fair value of the mortgage-backed securities at December 31, 2004 was $332.2 million, which is $900,000 less than the amortized cost of $333.1 million. At December 31, 2004, the Company's portfolio of mortgage-backed securities had a weighted average coupon rate of 4.77%. At that date, 78.3% of the mortgage-backed securities were fixed-rate and 21.7% were adjustable-rate. The estimated weighted average remaining life of the portfolio was 3.7 years based on the latest three months' "constant prepayment rate" (CPR) or the most recent CPR if less than three months' history was available.
Municipal Bonds: The Company's tax-exempt municipal bond portfolio, which at December 31, 2004 totaled $45.3 million at estimated fair value ($44.7 million at amortized cost), was comprised of general obligation bonds (i.e., backed by the general credit of the issuer) and revenue bonds (i.e., backed by revenues from the specific project being financed) issued by cities and counties and various housing authorities, and hospital, school, water and sanitation districts located in the states of Washington and Oregon. At December 31, 2004, general obligation bonds and revenue bonds had total estimated fair values of $29.7 million and $15.6 million, respectively. The Company also had taxable bonds in its municipal bond portfolio, which at December 31, 2004 totaled $7.2 million at estimated fair value ($7.1 million at amortized cost). This taxable municipal bond portfolio consisted of general obligation bonds and revenue bonds with estimated fair values of $4.8 million and $2.4 million, respectively. Many of the Company's qualifying municipal bonds are not rated by a nationally recognized credit rating agency due to the smaller size of the total issuance and a portion of these bonds have been acquired through direct private placement by the issuers to the Bank. At December 31, 2004, the Company's municipal bond portfolio had a weighted average maturity of approximately 13.0 years, an average coupon rate of 4.94% and an average taxable equivalent yield of 6.19%. The largest principal balance of any security in the municipal portfolio was a general obligation bond issued by the Public Hospital District No. 1, Columbia and Walla Walla Counties, Washington, with an amortized cost of $5.7 million and a fair value of $5.7 million.
Corporate Bonds: The Company's corporate bond portfolio, which totaled $70.7 million at fair value ($69.7 million at amortized cost) at December 31, 2004, was composed principally of short- and intermediate-term fixed- and adjustable-rate securities issued by automobile and other finance companies and long-term fixed- and adjustable-rate capital securities issued by financial institutions. At December 31, 2004, the portfolio had a weighted average maturity of 17.4 years and a weighted average coupon rate of 6.08%.
<PAGE>
U.S. Government and Agency Obligations: The Company's portfolio of U.S. Government and agency obligations had a fair value of $139.9 million ($142.2 million at amortized cost) at December 31, 2004, a weighted average maturity of 4.1 years and a weighted average coupon rate of 3.52%. Most of the U.S. Government and agency obligations owned by the Company include call features which allow the issuing agency the right to call the securities at various dates prior to the final maturity. Certain securities also include step-rate features which provide for increases in the coupon rate at future dates if the security is not called.
<PAGE>
The following tables set forth certain information regarding carrying values and percentage of total carrying values of the Company's consolidated portfolio of securities classified as available for sale, carried at estimated fair market value, and held to maturity, carried at amortized cost (dollars in thousands):
<PAGE>
The following table shows the maturity or period to repricing of the Company's consolidated portfolio of securities available for sale (dollars in thousands):
Table 3: Securities - Available for Sale-Maturity/Repricing and Rates
<PAGE>
The following table shows the maturity or period to repricing of the Company's consolidated portfolio of securities held to maturity (dollars in thousands):
Table 4: Securities - Held to Maturity-Maturity/Repricing and Rates
<PAGE>
Loans/Lending: The Company's net loan portfolio increased $362.4 million, or 21.3%, during the year ended December 31, 2004, compared to an increase of $153.9 million, or 10.0%, during the year ended December 31, 2003 and a decline of $28.5 million in the year ended December 31, 2002. While the Company originates a variety of loans, its ability to originate each type of loan is dependent upon the relative customer demand and competition in each market it serves. During the past three years, the exceptionally low level of market interest rates led to very strong demand for new real estate loans, including construction loans; however, the low rates also resulted in very high levels of prepayments on existing loans. For the years ended December 31, 2004, 2003 and 2002, the Company originated, net of repayments, $696.3 million, $721.5 million and $368.6 million of loans, respectively.
In recent years, the Company generally has sold most of its newly originated fixed-rate one- to four-family residential mortgage loans and a portion of its Small Business Administration (SBA) guaranteed loans to secondary market purchasers. Proceeds from sales of loans by the Company for the years ended December 31, 2004, 2003 and 2002 totaled $338.4 million, $572.2 million and $457.7 million, respectively. The Company sells loans on both a servicing-retained and a servicing-released basis. See "Loan Servicing Portfolio" below. The decision to hold or sell loans is based on asset/liability management goals and policies and market conditions. Loans held for sale decreased to $2.1 million at December 31, 2004, compared to $15.9 million at December 31, 2003.
At various times, the Company also purchases whole loans and participation interests in loans. During the years ended December 31, 2004, 2003 and 2002, the Company purchased $18.2 million, $34.5 million and $52.0 million, respectively, of loans and loan participation interests.
One- to Four-Family Residential Real Estate Lending: At December 31, 2004, $308.0 million, or 14.7% of the Company's loan portfolio, consisted of permanent loans on one- to four-family residences. The Bank and its subsidiary, CFC, are active originators of one- to four-family residential loans in communities where they have established offices in Washington, Oregon and Idaho. In the low interest rate environment of the past year, demand for residential loans was particularly strong and the Bank and CFC originated a combined total of $493.1 million of one- to four-family residential loans for the year. This significant origination activity for the year ended December 31, 2004 resulted in a $32.8 million increase in loans on one- to four-family residences compared to a year earlier, despite continued high prepayment activity and management's decision to sell a substantial portion of new loans originated.
Construction and Land Lending: The Bank invests a significant proportion of its loan portfolio in residential construction loans to professional home builders and, to a lesser extent, in land loans and construction loans for commercial and multifamily real estate. In 2004, strong housing markets and low interest rates provided continued favorable conditions for construction and development lending. At December 31, 2004, construction and land loans totaled $506.1 million (including $175.9 million of land or land development loans and $68.1 million of commercial and multifamily real estate construction loans), or 24.2% of total loans of the Company, compared to $399.0 million, or 23.1%, at December 31, 2003. Construction and land development loan originations totaled $703.6 million for the year ended December 31, 2004.
Commercial and Multifamily Real Estate Lending: The Bank also originates loans secured by multifamily and commercial real estate. Multifamily and commercial real estate loans originated by the Bank are both fixed- and adjustable-rate loans generally with intermediate terms of five to ten years. The Bank's commercial real estate portfolio consists of loans on a variety of property types with no concentration by property type. The Bank experienced significant demand for both multifamily and commercial real estate loans in 2004, but most particularly for commercial real estate loans. At December 31, 2004, the Company's loan portfolio included $107.7 million in multifamily and $547.6 million in commercial real estate loans. Multifamily and commercial real estate loans comprised 31.3% of total loans of the Company at December 31, 2004, compared to 31.6% a year earlier.
Commercial Lending: The Bank is active in small- to medium-sized business lending and, to a lesser extent, has engaged in agricultural lending. During the past 30 months the Bank has added experienced officers and staff focused on middle market corporate lending opportunities for borrowers with credit needs generally in a $3 million to $15 million range. Management intends to leverage the past success of these officers with local decision making ability to continue to expand this market niche. In addition to providing earning assets, it is anticipated that this type of lending will help increase the deposit base. Expanding commercial lending and related commercial banking services is currently an area of significant effort at the Bank and staffing has been increased in the areas of credit administration, business development, and loan and deposit operations. Reflecting this effort, for the year ended December 31, 2004, commercial loans increased by 22.9%. At December 31, 2004, commercial loans totaled $395.3 million, or 18.9% of total loans of the Company, compared to $321.7 million, or 18.6%, at December 31, 2003. Loan terms, including the fixed or adjustable interest rate, the loan maturity and the collateral considerations, vary significantly and are negotiated on an individual loan basis.
Agricultural Lending: Agriculture is a major industry in many eastern Washington, eastern Oregon and southern Idaho locations. While not a large part of the Bank's portfolio, agricultural loans experienced solid growth for the year ended December 31, 2004. The Bank intends to continue to make agricultural loans to borrowers with a strong capital base, sufficient management depth, proven ability to operate through agricultural cycles, reliable cash flows and adequate financial reporting. Payments on agricultural loans depend, to a large degree, on the results of operation of the related farm entity. The repayment is also subject to other economic and weather conditions as well as market prices for agricultural products, which can be highly volatile at times. At December 31, 2004, agricultural loans totaled $148.3 million, or 7.1% of the loan portfolio, compared to $118.9 million, or 6.9%, at December 31, 2003, an increase of 24.8% for the year.
<PAGE>
Consumer and Other Lending: The Bank originates a variety of consumer loans, including home equity lines of credit, automobile loans and loans secured by deposit accounts. While consumer lending has traditionally been a small part of the Bank's business with loans made primarily to accommodate its existing customer base, it has received renewed emphasis in 2003 and 2004 and management anticipates increased activity in future periods. This increased effort allowed non-real estate-related consumer loans to increase modestly despite accelerated prepayments in the current very low interest rate environment. At December 31, 2004, the Company had $36.6 million, or 1.7% of its loans receivable, in outstanding non-real estate secured consumer loans, compared to $35.9 million, or 2.1%, at December 31, 2003. More importantly, consumer loans secured by one- to four-family real estate, including home equity lines of credit, increased by $12.0 million to $43.3 million, or 2.1% of total loans, at December 31, 2004, compared to $31.3 million, or 1.8%, at December 31, 2003.
Loan Servicing Portfolio: At December 31, 2004, the Bank was servicing $250.7 million of loans for others, compared to $278.2 million at December 31, 2003. The loan servicing portfolio at December 31, 2004 included $185.6 million of Freddie Mac mortgage loans, $3.3 million of Fannie Mae mortgage loans and $61.8 million of loans serviced for a variety of private investors. The portfolio included loans secured by property located primarily in the states of Washington or Oregon. For the year ended December 31, 2004, $1.7 million of loan servicing fees, net of $489,000 of servicing rights amortization, was recognized in operations. For the prior year, net loan servicing fees were $1.1 million. The increased servicing income for the current year reflects a significant increase in early prepayment fee income on certain commercial real estate loans.
Mortgage Servicing Rights: The Bank records mortgage servicing rights (MSRs) with respect to loans it originates and sells in the secondary market on a servicing retained basis. The cost of MSRs is capitalized and amortized in proportion to, and over the period of, the estimated future net servicing income. For the years ended December 31, 2004, 2003 and 2002, the Company capitalized $78,000, $1,576,000 and $1,046,000, respectively, of MSRs relating to loans sold with servicing retained. Amortization of MSRs for the years ended December 31, 2004, 2003 and 2002, was $489,000, $1,021,000 and $686,000, respectively. Management periodically evaluates the estimates and assumptions used to determine the carrying values of MSRs and the amortization of MSRs. These carrying values are adjusted when the valuation indicates the carrying value is impaired. MSRs generally are adversely affected by current and anticipated prepayments resulting from decreasing interest rates. At December 31, 2004, MSRs were carried at a value, net of amortization, of $1,565,000, compared to $1,976,000 at December 31, 2003.
<PAGE>
The following table sets forth the composition of the Company's loan portfolio (including loans held for sale) by type of loan as of the dates indicated (dollars in thousands):
Table 5: Loan Portfolio Analysis
<PAGE>
The following table sets forth certain information at December 31, 2004 regarding the dollar amount of loans maturing in the Bank's portfolio based on their contractual terms to maturity, but does not include scheduled payments or potential prepayments. Demand loans, loans having no stated schedule of repayments and no stated maturity, and overdrafts are reported as due in one year or less. Loan balances are net of loans in progress (undisbursed loan proceeds), unamortized premiums and discounts, include loans held for sale and exclude the allowance for loan losses (in thousands):
Table 6: Loan Maturity
Maturing
Within One
Year
Maturing
Within 1 to 3
Years
Maturing
Within 3 to 5
Years
Maturing
Within 5 to 10
Years
Maturing
Beyond 10
Years
Total
Loans:
Commercial real estate
$
31,449
$
34,684
$
74,807
$
199,149
$
207,485
$
547,574
Multifamily real estate
10,580
8,518
35,524
53,100
107,745
Construction and land
383,283
111,426
3,870
7,042
506,137
Commercial business
171,729
59,516
99,945
49,999
14,060
395,249
Agricultural business, including secured by
farmland
91,505
24,406
15,229
6,661
10,542
148,343
One- to four-family real estate
52,183
1,407
4,611
12,433
237,352
307,986
Consumer
5,759
6,751
7,490
3,248
13,308
36,556
Consumer secured by one- to four-family real
estate
2,248
1,693
1,541
37,053
43,258
Total consumer
6,482
8,999
9,183
4,789
50,361
79,814
Total loans
$
736,654
$
251,018
$
216,163
$
309,071
$
579,942
$
2,092,848
Contractual maturities of loans do not reflect the actual life of such assets. The average life of loans is substantially less than their contractual maturities because of principal repayments and prepayments. In addition, due-on-sale clauses on loans generally give the Bank the right to declare loans immediately due and payable in the event that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase, however, when current mortgage loan market rates are substantially higher than rates on existing mortgage loans and, conversely, decreases when rates on existing mortgage loans are substantially higher than current mortgage loan market rates.
The following table sets forth the dollar amount of all loans due after December 31, 2005, which have fixed interest rates and floating or adjustable interest rates (in thousands):
Table 6(a): Loans Maturing after One Year
<PAGE>
Deposit Accounts: Deposits generally are attracted from within the Bank's primary market areas through the offering of a broad selection of deposit instruments, including demand checking accounts, NOW accounts, money market deposit accounts, regular savings accounts, certificates of deposit, cash management services and retirement savings plans. Deposit account terms vary according to the minimum balance required, the time periods the funds must remain on deposit and the interest rate, among other factors. At December 31, 2004, the Bank had $1.926 billion of deposits, including $870.7 million of transaction and savings accounts and $1.055 billion in time deposits, of which $664.4 million had remaining maturities of one year or less. Total deposits increased by $255.0 million, or 15.3%, for the year ended December 31, 2004. As illustrated in the following table, certificates of deposit have accounted for a larger percentage of the deposit portfolio than have transaction accounts. However, as reflected in the balances and percentages in the table, the Bank added significantly to demand, NOW and money market accounts in the year ended December 31, 2004. Total transaction accounts (demand, NOW, savings and money market accounts) increased by $180.8 million for the year, to 45.2% of total deposits at December 31, 2004, compared to 41.3% at December 31, 2003. Non-interest-bearing transaction accounts increased by $29.1 million over the same time period. In addition, the Bank offers a Money Market Certificate of Deposit which has limited withdrawal features but functions much like a savings account and competes effectively with other banks' and securities firms' money market accounts. At December 31, 2004, Bank customers had $141.8 million in these three-month maturity Money Market Certificates of Deposit. The Bank's deposit balances at December 31, 2004 also included $144.7 million of public funds owned by various counties, municipalities and other public entities (public funds) in Washington, Oregon and Idaho. Growing deposits in general and transaction accounts in particular is a core element of the Company's business plan and is a primary focus of the recent and ongoing branch expansion, relocation and renovation activities and increased advertising and marketing campaigns at the Bank.
<PAGE>
The following table sets forth the balances of deposits in the various types of accounts offered by the Bank at the dates indicated (dollars in thousands):
Table 7: Deposits
The following table indicates the amount of the Bank's certificates of deposit with balances equal to or greater than $100,000 by time remaining until maturity as of December 31, 2004. (in thousands):
Table 8: Maturity Period-$100,000 or greater CDs
<PAGE>
Borrowings: The FHLB-Seattle serves as the Bank's primary borrowing source. To access funds, the Bank is required to own capital stock in the FHLB-Seattle and may apply for advances on the security of such stock and certain of its mortgage loans and securities provided certain credit worthiness standards have been met. At December 31, 2004, the Bank had $583.6 million of borrowings from the FHLB-Seattle at a weighted average rate of 3.77%, a decrease of $29.0 million compared to a year earlier. Also at that date, the Bank had an investment of $35.7 million in FHLB-Seattle capital stock. Additional short-term funds are also available through a $26.0 million commercial bank credit line; however, at December 31, 2004, the Bank had no balances advanced on that credit line.
Table 9: FHLB Advances Outstanding at December 31, 2004
(dollars in thousands)
*Weighted average interest rate
The Bank also issues retail repurchase agreements, generally due within 90 days, and borrows funds through the use of secured wholesale repurchase agreements with securities brokers as a source of funds. At December 31, 2004, retail repurchase agreements totaling $38.4 million, with a weighted average rate of 1.49%, were secured by a pledge of certain mortgage-backed securities and agency securities with a market value of $41.5 million. Retail repurchase agreement balances increased by $30.0 million during 2004, largely as a result of increased use of the Bank's cash management services by commercial deposit customers. The Bank's outstanding borrowings under wholesale repurchase agreements at December 31, 2004 totaled $29.8 million at a weighted average rate of 2.38%, with a weighted average maturity of seven days, and were collateralized by mortgage-backed securities with a fair value of $31.1 million.
In addition to borrowings at the Bank, the Company has generated funding by issuing $70 million of trust preferred securities (TPS). The Company issued $15 million of the TPS in 2004, which was in addition to $15 million issued in 2003 and $40 million issued in 2002. The TPS were issued by special purpose business trusts owned by the Company and were sold to pooled investment vehicles. The Junior Subordinated Debentures associated with the TPS have been recorded as liabilities on the Company's statement of financial condition but qualify as Tier 1 capital for regulatory capital purposes. See "Recent Developments and Significant Events" and Note 1 and Note 13 of the Notes to the Consolidated Financial Statements for additional information with respect to the TPS. At December 31, 2004, the TPS had a weighted average rate of 5.42%.
Asset Quality: During the years ended December 31, 2001 and 2002, the Bank experienced deterioration in asset quality, which had a significant adverse effect on operating results, primarily through increased loan loss provisioning and increased loan collection costs. Collection costs remained high in 2003 and 2004; however, during the years ended December 31, 2003 and 2004, the Bank achieved meaningful improvement in asset quality, with non-performing assets declining by 25% and 45%, respectively, compared to a year earlier, resulting in a significant decrease in loan loss provisioning. Table 10 highlights the earlier deterioration and more recent improvement in the Bank's measures of asset quality during the five-year period. Non-performing assets decreased to $17.4 million, or 0.60% of total assets, at December 31, 2004, compared to $31.6 million, or 1.20% of total assets, at December 31, 2003, and $42.2 million, or 1.86% of total assets at December 31, 2002. Problem loans have been primarily due from borrowers located in the Puget Sound region and were the result of poor risk assessment at the time they were originated, coupled with weakened economic conditions in that area. However, during the year ended December 31, 2003, the Bank had a significant increase in non-performing agricultural loans and agricultural-related business loans due from borrowers located in northeastern Oregon. Generally, these problem loans reflect unique operating difficulties for individual borrowers rather than weakness in the overall agricultural economy of the area. For the year ended December 31, 2004, the Bank had a $12.6 million decrease in non-performing loans, with decreases in all categories other than agricultural loans. The Bank also reduced its holdings of foreclosed real estate and other repossessed assets by $1.6 million from year earlier levels, primarily through the sale of properties. At December 31, 2004, the Bank's largest non-performing loan exposure was for loans totaling $4.8 million to a diversified farming operation in northeastern Oregon which were secured by land, crops, receivables and equipment. The Company's next largest non-performing loan exposure encompasses loans totaling $3.0 million to an agricultural-related business operating in northeastern Oregon which are primarily secured by non-farm real estate and processing equipment. Balances for this second group of loans are reflected in the non-accrual loan totals for commercial real estate and commercial business loans in the table on the following pages of this report. The Company had two additional non-performing credit relationships with balances in excess of $1.0 million, the largest of which had an aggregate carrying value of $1.5 million at December 31, 2004 and was secured by a single-family residential property. Very meaningful progress was made in the past two years in reducing non-performing loans and improving asset quality, which significantly contributed to the Bank's improved operating performance. For additional discussion concerning asset quality, non-performing loans and the allowance for loan losses, see "Provision and Allowance for Loan Losses" and Tables 11 and 12 contained therein.
<PAGE>
The following table sets forth information with respect to the Bank's non-performing assets and restructured loans within the meaning of SFAS No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructuring, at the dates indicated (dollars in thousands):
Table 10: Non-Performing Assets
(1) For the year ended December 31, 2004, $772,000 in interest income would have been recorded had nonaccrual loans been current, and no interest income on these loans was included in net income for this period.
(2) Real estate acquired by the Company as a result of foreclosure or by deed-in-lieu of foreclosure is classified as real estate held for sale until it is sold. When property is acquired, it is recorded at the lower of its cost (the unpaid principal balance of the related loan plus foreclosure costs) or net realizable value. Subsequent to foreclosure, the property is carried at the lower of the foreclosed amount or net realizable value. Upon receipt of a new appraisal and market analysis, the carrying value is written down through the establishment of a specific reserve to the anticipated sales price, less selling and holding costs. At December 31, 2004, the Company had $1.5 million of real estate owned, which consisted of five single-family residences valued at $1,119,000, and two commercial properties valued at $366,000.
(3) These loans are performing under their restructured terms but are classified substandard.
<PAGE>
Comparison of Results of Operations for the Years Ended December 31, 2004 and 2003
General: Net income for the year ended December 31, 2004 was $19.3 million, or $1.65 per share (diluted), compared to net income of $16.1 million, or $1.44 per share (diluted), for the year ended December 31, 2003. The Company's 2004 operating results reflect significant growth of assets and liabilities, as well as an increase in the net interest margin, and a lower level of loan loss provision. The Company's operating results also reflect a decrease in other operating income, primarily as a result of a decrease in mortgage banking revenues, combined with significant increases in other operating expenses, particularly compensation, occupancy, information services and advertising expenses. Compared to levels a year ago, total assets increased 9.9%, to $2.897 billion at December 31, 2004, net loans increased 21.3%, to $2.063 billion, deposits grew 15.3%, to $1.926 billion, and borrowings, including junior subordinated debentures, decreased 2.0%, to $723.8 million. Average interest earning assets were $2.593 billion for the year ended December 31, 2004, an increase of $312.9 million, or 13.7%, compared to the same period a year earlier. Average equity was 7.62% of average assets for the year ended December 31, 2004, compared to 8.03% of average assets for the year ended December 31, 2003, reflecting increased balance sheet leverage.
Net Interest Income. Net interest income before provision for loan losses increased to $96.3 million for the year ended December 31, 2004, compared to $80.6 million for the year ended December 31, 2003, largely as a result of the growth in average interest-earning assets noted above. In addition, the net interest margin increased 18 basis points to 3.71% for the current year from 3.53% for the prior year, reflecting a similar 18 basis point increase in the net interest rate spread and a slight increase in the ratio of interest-bearing assets relative to interest-earning liabilities. The increase in net interest margin in the current year was largely a result of growth of loans relative to investment securities, an increased yield on mortgage-backed securities and reduced funding costs, all as more fully explained below.
Interest Income: Interest income for the year ended December 31, 2004 was $156.2 million compared to $140.4 million for the year ended December 31, 2003, an increase of $15.8 million, or 11.2%. The increase in interest income occurred as a result of a $312.9 million, or 13.7%, growth in average balances of interest-earning assets and despite a 13 basis point decrease in the average yield on those assets. The yield on average interest-earning assets decreased to 6.03% for the year ended December 31, 2004, compared to 6.16% for the prior year. Average loans receivable for the year ended December 31, 2004 increased by $244.3 million, or 14.8%, when compared to the year ended December 31, 2003, reflecting strong new loan originations. Interest income on loans increased by $10.8 million, or 9.3%, compared to the prior year, as the effect of the substantial increase in average loan balances was partially offset by a 33 basis point decrease in the average yield. The decrease in average loan yield reflects the decline in the level of market interest rates that occurred during the prior year, which led to a significant amount of prepayments of higher-rate real estate and other fixed-rate, fixed-term loans, and occurred despite recent increases in short-term market interest rates, particularly the prime rate, which affects a large portion of construction, commercial and agricultural loans. Loans yielded 6.69% for the year ended December 31, 2004, compared to 7.02% for the year ended December 31, 2003. Further, while the recent level of market interest rates was higher than a year earlier, loan yields did not change appreciably as certain loans with rate floors did not adjust upward in response to the initial modest increase in prime and other index rates. In addition, lower market rates three to twelve months earlier, as well as changes in the portfolio mix, resulted in lower spreads and yields on new loan originations. The combined average balance of mortgage-backed securities, investment securities, daily interest-bearing deposits and FHLB stock increased by $68.6 million for the year ended December 31, 2004, while the interest and dividend income from those investments increased $5.0 million compared to the prior year. The average yield on mortgage-backed securities increased from 3.64% for the year ended December 31, 2003 to 4.37% for the current year. Yields on mortgage-backed securities were higher in 2004, reflecting reduced amortization of purchase premiums on certain portions of the portfolio as well as a reduction in the adverse effects of delayed receipt of principal payments on mortgage-backed securities as a result of slower prepayments. Both premium amortization and principal prepayments were significantly elevated in the year earlier period. The average yield on investment securities and short-term cash investments increased from 3.96% for the year ended December 31, 2003 to 4.10% for the current year, reflecting higher market rates. Earnings on FHLB stock decreased by $683,000 to $1.2 million for the year ended December 31, 2004. The dividend yield on FHLB stock was 3.35% for the year ended December 31, 2004, compared to 5.55% for the year ended December 31, 2003. Dividends on FHLB stock are established on a quarterly basis by vote of the Directors of the FHLB and are paid by distribution of additional shares of FHLB stock. Late in the fourth quarter of 2004 and again subsequent to year end, the FHLB announced changes in its dividend policy which will likely lead to a much lower level of dividend yield in 2005.
Interest Expense: Interest expense for the year ended December 31, 2004 was $59.9 million, compared to $59.8 million for the prior year, an increase of $67,000, or 0.1%. The slight increase in interest expense occurred despite a continued decrease in the average cost of all interest-bearing liabilities from 2.69% to 2.38%, as a result of the significant growth in the average balances of deposits and borrowings. The $189.8 million increase in average interest-bearing deposits for the year ended December 31, 2004, compared to December 31, 2003, reflects the solid deposit growth throughout the Company over the past two years. However, deposit interest expense increased only a modest $83,000 for the year ended December 31, 2004, compared to the prior year. Average deposit balances increased from $1.619 billion for the year ended December 31, 2003, to $1.809 billion for the year ended December 31, 2004, while, at the same time, the average rate paid on deposit balances decreased 22 basis points. To a significant degree, deposit costs for each quarter reflect market interest rates and pricing decisions made three to twelve months prior to the end of that quarter. Generally, market interest rates for deposits were declining and lower throughout the year ended December 31, 2004, than in the year ended December 31, 2003, although deposit costs did begin moving higher in the fourth quarter, reflecting increases in short-term market interest rates subsequent to Federal Reserve monetary policy changes in June 2004. Average FHLB advances totaled $568.9 million during the year ended December 31, 2004, compared to $513.8 million during the prior year, an increase of $55.1 million that, combined with a 68 basis point decrease in the average cost of advances, resulted in a $1.5 million decrease in related interest expense. The average rate paid on those advances decreased to 3.57% for the year ended December 31, 2004, from 4.25% for the prior year.
<PAGE>
FHLB advances are generally fixed-rate, fixed-term borrowings with rates on many of those advances having been established in periods when market rates were considerably higher than are currently available. The significant decrease in the average rate paid on FHLB advances reflects renewal of maturing advances at current market rates as well as additional advances also priced at current market rates. In the year ended December 31, 2004, additional funding was also provided by the issuance of $15 million of TPS. The average balance of TPS was $68.6 million and the average rate paid was 5.04% (including amortization of prepaid loan underwriting costs) for the year ended December 31, 2004. Other borrowings consist of retail repurchase agreements with customers and wholesale repurchase agreements with investment banking firms secured by certain investment securities. The average balance for other borrowings increased $21.2 million from $51.7 million for the year ended December 31, 2003, to $72.9 million for the current year, while the related interest expense increased $262,000 from $789,000 to $1.1 million for the respective periods. The average rate paid on other borrowings was 1.44% in the year ended December 31, 2004, compared to 1.53% for the prior year. The Company's other borrowings generally have relatively short terms and therefore reprice to current market levels more quickly than FHLB advances which generally lag current market rates. While FHLB advances and other borrowing costs were lower in 2004 than in 2003, similar to deposit costs, the decision of the Federal Reserve to move short-term interest rates higher in the second half of 2004 did result in higher borrowing costs in the fourth quarter. Management anticipates that both deposit and borrowing costs will be higher in 2005 than in 2004.
Provision and Allowance for Loan Losses: During the year ended December 31, 2004, the provision for loan losses was $5.6 million, compared to $7.3 million for the prior year, a decrease of $1.7 million. As noted above, the provision for loan losses is one of the most critical accounting estimates included in the Company's financial statements requiring significant management judgment. The decrease in the provision for losses reflects the amount required to maintain the allowance for losses at an appropriate level based upon management's evaluation of the adequacy of general and specific loss reserves as more fully explained in the following paragraphs. The lower provision in the current period reflects lower levels of non-performing loans and net charge-offs and strengthening in the prospects for collection on previously identified non-performing loans balanced against significant growth in the size of the loan portfolio. Non-performing loans decreased to $15.9 million at December 31, 2004, compared to $28.4 million at December 31, 2003. Net charge-offs were $2.1 million, or 0.11% of average loans, for the year ended December 31, 2004, compared to $7.8 million, or 0.47% of average loans, for the prior year. A comparison of the allowance for loan losses at December 31, 2004 and 2003, shows an increase of $3.6 million from $26.1 million at December 31, 2003, to $29.6 million at December 31, 2004. The allowance for loan losses as a percentage of net loans (loans receivable excluding allowance for losses) was 1.41% and 1.51% at December 31, 2004 and December 31, 2003, respectively. The allowance for loan losses equaled 186% of non-performing loans at December 31, 2004, compared to 92% of non-performing loans at December 31, 2003.
In originating loans, the Company recognizes that losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the credit worthiness of the borrower over the term of the loan, general economic conditions and, in the case of a secured loan, the quality of the security for the loan. As a result, the Company maintains an allowance for loan losses consistent with the generally accepted accounting principles (GAAP) guidelines outlined in SFAS No. 5, Accounting for Contingencies. The Company has established systematic methodologies for the determination of the adequacy of its allowance for loan losses. The methodologies are set forth in a formal policy and take into consideration the need for an overall general valuation allowance as well as specific allowances that are tied to individual problem loans. The Company increases its allowance for loan losses by charging provisions for possible loan losses against the Company's income and values impaired loans consistent with the guidelines in SFAS No. 114, Accounting by Creditors for Impairment of a Loan, and SFAS No. 118, Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosure.
The allowance for losses on loans is maintained at a level sufficient to provide for estimated losses based on evaluating known and inherent risks in the loan portfolio and upon management's continuing evaluation of the factors underlying the quality of the loan portfolio. These factors include changes in the size and composition of the loan portfolio, actual loan loss experience, current and anticipated economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. Losses that are related to specific assets are usually applied as a reduction of the carrying value of the assets and charged immediately against the allowance for loan loss reserve. Recoveries on previously charged off loans are credited to the allowance. The reserve is based upon factors and trends identified by management at the time financial statements are prepared. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses. These agencies may require additions to the allowance based upon judgments different from management. Although management uses the best information available, future adjustments to the allowance may be necessary due to economic, operating, regulatory and other conditions beyond the Company's control. The adequacy of general and specific reserves is based on management's continuing evaluation of the pertinent factors influencing the quality of the loan portfolio, including changes in the size and composition of the loan portfolio, delinquency rates, actual loan loss experience and current economic conditions, as well as individual review of certain large balance loans. Large groups of smaller-balance homogeneous loans are collectively evaluated for impairment. Loans that are collectively evaluated for impairment include residential real estate and consumer loans. Smaller balance non-homogeneous loans also may be evaluated collectively for impairment. Larger balance non-homogeneous residential construction and land, commercial real estate, commercial business loans and unsecured loans are individually evaluated for impairment. Loans are considered impaired when, based on current information and events, management determines that it is probable that the Bank will be unable to collect all amounts due according to the contractual terms of the loan agreement. Factors involved in determining impairment include, but are not limited to, the financial condition of the borrower, value of the underlying collateral and current status of the economy. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of collateral if the loan is collateral dependent. Subsequent changes in the value of impaired loans are included within the provision for loan losses in the same manner in which impairment initially was recognized or as a reduction in the provision that would otherwise be reported. As of December 31, 2004, the Company had identified $15.4 million of impaired loans as defined by SFAS No. 114 and had established $3.6 million of specific reserves for these loans.
<PAGE>
The Company's methodology for assessing the appropriateness of the allowance consists of several key elements, which include specific allowances, an allocated formula allowance, and an unallocated allowance. Losses on specific loans are provided for when the losses are probable and estimable. General loan loss reserves are established to provide for inherent loan portfolio risks not specifically provided for. The level of general reserves is based on analysis of potential exposures existing in the Bank's loan portfolio including evaluation of historical trends, current market conditions and other relevant factors identified by management at the time the financial statements are prepared. The formula allowance is calculated by applying loss factors to outstanding loans, excluding loans with specific allowances. Loss factors are based on the Company's historical loss experience adjusted for significant factors including the experience of other banking organizations that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date. The unallocated allowance is based upon management's evaluation of various factors that are not directly measured in the determination of the formula and specific allowances. This methodology may result in losses or recoveries differing significantly from those provided in the financial statements.
While the Company believes that it has established existing allowance for loan losses in accordance with GAAP, there can be no assurance that regulators, in reviewing the Bank's loan portfolio, will not request the Bank to increase significantly its allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that substantial increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above. Any material increase in the allowance for loan losses may adversely affect the Company's financial condition and results of operations.
The following table sets forth an analysis of the Company's gross allowance for possible loan losses for the periods indicated (dollars in thousands):
Table 11: Changes in Allowance for Loan Losses
<PAGE>
The following table sets forth the breakdown of the allowance for loan losses by loan category at the dates indicated (dollars in thousands):
Table 12: Allocation of Allowance for Loan Losses
(1) The Company establishes specific loss allowances when individual loans are identified that present a possibility of loss (i.e., that full collectibility is not reasonably assured). The remainder of the allocated and unallocated allowance for loan losses is established for the purpose of providing for estimated losses which are inherent in the loan portfolio.
<PAGE>
Other Operating Income: Other operating income was $17.0 million for the year ended December 31, 2004, a decrease of $2.6 million from the year ended December 31, 2003. This primarily reflects a $3.9 million decrease in the gain on sale of loans as higher interest rates led to decreased mortgage banking activity. Loan sales for the year ended December 31, 2004 totaled $338.4 million, compared to $572.2 million for the year ended December 31, 2003. Gain on sale of loans included $539,000 of fees on $43.3 million of loans which were brokered and are not reflected in the volume of loans sold. Partially offsetting the decline in loan sale gains was improvement in loan servicing fees, which increased by $685,000 for the year ended December 31, 2004 compared to a year earlier. As previously noted, the increased loan servicing income for the current year reflects a significant increase in early prepayment fee income on certain commercial real estate loans. Management does not anticipate that a similar level of prepayment fees will be collected in 2005. Deposit fee and service charge income for the Company increased by $908,000 to $8.1 million for the year ended December 31, 2004, from $7.2 million for the year ended December 31, 2003, primarily reflecting growth in customer transaction accounts, although changes in certain pricing schedules also contributed to the increase. Miscellaneous income decreased by $359,000, largely as a result of the recognition of $613,000 of losses on certain partnership investments in low- and moderate-income housing projects, although a slightly lower return on the Company's investment in bank-owned life insurance also contributed to this decrease. These partnership investments, which were made as part of the Bank's Community Reinvestment Act (CRA) program, generate significant tax credits to offset the operating losses. These partnership losses are generally offset by tax credits associated with the projects which generate positive net returns on the investments over time.
Other Operating Expenses: Other operating expenses increased $9.8 million from $69.9 million for the year ended December 31, 2003, to $79.7 million for the year ended December 31, 2004. Increases in other operating expenses reflect the overall growth in assets and liabilities, customer relationships and complexity of operations as the Company continues to expand. The higher level of operating expenses in the current year includes significant increases in compensation, occupancy and information services for additional branch and commercial loan expansion to position the Company for future growth. In addition, compensation was higher as a result of general wage and salary increases, as well as increased costs associated with employee benefit programs and employer-paid taxes. These increases were mitigated to a degree by lower commission expenses related to mortgage banking operations. The Company also significantly increased its commitment to advertising and marketing expenditures, which were $1.5 million greater in the year ended December 31, 2004 than in the prior year. The increase in expenses includes operating costs associated with opening new branch offices in Seattle, Yakima and Walla Walla, Washington, Hillsboro, Oregon and Boise and Twin Falls, Idaho, new commercial lending centers in Seattle, Spokane and Federal Way, Washington, mortgage lending offices in Burlington and Moses Lake, Washington and the recently completed operations center in Walla Walla. The current year also had higher costs related to deposit operations and merchant credit card services. The Company also had significant expenses for professional services in the current year, in part as a result of services related to compliance with certain provisions of the Sarbanes-Oxley Act of 2002, but also as a result of legal fees associated with loan collection efforts. Despite higher revenues, these increases in operating expenses caused the Company's efficiency ratio to increase slightly to 70.37% for the year ended December 31, 2004, from 69.75% for the year ended December 31, 2003. Other operating expenses as a percentage of average assets also increased to 2.90% for the year ended December 31, 2004, compared to 2.86% for the prior year.
Income Taxes: Income tax expense was $8.6 million for the year ended December 31, 2004, compared to $6.9 million for the prior year. The Company's effective tax rates for the years ended December 31, 2004 and 2003 were 30.7% and 30.0%, respectively. The higher effective tax rate in the current year is primarily as a result of an increase in the relative amount of taxable income versus tax-exempt income compared to the prior year and occurred even though the level of tax credits related to the CRA investments increased as noted above.
Comparison of Results of Operations for the Years Ended December 31, 2003 and 2002
General: Net income for the year ended December 31, 2003 was $16.1 million, or $1.44 per share (diluted), compared to net income of $9.3 million, or $0.82 per share (diluted), for the year ended December 31, 2002. Net income for 2002 was significantly adversely affected by extraordinary levels of provision for loan losses. The Company's full year 2003 operating results reflect significant growth of assets and liabilities, which was largely offset by a narrower net interest margin, a substantially lower level of loan loss provision and significantly increased non-interest income and other operating expenses. Compared to levels a year earlier, total assets increased 16.4% to $2.635 billion at December 31, 2003, net loans increased by 10.0% to $1.701 billion, deposits grew 11.6% to $1.671 billion and borrowings increased 35.1% to $738.7 million. Average equity was 8.03% of average assets for the year ended December 31, 2003, compared to 9.13% of average assets for the prior year. Net interest margin decreased 38 basis points for the year reflecting a 33 basis point decrease in net interest rate spread, the increased use of interest-bearing liabilities relative to interest-earning assets and lower yields on assets funded by non-interest-bearing liabilities and stockholders' equity. The changes in net interest spread and net interest margin are notable in light of the significant volatility and changes in the level of market interest rates over the previous two years. Changes in the level of interest rates during this two-year period initially increased the Company's net interest margin largely as a result of declining funding costs; however, net interest margin decreased for the year ended December 31, 2003 as asset yields declined sharply and a proportionally greater amount of asset growth was invested in securities rather than loans. The changes in the net interest spread and net interest margin reflect the impact of the very low level of market rates as well as the effects of changes in the asset and liability mix.
Interest Income: Interest income for the year ended December 31, 2003 was $140.4 million compared to $144.3 million for the year ended December 31, 2002, a decrease of $3.8 million, or 2.7%. The decrease in interest income occurred despite a $277.7 million, or 13.9%, growth in average balances of interest-earning assets as a result of a 104 basis point decrease in the average yield on those assets. The yield on average interest-earning assets decreased to 6.16% for the year ended December 31, 2003, compared to 7.20% for the prior year. Average loans
<PAGE>
receivable for the year ended December 31, 2003 increased by $65.3 million, or 4.1%, when compared to the year ended December 31, 2002, reflecting modest growth as accelerated loan prepayments largely offset record levels of new loan originations. Interest income on loans decreased by $7.1 million, or 5.8%, compared to the prior year, as the effect of the increase in average loan balances was offset by a 74 basis point decrease in the average yield. The decrease in average loan yield reflected the continued decline in the level of market interest rates, particularly the prime rate, compared to prior year levels. The loan mix continued to change as the portion of the portfolio invested in one- to four-family residential loans declined, while the portion invested in construction, land development and commercial loans increased. Loans yielded 7.02% for the year ended December 31, 2003, compared to 7.76% for the year ended December 31, 2002. While the level of market interest rates experienced a steep decline throughout the two-year period, loan yields were supported to a degree by certain loans with rate floors and by changes in the portfolio mix. However, as market rates continued to decline and remained very low, the level of rate floors on loans eroded through the normal maturity and replacement process. The combined average balance of mortgage-backed securities, investment securities, daily interest-bearing deposits and FHLB stock increased by $212.4 million for the year ended December 31, 2003, while the interest and dividend income from those investments increased $3.3 million compared to the prior year. The average yield on mortgage-backed securities decreased from 5.13% for the year ended December 31, 2002 to 3.64% for the year ended December 31, 2003. Yields on mortgage-backed securities were lower in 2003, reflecting significantly accelerated amortization of purchase premiums on certain portions of the portfolio as a result of rapid prepayments, as well as the effect of lower market rates on the interest rates paid on the portion of those securities that have adjustable rates, prepayments on certain higher-yielding portions of the portfolio, and reinvestment and growth at lower current market rates. The average yield on investment securities and short-term cash investments decreased from 4.77% for the year ended December 31, 2002 to 3.96% for the year ended December 31, 2003, also reflecting the lower level of market rates. Earnings on FHLB stock decreased by $97,000 despite an increase of $2.0 million in the average balance of FHLB stock for the year ended December 31, 2003. The dividend yield on FHLB stock was 5.55% for the year ended December 31, 2003, compared to 6.21% for the year ended December 31, 2002.
Interest Expense: Interest expense for the year ended December 31, 2003 was $59.8 million, compared to $66.0 million for the prior year, a decrease of $6.1 million, or 9.3%. The decrease in interest expense was as a result of a decrease in the average cost of all interest-bearing liabilities from 3.40% to 2.69%, primarily reflecting the lower level of market interest rates and occurred despite significant growth of deposits and borrowings. The $287.1 million increase in average interest-bearing deposits for the year ended December 31, 2003, compared to December 31, 2002, reflects the solid deposit growth throughout the Company over both years. Deposit interest expense decreased $4.2 million for the year ended December 31, 2003, compared to the prior year. Average deposit balances increased from $1.404 billion for the year ended December 31, 2002, to $1.619 billion for the year ended December 31, 2003, while, at the same time, the average rate paid on deposit balances decreased 63 basis points. To a significant degree, deposit costs for each quarter reflect market interest rates and pricing decisions made three to twelve months prior to the end of that quarter. Generally, market interest rates for deposits were declining and lower throughout the year ended December 31, 2003, than in the year ended December 31, 2002. Average FHLB advances totaled $513.8 million during the year ended December 31, 2003, compared to $451.8 million during the prior year, an increase of $62.0 million that, combined with a 108 basis point decrease in the average cost of advances, resulted in a $2.3 million decrease in related interest expense. The average rate paid on those advances decreased to 4.25% for the year ended December 31, 2003, from 5.33% for the prior year. FHLB advances are generally fixed-rate, fixed-term borrowings with rates on many of those advances having been established in periods when market rates were considerably higher than were currently available. The significant decrease in the average rate paid on FHLB advances reflects renewal of maturing advances at then lower current market rates as well as additional advances also priced at lower market rates. In the year ended December 31, 2003, additional funding was also provided by the issuance of $15 million of TPS. The average balance of TPS was $43.8 million and the average rate paid was 5.10% (including amortization of prepaid loan underwriting costs) for the year ended December 31, 2003. Other borrowings consist of retail repurchase agreements with customers and wholesale repurchase agreements with investment banking firms secured by certain investment securities. The average balance for other borrowings decreased $14.9 million from $66.6 million for the year ended December 31, 2002, to $51.7 million for the year ended December 31, 2003, while the related interest expense decreased $729,000 from $1.5 million to $789,000 for the respective periods. The average rate paid on other borrowings was 1.53% in the year ended December 31, 2003, compared to 2.28% for the prior year.
Provision and Allowance for Loan Losses: During the year ended December 31, 2003, the provision for loan losses was $7.3 million, compared to $21.0 million for the prior year, a decrease of $13.7 million. The decrease in the provision for losses refleced the amount required to maintain the allowance for losses at an appropriate level based upon management's evaluation of the adequacy of general and specific loss reserves. Despite continuing concerns about the economic environment, the significantly lower provision in 2003 reflected lower levels of non-performing loans and net charge-offs and strengthening in the prospects for collection on previously identified non-performing loans, as well as the previous recognition of problem loans through the very large provision recorded in the fourth quarter of 2002. Non-performing loans decreased to $28.4 million at December 31, 2003, compared to $36.1 million at December 31, 2002. However, during the year ended December 31, 2003, the Bank had a significant increase in non-performing agricultural loans and agricultural-related business loans due from borrowers located in northeastern Oregon. Net charge-offs were $7.8 million, or 0.47% of average loans, for the year ended December 31, 2003, compared to $12.5 million, or 0.78% of average loans, for the prior year. Net charge-offs for the year ended December 31, 2002 included $6.5 million associated with the credit manipulation activities of a former senior commercial loan officer which were designed to conceal weaknesses of several loan customers. A comparison of the allowance for loan losses at December 31, 2003 and 2002 shows a decrease of $479,000 from $26.5 million at December 31, 2002, to $26.1 million at December 31, 2003. The allowance for loan losses as a percentage of net loans (loans receivable excluding allowance for losses) was 1.51% and 1.69% at December 31, 2003 and 2002, respectively. The allowance for loan losses equaled 92% of non-performing loans at December 31, 2003, compared to 74% of non-performing loans at December 31, 2002.
<PAGE>
Other Operating Income: Other operating income was $19.6 million for the year ended December 31, 2003, an increase of $3.7 million from the year ended December 31, 2002. This included a $415,000 decrease in loan servicing income and a $2.8 million increase in the gain on sale of loans for the year as lower interest rates led to increased mortgage banking activity. Loan sales for the year ended December 31, 2003 totaled $572.2 million, compared to $457.7 million for the year ended December 31, 2002. Gain on sale of loans included $569,000 of fees on $42.0 million of loans which were brokered and are not reflected in the volume of loans sold. Other fee and service charge income for the Company increased by $1.4 million to $7.2 million for the year ended December 31, 2003, from $5.8 million for the year ended December 31, 2002, primarily reflecting growth in customer transaction accounts, although increased fees also reflect changes in the Bank's overdraft protection program that were implemented during the year. Miscellaneous income decreased by $89,000, despite the Company's increased investment in bank-owned life insurance and the resulting $1.9 million increase in cash surrender value, largely as a result of the recognition of $411,000 of losses on certain partnership investments in low- and moderate-income housing projects. These investments, which were made as part of the Bank's Community Reinvestment Act (CRA) program, generate significant tax credits to offset the operating losses.
Other Operating Expenses: Other operating expenses increased $9.4 million from $60.4 million for the year ended December 31, 2002, to $69.9 million for the year ended December 31, 2003. Increases in other operating expenses reflect the overall growth in assets and liabilities, customer relationships and complexity of operations as the Company continued to expand. The higher level of operating expenses for 2003 included significant increases in compensation for credit examination and special assets personnel as well as additional executive management and production staff hired to re-position the Company for future growth. In addition, compensation was higher as a result of increased incentive compensation and staffing caused by the elevated level of mortgage banking activity during the year. The higher level of mortgage banking activity was also reflected in the increase in capitalized loan origination costs. The Company also significantly increased its commitment to advertising and marketing expenditures which were $1.2 million greater in the year ended December 31, 2003 than in the prior year. The increase in expenses includes a full year's operating costs associated with new branch offices in Spokane and Pasco, Washington and new commercial lending centers in Portland, Oregon and Bellevue (greater Seattle), Spokane and the Tri-Cities, Washington, all of which opened during the prior year, as well as additional costs for new offices in Seattle and Moses Lake, Washington opened in 2003. The increase in other operating expenses was partially offset by a $590,000 increase in capitalized loan origination costs, reflecting a greater level of loan origination activity. Higher operating expenses, as well as a reduction in the net interest margin, caused the Company's efficiency ratio to increase to 69.75% for the year ended December 31, 2003, from 64.18% for the year ended December 31, 2002. Other operating expenses as a percentage of average assets increased to 2.86% for the year ended December 31, 2003, compared to 2.81% for the prior year.
Income Taxes: Income tax expense was $6.9 million for the year ended December 31, 2003, compared to $3.5 million for the prior year. The Company's effective tax rates for the years ended December 31, 2003 and 2002 were 30.0% and 27.3%, respectively. The higher effective tax rate for 2003 was primarily a result of an increase in the relative amount of taxable income versus tax-exempt income compared to the prior year and occurred despite the increased level of tax credits related to the CRA investments noted above.
<PAGE>
Table 13: Analysis of Net Interest Spread (dollars in thousands)
(footnotes follow tables)
<PAGE>
Table 13: Analysis of Net Interest Spread (dollars in thousands) (continued)
(1)
Average balances include loans accounted for on a nonaccrual basis and loans 90 days or more past due. Amortized net deferred loan fees are included with interest and dividends on loans.
(2)
Average balances include non-interest-bearing deposits.
<PAGE>
Table 14, Rate/Volume Analysis, sets forth the effects of changing rates and volumes on net interest income of the Company. Information is provided with respect to (i) effects on interest income attributable to changes in volume (changes in volume multiplied by prior rate) and (ii) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume). Effects on interest income attributable to changes in rate and volume (changes in rate multiplied by changes in volume) have been allocated between changes in rate and changes in volume.
Table 14: Rate/Volume Analysis (in thousands)
(1) Does not include interest on loans 90 days or more past due.
<PAGE>
Market Risk and Asset/Liability Management
The financial condition and operations of the Company are influenced significantly by general economic conditions, including the absolute level of interest rates as well as changes in interest rates and the slope of the yield curve. The Company's profitability is dependent to a large extent on its net interest income, which is the difference between the interest received from its interest-earning assets and the interest expense incurred on its interest-bearing liabilities.
The activities of the Company, like all financial institutions, inherently involve the assumption of interest rate risk. Interest rate risk is the risk that changes in market interest rates will have an adverse impact on the institution's earnings and underlying economic value. Interest rate risk is determined by the maturity and repricing characteristics of an institution's assets, liabilities and off-balance-sheet contracts. Interest rate risk is measured by the variability of financial performance and economic value resulting from changes in interest rates. Interest rate risk is the primary market risk affecting the Company's financial performance.
The greatest source of interest rate risk to the Company results from the mismatch of maturities or repricing intervals for rate sensitive assets, liabilities and off-balance-sheet contracts. This mismatch or gap is generally characterized by a substantially shorter maturity structure for interest-bearing liabilities than interest-earning assets; however, in the current low interest rate environment, accelerated prepayments and calls on loans and securities have resulted in shorter expected lives on many earning assets than has historically been the case, significantly mitigating this general characterization. Additional interest rate risk results from mismatched repricing indices and formulae (basis risk and yield curve risk), and product caps and floors and early repayment or withdrawal provisions (option risk), which may be contractual or market driven, that are generally more favorable to customers than to the Company.
The principal objectives of asset/liability management are: to evaluate the interest rate risk exposure of the Company; to determine the level of risk appropriate given the Company's operating environment, business plan strategies, performance objectives, capital and liquidity constraints, and asset and liability allocation alternatives; and to manage the Company's interest rate risk consistent with regulatory guidelines and policies approved by the Board of Directors. Through such management, the Company seeks to reduce the vulnerability of its earnings and capital position to changes in the level of interest rates. The Company's actions in this regard are taken under the guidance of the Asset/Liability Management Committee, which is comprised of members of the Company's senior management. The Committee closely monitors the Company's interest sensitivity exposure, asset and liability allocation decisions, liquidity and capital positions, and local and national economic conditions and attempts to structure the loan and investment portfolios and funding sources of the Company to maximize earnings within acceptable risk tolerances.
Sensitivity Analysis
The Company's primary monitoring tool for assessing interest rate risk is asset/liability simulation modeling, which is designed to capture the dynamics of balance sheet, interest rate and spread movements and to quantify variations in net interest income resulting from those movements under different rate environments. The sensitivity of net interest income to changes in the modeled interest rate environments provides a measurement of interest rate risk. The Company also utilizes market value analysis, which addresses changes in estimated net market value of equity arising from changes in the level of interest rates. The net market value of equity is estimated by separately valuing the Company's assets and liabilities under varying interest rate environments. The extent to which assets gain or lose value in relation to the gains or losses of liability values under the various interest rate assumptions determines the sensitivity of net equity value to changes in interest rates and provides an additional measure of interest rate risk.
The interest rate sensitivity analysis performed by the Company incorporates beginning-of-the-period rate, balance and maturity data, using various levels of aggregation of that data, as well as certain assumptions concerning the maturity, repricing, amortization and prepayment characteristics of loans and other interest-earning assets and the repricing and withdrawal of deposits and other interest-bearing liabilities into an asset/liability computer simulation model. The Company updates and prepares simulation modeling at least quarterly for review by senior management and the directors. The Company believes the data and assumptions are realistic representations of its portfolio and possible outcomes under the various interest rate scenarios. Nonetheless, the interest rate sensitivity of the Company's net interest income and net market value of equity could vary substantially if different assumptions were used or if actual experience differs from the assumptions used.
<PAGE>
Tables 15 and 15(a), Interest Rate Risk Indicators, set forth as of December 31, 2004 and 2003, the estimated changes in the Company's net interest income over a one-year time horizon and the estimated changes in market value of equity based on the indicated interest rate environments.
(1) Assumes an instantaneous and sustained uniform change in market interest rates at all maturities.
Another although less reliable monitoring tool for assessing interest rate risk is "gap analysis." The matching of the repricing characteristics of assets and liabilities may be analyzed by examining the extent to which assets and liabilities are "interest sensitive" and by monitoring an institution's interest sensitivity "gap." An asset or liability is said to be interest sensitive within a specific time period if it will mature or reprice within that time period. The interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets anticipated, based upon certain assumptions, to mature or reprice within a specific time period and the amount of interest-bearing liabilities anticipated to mature or reprice, based upon certain assumptions, within that same time period. A gap is considered positive when the amount of interest-sensitive assets exceeds the amount of interest-sensitive liabilities. A gap is considered negative when the amount of interest-sensitive liabilities exceeds the amount of interest-sensitive assets. Generally, during a period of rising rates, a negative gap would tend to adversely affect net interest income while a positive gap would tend to result in an increase in net interest income. During a period of falling interest rates, a negative gap would tend to result in an increase in net interest income while a positive gap would tend to adversely affect net interest income.
Certain shortcomings are inherent in gap analysis. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as ARM loans, have features that restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the table. Finally, the ability of some borrowers to service their debt may decrease in the event of a severe interest rate increase.
Tables 16 and 16(a), Interest Sensitivity Gap, present the Company's interest sensitivity gap between interest-earning assets and interest-bearing liabilities at December 31, 2004 and 2003. The tables set forth the amounts of interest-earning assets and interest-bearing liabilities which are anticipated by the Company, based upon certain assumptions, to reprice or mature in each of the future periods shown. At December 31, 2004, total interest-bearing liabilities maturing or repricing within one year exceeded total interest-earning assets maturing or repricing in the same time period by $87.8 million, representing a one-year cumulative gap to total assets ratio of (3.03%).
Management is aware of the sources of interest rate risk and in its opinion actively monitors and manages it to the extent possible. The interest rate risk indicators and interest sensitivity gaps for the Company as of December 31, 2004 and 2003 are within policy guidelines. Management considers that the Company's current level of interest rate risk is reasonable.
<PAGE>
(footnotes follow Table 16(a))
<PAGE>
(footnotes follow table)
<PAGE>
Footnotes for Tables 16 and 16(a): Interest Sensitivity Gap
(1) Adjustable-rate assets are included in the period in which interest rates are next scheduled to adjust rather than in the period in which they are due to mature, and fixed-rate assets are included in the period in which they are scheduled to be repaid based upon scheduled amortization, in each case adjusted to take into account estimated prepayments. Mortgage loans and other loans are not reduced for allowances for loan losses and non-performing loans. Mortgage loans, mortgage-backed securities, other loans and investment securities are not adjusted for deferred fees and unamortized acquisition premiums and discounts.
(2) Adjustable-rate liabilities are included in the period in which interest rates are next scheduled to adjust rather than in the period they are due to mature. Although the Bank's regular savings, demand, NOW, and money market deposit accounts are subject to immediate withdrawal, based on historical experience management considers a substantial amount of such accounts to be core deposits having significantly longer maturities. For the purpose of the gap analysis, these accounts have been assigned decay rates to reflect their longer effective maturities. If all of these accounts had been assumed to be short-term, the one-year cumulative gap of interest-sensitive assets would have been $(411.8) million, or (14.22%) of total assets at December 31, 2004, and $(209.2) million, or (7.94%), at December 31, 2003. Interest-bearing liabilities for this table exclude certain non-interest-bearing deposits that are included in the average balance calculations reflected in Table 13, Analysis of Net Interest Spread.
Liquidity and Capital Resources
The Company's primary sources of funds are deposits, borrowings, proceeds from loan principal and interest payments and sales of loans, and the maturity of and interest income on mortgage-backed and investment securities. While maturities and scheduled amortization of loans and mortgage-backed securities are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by market interest rates, economic conditions and competition.
The primary investing activity of the Company, through its subsidiaries, is the origination and purchase of loans. During the years ended December 31, 2004, 2003 and 2002, the Company purchased loans of $18.2 million, $34.5 million and $52.0 million, respectively, while loan originations, net of repayments, totaled $696.3 million, $721.5 million and $368.6 million, respectively. This activity was funded primarily by principal repayments on loans and securities, sales of loans, and deposit growth. During the years ended December 31, 2004, 2003 and 2002, the Company sold $338.4 million, $572.2 million and $457.7 million, respectively, of loans. Net deposit growth was $255.0 million, $173.2 million and $202.0 million for the years ended December 31, 2004, 2003 and 2002, respectively. FHLB advances decreased $29.0 million for the year ended December 31, 2004, increased $146.8 million for the year ended December 31, 2003, and decreased $36.2 million for the year ended December 31, 2002. Other borrowings, including junior subordinated debentures, increased $14.1 million for the year ended December 31, 2004, increased $44.9 million for the year ended December 31, 2003, and decreased $35.5 million for the year ended December 31, 2002.
The Bank must maintain an adequate level of liquidity to ensure the availability of sufficient funds to accommodate deposit withdrawals, to support loan growth, to satisfy financial commitments and to take advantage of investment opportunities. During the years ended December 31, 2004, 2003 and 2002, the Bank used its sources of funds primarily to fund loan commitments, to purchase securities, and to pay maturing savings certificates and deposit withdrawals. At December 31, 2004, the Bank had outstanding loan commitments totaling $633.4 million, including undisbursed loans in process and unused credit lines totaling $599.3 million. While reflecting growth in the loan portfolio and lending activities, this level of commitments is proportionally consistent with the Bank's historical experience and does not represent a departure from normal operations. The Bank generally maintains sufficient cash and readily marketable securities to meet short-term liquidity needs; however, its primary liquidity management practice is to increase or decrease short-term borrowing including FHLB advances. The Bank maintains a credit facility with the FHLB-Seattle, which provides for advances that in the aggregate may equal the lesser of 35% of the Bank's assets or adjusted qualifying collateral, up to a total possible credit line of $870.2 million at December 31, 2004. Advances under this credit facility totaled $583.6 million, or 20.2% of the Bank's assets, at December 31, 2004. The Bank also has access to additional short-term funds through a $26.0 million commercial bank credit line.
At December 31, 2004, certificates of deposit amounted to $1.055 billion, or 54.8% of the Bank's total deposits, including $664.4 million which were scheduled to mature by December 31, 2005. Historically, the Bank has been able to retain a significant amount of its deposits as they mature. Management believes it has adequate resources to fund all loan commitments from savings deposits and FHLB-Seattle advances and sale of mortgage loans and that it can adjust the offering rates of savings certificates to retain deposits in changing interest rate environments.
<PAGE>
Capital Requirements
The Company is a bank holding company registered with the Federal Reserve. Bank holding companies are subject to capital adequacy requirements of the Federal Reserve under the Bank Holding Company Act of 1956, as amended (BHCA), and the regulations of the Federal Reserve. Banner Bank, as a state-chartered, federally insured commercial bank, is subject to the capital requirements established by the FDIC.
The capital adequacy requirements are quantitative measures established by regulation that require the Company and the Bank to maintain minimum amounts and ratios of capital. The Federal Reserve requires the Company to maintain capital adequacy that generally parallels the FDIC requirements. The FDIC requires the Bank to maintain minimum ratios of Tier 1 total capital to risk-weighted assets as well as Tier 1 leverage capital to average assets. At December 31, 2004, the Company and the Bank exceeded all current regulatory capital requirements. (See Item 1, "Business - Regulation," and Note 18 of the Notes to the Consolidated Financial Statements for additional information regarding the Company's and the Bank's regulatory capital requirements.
Table 17, Regulatory Capital Ratios, shows the regulatory capital ratios of the Company and its subsidiary Bank as of December 31, 2004 and minimum regulatory requirements for the Bank to be categorized as "well-capitalized."
Table 17: Regulatory Capital Ratios
The Company
The Bank
"Well-capitalized" Minimum Ratio
Capital Ratios
Total capital to risk-weighted assets
12.24
%
11.26
%
10.00
%
Tier 1 capital to risk-weighted assets
10.94
9.98
6.00
Tier 1 leverage capital to average assets
8.93
8.13
5.00
Effect of Inflation and Changing Prices
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, which require the measurement of financial position and operating results in terms of historical dollars, without considering the changes in relative purchasing power of money over time due to inflation. The primary effect of inflation on operations of the Company is reflected in increased operating costs. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant effect 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.
Contractual Obligations
At December 31, 2004, the Company had commitments to extend credit of $633.4 million. In addition, the Company has contracts with various vendors to provide services, including information processing, for periods generally ranging from one to five years, for which the financial obligations of the Company are dependent upon acceptable performance by the vendor. For additional information regarding future financial commitments, this discussion should be read in conjunction with our Consolidated Financial Statements and related notes included elsewhere in this filing, including Note 28: "Financial Instruments With Off-Balance-Sheet Risk."
ITEM 7A
ITEM 7A - Quantitative and Qualitative Disclosures about Market Risk
See pages 46-50 of Management's Discussion and Analysis of Financial Condition and Results of Operations.
ITEM 8
ITEM 8 - Financial Statements and Supplementary Data
For financial statements, see index on page 56.
<PAGE>
ITEM 9
ITEM 9 - Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
(a) On June 9, 2004, the Registrant's Audit Committee determined that the firm of Deloitte & Touche LLP, Seattle, Washington, would no longer serve as the Registrant's certifying accountants. The decision to dismiss Deloitte & Touche LLP was made by the Audit Committee of the Board of Directors in consultation with management.
The report of Deloitte & Touche LLP on the Registrant's financial statements for either of the last two fiscal years did not contain an adverse opinion or a disclaimer of opinion and was not qualified or modified as to uncertainty, audit scope, or accounting principles.
During the Registrant's two most recent fiscal years and subsequent interim periods preceding the date of termination of the engagement of Deloitte & Touche LLP, the Registrant was not in disagreement with Deloitte & Touche LLP on any matter of accounting principles and practices, financial statement disclosure, or auditing scope or procedure, which disagreement, if not resolved to the satisfaction of Deloitte & Touche LLP, would have caused Deloitte & Touche to make reference to the subject matter of the disagreement in connection with its report.
Additionally, during the last two years and for the subsequent interim period preceding the date the Registrant determined to terminate Deloitte & Touche LLP, there were no reportable matters as defined in Regulation S-K Item 304(a)(1)(v).
The Registrant requested that Deloitte & Touche LLP furnish the Registrant with a letter, as promptly as possible, addressed to the Securities and Exchange Commission, stating whether they agree with the statements made in this Item 9, and if not, stating the respects in which they do not agree. The required letter from Deloitte & Touche LLP with respect to the above statements made by the Registrant is filed as Exhibit 16 to the 8-K filed June 11, 2004.
(b) On June 4, 2004, the Registrant's Audit Committee voted to engage Moss Adams, LLP, Spokane, Washington, as the Registrant's certifying accountants for the fiscal year ending December 31, 2004 subject to Moss Adams' acceptance of this engagement. On June 9, 2004, Moss Adams contacted the Registrant accepting the engagement. The Registrant has not consulted with Moss Adams, LLP during its two most recent fiscal years nor during any subsequent interim period prior to its appointment as auditor for the fiscal 2004 audit regarding the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on the Registrant's financial statements, or regarding the reportable condition set forth in Regulation S-K Items 304 (a)(2)(i) and (ii).
ITEM 9A
ITEM 9A - Controls and Procedures
Evaluation of Disclosure Controls and Procedures: An evaluation of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the "Act")) was carried out under the supervision and with the participation of the Company's Chief Executive Officer, Chief Financial Officer and several other members of the Company's senior management as of the end of the period covered by this report. The Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures as currently in effect are effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Act is (i) accumulated and communicated to the Company's management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms.
Management's Annual Report on Internal Control over Financial Reporting: Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we included a report of management's assessment of the design and effectiveness of its internal controls as part of this Annual Report on Form 10-K for the year ended December 31, 2004. Our independent registered public accounting firm also attested to, and reported on, management's assessment of the effectiveness of internal control over financial reporting. Management's report and the independent registered public accounting firm's attestation report are included in our 2004 Financial Statements under the captions entitled "Management Report on Internal Control over Financial Reporting" and "Independent Registered Public Accounting Firm's Report."
Changes in Internal Control Over Financial Reporting: There have not been any changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) of the Act) during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.
ITEM 9B
ITEM 9B - Other Information
None.
<PAGE>
Part III
ITEM 10
ITEM 10 - Directors and Executive Officers of the Registrant
The information contained under the section captioned "Proposal - Election of Directors," "Meetings and Committees of the Board of Directors" and "Shareholder Proposals" in the Registrant's Proxy Statement is incorporated herein by reference.
Information regarding the executive officers of the Registrant is provided herein in Part I, Item 1 hereof.
Reference is made to the cover page of this Annual Report and the section captioned "Section 16(a) Beneficial Ownership Reporting Compliance" of the Proxy Statement for the Annual Meeting of the Stockholders regarding compliance with Section 16(a) of the Securities Exchange Act of 1934.
ITEM 11
ITEM 11 - Executive Compensation
Information regarding management compensation and employment contracts, director compensation, and Compensation Committee interlocks and insider participation in compensation decisions, Compensation Committee report and performance graph is incorporated by reference to the sections captioned "Executive Compensation," "Directors' Compensation," and "Compensation Committee Matters," respectively, in the Proxy Statement for the Annual Meeting of Stockholders.
ITEM 12
ITEM 12 - Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The following table summarizes share and exercise price information about the Company's equity compensation plans as of December 31, 2004.
(a) Security Ownership of Certain Beneficial Owners
Information required by this item is incorporated herein by reference to the section captioned "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement for the Annual Meeting of Stockholders.
(b) Security Ownership of Management
Information required by this item is incorporated herein by reference to the section captioned "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement for the Annual Meeting of Stockholders.
(c) Changes in Control
The Company is not aware of any arrangements, including any pledge by any person of securities of the Company, the operation of which may at a subsequent date result in a change in control of the Company.
<PAGE>
ITEM 13
ITEM 13 - Certain Relationships and Related Transactions
The information contained under the section captioned "Transactions with Management" in the Proxy Statement for the Annual Meeting of Stockholders is incorporated herein by reference.
ITEM 14
ITEM 14 - Principal Accountant Fees and Services
The information contained under the section captioned "Independent Auditors" in the Proxy Statement for the Annual Meeting of Stockholders is incorporated herein by reference.
Part IV
ITEM 15
ITEM 15 - Exhibits and Financial Statement Schedules
(a)
(1)
Financial Statements
See Index to Consolidated Financial Statements on page 56.
(2)
Financial Statement Schedules
All financial statement schedules are omitted because they are not applicable or not required, or because the required information is included in the Consolidated Financial Statements or the Notes thereto or in Part 1, Item 1.
(b)
Exhibits
See Index of Exhibits on page 102.
<PAGE>
Signatures
<PAGE>
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Banner CORPORATION AND SUBSIDIARIES
(Item 8 and Item 15(a)(1))
Page
Report of Management
Report of the Audit Committee of the Board of Directors
Management Report on Internal Control Over Financial Reporting
Reports of Independent Registered Public Accounting Firm
Consolidated Statements of Financial Condition as of December 31, 2004 and 2003
Consolidated Statements of Income for the Years Ended December 31, 2004, 2003 and 2002
Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2004, 2003 and 2002
Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 2004, 2003 and 2002
Consolidated Statements of Cash Flows for the Years Ended December 31, 2004, 2003 and 2002
Notes to the Consolidated Financial Statements
<PAGE>
March 11, 2005
Report of Management
To the Stockholders:
The management of Banner Corporation (the Company) is responsible for the preparation, integrity, and fair presentation of its published financial statements and all other information presented in this annual report. The financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and, as such, include amounts based on informed judgments and estimates made by management. In the opinion of management, the financial statements and other information herein present fairly the financial condition and operations of the Company at the dates indicated in conformity with accounting principles generally accepted in the United States of America.
Management is responsible for establishing and maintaining an effective system of internal control over financial reporting. The internal control system is augmented by written policies and procedures and by audits performed by an internal audit staff (assisted in certain instances by contracted external audit resources other than the independent registered public accounting firm), which reports to the Audit Committee of the Board of Directors. Internal auditors monitor the operation of the internal and external control system and report findings to management and the Audit Committee. When appropriate, corrective actions are taken to address identified control deficiencies and other opportunities for improving the system. The Audit Committee provides oversight to the financial reporting process. There are inherent limitations in the effectiveness of any system of internal control, including the possibility of human error and circumvention or overriding of controls. Accordingly, even an effective internal control system can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of an internal control system may vary over time.
The Audit Committee of the Board of Directors is comprised entirely of outside directors who are independent of the Company's management. The Audit Committee is responsible for the selection of the independent auditors. It meets periodically with management, the independent auditors and the internal auditors to ensure that they are carrying out their responsibilities. The Committee is also responsible for performing an oversight role by reviewing and monitoring the financial, accounting, and auditing procedures of the Company in addition to reviewing the Company's financial reports. The independent auditors and the internal auditors have full and free access to the Audit Committee, with or without the presence of management, to discuss the adequacy of the internal control structure for financial reporting and any other matters which they believe should be brought to the attention of the Committee.
D. Michael Jones, Chief Executive Officer
Lloyd W. Baker, Chief Financial Officer
March 11, 2005
Report of the Audit Committee of the Board of Directors
The Audit Committee of the Board of Directors is comprised entirely of independent directors who are not employees of the Company. The Audit Committee has reviewed the audited financial statements of Banner Corporation with management of the Company, including a discussion of the quality of the accounting principles applied and significant judgments and estimates affecting the financial statements. The Audit Committee has also discussed with the independent auditors the auditors' opinion of the quality of those principles and significant judgments as applied by management in preparation of the financial statements. In addition, the members of the Audit Committee have discussed among themselves, without management or the independent auditors present, the information disclosed to the Committee by management and the independent auditors and have met regularly with the internal audit staff, without management present, to review compliance with approved policies and procedures. In reliance on these reviews and discussions, the Audit Committee believes that the financial statements of Banner Corporation and subsidiaries are fairly presented.
Gordon E. Budke
Audit Committee Chairman
<PAGE>
Management Report on Internal Control over Financial Reporting
March 11, 2005
The management of Banner Corporation is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f).
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 risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management with the participation of the Chief Executive Officer and Chief Financial Officer assessed the effectiveness of Banner Corporation's internal control over financial reporting as of December 31, 2004. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.
Based on its assessment, Management concluded that Banner Corporation maintained effective internal control over financial reporting as of December 31, 2004.
Management's assessment of the effectiveness of internal control over financial reporting as of December 31, 2004 has been audited by Moss Adams LLP, an independent registered public accounting firm, as stated in their attestation report that is included herein.
REPORT OF INDEPENDENT REGISTERED
PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
Banner Corporation and Subsidiaries
Walla Walla, Washington
We have audited the accompanying consolidated statement of financial condition of Banner Corporation and subsidiaries as of December 31, 2004, and the related consolidated statements of income, comprehensive income, changes in stockholders' equity, and cash flows for the year then ended. We also have audited management's assessment included in the accompanying Management Report on Internal Control over Financial Reporting, that Banner Corporation maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Banner Corporation and subsidiaries' management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management's assessment, and an opinion on the effectiveness of the Banner Corporation and subsidiaries' internal control over financial reporting based on our audit.
We conducted our audit in accordance with auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement in all material respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
The 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.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Banner Corporation and subsidiaries as of December 31, 2004, and the results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, management's assessment that Banner Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Furthermore, in our opinion, Banner Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
/s/Moss Adams LLP
Moss Adams LLP
Spokane, Washington
February 4, 2005
<PAGE>
REPORT OF INDEPENDENT REGISTERED
PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
Banner Corporation and Subsidiaries
Walla Walla, Washington
We have audited the accompanying consolidated statement of financial condition of Banner Corporation and subsidiaries (the Company) as of December 31, 2003, and the related consolidated statements of income, comprehensive income, changes in stockholders' equity, and cash flows for each of the two years in the period ended December 31, 2003. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial condition of the Company as of December 31, 2003, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.
/s/Deloitte & Touche LLP
Deloitte & Touche LLP
Seattle, Washington
March 11, 2005
<PAGE>
BANNER CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(in thousands, except shares)
December 31, 2004 and 2003
ASSETS
Cash and due from banks
$
51,767
$
77,298
Securities available for sale, cost $548,722 and $670,033
Encumbered
31,096
55,228
Unencumbered
516,739
619,714
547,835
674,942
Securities held to maturity, fair value $51,437 and $28,402
Encumbered
--
Unencumbered
49,914
27,016
49,914
27,232
Federal Home Loan Bank stock
35,698
34,693
Loans receivable:
Held for sale, fair value $2,176 and $16,199
2,145
15,912
Held for portfolio
2,090,703
1,711,013
Allowance for loan losses
(29,610
)
(26,060
)
2,063,238
1,700,865
Accrued interest receivable
15,097
13,410
Real estate owned held for sale, net
1,485
2,967
Property and equipment, net
39,315
22,818
Goodwill and other intangibles, net
36,369
36,513
Deferred income tax asset, net
5,888
1,941
Bank-owned life insurance
35,371
33,669
Other assets
15,090
8,965
$
2,897,067
$
2,635,313
LIABILITIES
Deposits:
Non-interest-bearing
$
234,761
$
205,656
Interest-bearing
1,691,148
1,465,284
1,925,909
1,670,940
Advances from Federal Home Loan Bank
583,558
612,552
Junior subordinated debentures
72,168
56,703
Other borrowings
68,116
69,444
Accrued expenses and other liabilities
25,027
18,444
Deferred compensation
5,208
4,252
Income taxes payable
1,861
2,681,847
2,432,513
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY
Common stock - $0.01 par value, 27,500,000 shares authorized, 13,201,419 shares issued:
11,856,889 shares and 11,473,331 shares outstanding at December 31, 2004 and 2003, respectively
127,460
123,375
Retained earnings
92,327
80,286
Accumulated other comprehensive income (loss):
Unrealized gain (loss) on securities available for sale
(888
)
3,191
Unearned shares of common stock issued to Employee Stock Ownership Plan (ESOP) trust:
374,595 and 434,299 restricted shares outstanding at December 31, 2004 and 2003, respectively, at cost
(3,096
)
(3,589
)
Carrying value of shares held in trust for stock related compensation plans
(6,135
)
(3,554
)
Liability for common stock issued to deferred, stock related, compensation plan
5,552
3,091
(583
)
(463
)
215,220
202,800
$
2,897,067
$
2,635,313
See notes to consolidated financial statements
<PAGE>
BANNER CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(in thousands except for per share data)
For the Years Ended December 31, 2004, 2003 and 2002
INTEREST INCOME:
Loans receivable
$
126,992
$
116,211
$
123,352
Mortgage-backed securities
16,882
12,319
10,738
Securities and cash equivalents
12,356
11,911
10,186
156,230
140,441
144,276
INTEREST EXPENSE:
Deposits
35,067
34,984
39,206
Federal Home Loan Bank advances
20,336
21,842
24,094
Junior subordinated debentures
3,461
2,233
1,151
Other borrowings
1,051
1,518
59,915
59,848
65,969
Net interest income before provision for loan losses
96,315
80,593
78,307
PROVISION FOR LOAN LOSSES
5,644
7,300
21,000
Net interest income
90,671
73,293
57,307
OTHER OPERATING INCOME:
Deposit fees and other service charges
8,132
7,224
5,804
Mortgage banking operations
5,522
9,447
6,695
Loan servicing fees
1,741
1,056
1,471
Gain on sale of securities
Miscellaneous
1,432
1,791
1,880
Total other operating income
16,968
19,581
15,877
OTHER OPERATING EXPENSES:
Salary and employee benefits
52,331
47,032
38,262
Less capitalized loan origination costs
(7,008
)
(7,196
)
(5,780
)
Occupancy and equipment
11,100
9,575
8,522
Information/computer data services
4,212
3,532
3,331
Professional services
3,258
2,684
2,081
Advertising
4,905
3,373
2,220
Miscellaneous
10,916
10,876
11,809
Total other operating expenses
79,714
69,876
60,445
Income before provision for income taxes
27,925
22,998
12,739
PROVISION FOR INCOME TAXES
8,585
6,891
3,479
NET INCOME
$
19,340
$
16,107
$
9,260
Earnings per common share: see Note 25
Basic
$
1.74
$
1.49
$
0.85
Diluted
$
1.65
$
1.44
$
0.82
Cumulative dividends declared per common share
$
0.65
$
0.61
$
0.60
See notes to consolidated financial statements
<PAGE>
BANNER CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
For the Years Ended December 31, 2004, 2003 and 2002
See notes to consolidated financial statements
<PAGE>
BANNER CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(in thousands)
For the Years Ended December 31, 2004, 2003 and 2002
Continued
<PAGE>
BANNER CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(in thousands)
For the Years Ended December 31, 2004, 2003 and 2002
Continued
<PAGE>
BANNER CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(in thousands)
For the Years Ended December 31, 2004, 2003 and 2002
<PAGE>
BANNER CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(continued) (in thousands)
For the Years Ended December 31, 2004, 2003 and 2002
COMMON STOCK, SHARES ISSUED:
Number of shares, beginning of period
13,201
13,201
13,201
Number of shares, end of period
13,201
13,201
13,201
LESS COMMON STOCK RETIRED:
Number of shares, beginning of period
(1,728
)
(1,894
)
(1,567
)
Purchase and retirement of common stock
(134
)
(24
)
(423
)
Issuance of common stock to deferred compensation plans
and/or exercised stock options
Number of shares retired, end of period
(1,344
)
(1,728
)
(1,894
)
SHARES OUTSTANDING, END OF PERIOD
11,857
11,473
11,307
UNEARNED, RESTRICTED ESOP SHARES:
Number of shares, beginning of period
(434
)
(516
)
(577
)
Release of earned shares
Number of shares, end of period
(375
)
(434
)
(516
)
See notes to consolidated financial statements
<PAGE>
BANNER CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
For the Years Ended December 31, 2004, 2003 and 2002
OPERATING ACTIVITIES:
Net income
$
19,340
$
16,107
$
9,260
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization
4,515
6,308
3,798
Loss (gain) on sale of securities
(141
)
(63
)
(27
)
Increase in cash surrender value of bank owned life insurance
(1,702
)
(1,860
)
(1,505
)
Loss (gain) on sale of loans, excluding capitalized servicing rights
(5,444
)
(7,870
)
(5,649
)
Loss (gain) on disposal of real estate held for sale and property
and equipment
(734
)
(50
)
Provision for losses on loans and real estate held for sale
5,835
7,698
21,000
FHLB stock dividend
(1,005
)
(1,862
)
(1,957
)
Net change in:
Loans held for sale
13,767
23,454
3,869
Other assets
(10,417
)
(3,104
)
4,000
Other liabilities
11,458
(5,177
)
7,698
Net cash provided by operating activities
35,472
33,581
41,407
INVESTING ACTIVITIES:
Purchases of available for sale securities
(177,129
)
(724,136
)
(354,218
)
Principal repayments and maturities of available for sale securities
231,982
416,247
230,675
Proceeds from sales of available for sale securities
49,421
49,287
4,670
Purchases of held to maturity securities
(10,237
)
(15,650
)
(1,006
)
Principal repayments and maturities of held to maturity securities
3,391
4,112
Origination of loans, net of principal repayments
(696,310
)
(721,473
)
(368,621
)
Purchases of loans and participating interest in loans
(18,207
)
(34,458
)
(51,999
)
Proceeds from sales of loans and participating interest in loans
338,412
572,231
457,671
Purchases of property and equipment-net
(20,446
)
(5,285
)
(5,452
)
Proceeds from sale of real estate held for sale-net
4,101
10,859
2,481
Investment in bank owned life insurance
--
--
(10,000
)
Cash (used for) provided by acquisitions
--
--
(6,519
)
Other
(180
)
(47
)
(336
)
Net cash used by investing activities
(297,845
)
(449,034
)
(98,542
)
FINANCING ACTIVITIES
Increase in deposits
254,969
173,162
168,468
Proceeds from FHLB advances
1,601,100
463,000
310,931
Repayment of FHLB advances
(1,630,094
)
(316,191
)
(347,170
)
Proceeds from issuance of junior subordinated debentures
15,000
15,000
38,723
Proceeds from issuance of repurchase agreement borrowings
--
51,917
2,082
Repayment of repurchase agreement borrowings
(22,289
)
(30,331
)
(31,447
)
Increase (decrease) in other borrowings, net
20,961
6,656
(6,849
)
Cash dividends paid
(7,113
)
(6,486
)
(6,479
)
Repurchases of stock, net of forfeitures
(4,162
)
(475
)
(8,391
)
ESOP shares earned
1,742
1,635
1,244
Exercise of stock options
6,728
1,954
1,205
Net cash provided by financing activities
236,842
359,841
122,317
NET INCREASE (DECREASE) IN CASH AND DUE FROM BANK
(25,531
)
(55,612
)
65,182
CASH AND DUE FROM BANKS, BEGINNING OF PERIOD
77,298
132,910
67,728
CASH AND DUE FROM BANKS, END OF PERIOD
$
51,767
$
77,298
$
132,910
(Continued on next page)
<PAGE>
BANNER CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 2004, 2003 and 2002
(in thousands)
(continued from prior page)
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Interest paid
$
60,154
$
60,200
$
67,372
Taxes paid
8,807
5,000
4,900
Non-cash transactions:
Loans, net of discounts, specific loss allowances and unearned
income transferred to real estate owned
1,985
7,733
6,442
Net change in accrued dividends payable
Stock issued to Rabbi Trust/MRP
Recognize tax benefit of vested MRP shares
--
Recognition of investment in trusts due to deconsolidation
--
1,703
--
Securities classified as available for sale reclassified held to maturity
15,334
--
--
Change in other assets/liabilities
1,664
1,488
The following summarizes the non-cash activities relating to acquisitions:
Fair value of assets and intangibles acquired, including goodwill
$
--
$
--
$
(44,544
)
Fair value of liabilities assumed
--
--
34,453
Cash paid out in acquisition
--
--
(10,091
)
Less cash acquired
--
--
3,572
Net cash (used for) provided by acquisitions
$
--
$
--
$
(6,519
)
See notes to consolidated financial statements
<PAGE>
BANNER CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1: BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Business: Banner Corporation (BANR or the Company) is a bank holding company incorporated in the State of Washington. The Company is primarily engaged in the business of planning, directing and coordinating the business activities for its wholly owned subsidiary, Banner Bank (BB or the Bank). The Bank is a Washington-chartered commercial bank the deposits of which are insured by the Federal Deposit Insurance Corporation (FDIC) under both the Bank Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF). The Bank conducts business from its main office in Walla Walla, Washington, and, as of December 31, 2004, its 49 branch offices and 12 loan production offices located in 23 counties in Washington, Oregon and Idaho. The Company is subject to regulation by the Federal Reserve Board (FRB). The Bank is subject to regulation by the State of Washington Department of Financial Institutions, Division of Banks and the FDIC.
The operating results of the Company depend primarily on its net interest income, which is the difference between interest income on interest-earning assets, consisting of loans and securities, and interest expense on interest-bearing liabilities, composed primarily of customer checking and savings deposits, Federal Home Loan Bank (FHLB) advances, junior subordinated debentures and repurchase agreements. Net interest income is a function of the Company's interest rate spread, which is the difference between the yield earned on interest-earning assets and the rate paid on interest-bearing liabilities, as well as a function of the average balance of interest-earning assets as compared to the average balance of interest-bearing liabilities. BANR's net income is significantly affected by provisions for loan losses and the level of its other income, including deposit service charges, loan origination and servicing fees, and gains and losses on the sale of loans and securities, as well as its non-interest operating expenses and income tax provisions.
Principles of Consolidation: The consolidated financial statements include the accounts of BANR and its wholly owned subsidiaries. All material intercompany transactions, profits and balances have been eliminated.
Use of Estimates: The preparation of the financial statements in conformity with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect amounts reported in the financial statements. Various elements of the Company's accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. In particular, management has identified several accounting policies that, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of the Company's financial statements. These policies relate to the methodology for the determination of the allowance for loan and lease losses, the valuation of goodwill and other intangible assets, the valuation of mortgage servicing rights, and the valuation for real estate held for sale. Management believes that the judgments, estimates and assumptions used in the preparation of the Company's financial statements are appropriate given the factual circumstances at the time. However, given the sensitivity of the Company's financial statements to the critical accounting policies, the use of other judgments, estimates and assumptions could result in material differences in the Company's results of operation of financial condition.
Securities: Securities are classified as held to maturity when the Company has the ability and positive intent to hold them to maturity. Securities classified as available for sale are available for future liquidity requirements and may be sold prior to maturity. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Securities held to maturity are carried at cost, adjusted for amortization of premiums and accretion of discounts to maturity and, if appropriate, any other-than-temporary impairment losses. Securities available for sale are carried at fair value. Normally, unrealized gains and losses on securities available for sale are excluded from earnings and are reported net of tax as accumulated other comprehensive income, a component of stockholders' equity, until realized. Declines in the fair value of securities below their cost that are deemed to be other-than-temporary are recognized in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Realized gains and losses on sale are computed on the specific identification method and are included in operations on the trade date sold.
Investment in FHLB Stock: The Company's investment in the stock of the Federal Home Loan Bank (FHLB) is carried at cost and is classified as restricted, as the Company can only sell stock back to the FHLB at par value or to other member banks. Dividends are included within interest income on securities and cash equivalents.
Loans Receivable: The Bank originates mortgage loans for both portfolio investment and sale in the secondary market. At the time of origination, mortgage loans are designated as held for sale or held for investment. Loans held for sale are stated at lower of cost or estimated fair value determined on an aggregate basis. Net unrealized losses on loans held for sale are recognized through a valuation allowance by charges to income. The Bank also originates commercial, agricultural and consumer loans for portfolio investment. Loans receivable not designated as held for sale are recorded at the principal amount outstanding, net of allowance for loan losses, deferred fees, discounts and premiums. Premiums, discounts and deferred loan fees are amortized to maturity using the level-yield methodology.
Interest is accrued as earned unless management doubts the collectibility of the loan or the unpaid interest. Interest accruals are generally discontinued when loans become 90 days past due for interest. All previously accrued but uncollected interest is deducted from interest income upon transfer to nonaccrual status. Future collection of interest is included in interest income based upon an assessment of the likelihood that the loans will be repaid or recovered. A loan may be put on nonaccrual status sooner than this policy would dictate if, in management's judgment, the loan may be uncollectible. Such interest is then recognized as income only if it is ultimately collected.
<PAGE>
Allowance for Loan Losses: The adequacy of general and specific reserves is based on management's continuing evaluation of the pertinent factors underlying the quality of the loan portfolio, including changes in the size and composition of the loan portfolio, delinquency rates, actual loan loss experience and current economic conditions, as well as individual review of certain large balance loans. Large groups of smaller-balance homogeneous loans are collectively evaluated for impairment. Loans that are collectively evaluated for impairment include residential real estate and consumer loans. Smaller balance non-homogeneous loans also may be evaluated collectively for impairment. Larger balance non-homogeneous residential construction and land, commercial real estate, commercial business loans and unsecured loans are individually evaluated for impairment. Loans are considered impaired when, based on current information and events, management determines that it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Factors involved in determining impairment include, but are not limited to, the financial condition of the borrower, value of the underlying collateral and current status of the economy. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of collateral if the loan is collateral dependent. Subsequent changes in the value of impaired loans are included within the provision for loan losses in the same manner in which impairment initially was recognized or as a reduction in the provision that would otherwise be reported.
The Company's methodology for assessing the appropriateness of the allowance consists of several key elements, which include specific allowances, an allocated formula allowance and an unallocated allowance. Losses on specific loans are provided for when the losses are probable and estimable. General loan loss reserves are established to provide for inherent loan portfolio risks not specifically provided for. The level of general reserves is based on analysis of potential exposures existing in the Bank's loan portfolio including evaluation of historical trends, current market conditions and other relevant factors identified by management at the time the financial statements are prepared. The formula allowance is calculated by applying loss factors to outstanding loans, excluding loans with specific allowances. Loss factors are based on the Company's historical loss experience adjusted for significant factors including the experience of other banking organizations that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date. The unallocated allowance is based upon management's evaluation of various factors that are not directly measured in the determination of the formula and specific allowances. This methodology may result in losses or recoveries differing significantly from those provided in the financial statements.
When available information confirms that specific loans or portions thereof are uncollectible, these amounts are charged off against the allowance for loan losses. The existence of some or all of the following criteria will generally confirm that a loss has been incurred: the loan is significantly delinquent and the borrower has not evidenced the ability or intent to bring the loan current; the Company has no recourse to the borrower, or if it does, the borrower has insufficient assets to pay the debt; or the fair value of the loan collateral is significantly below the current loan balance and there is little or no near-term prospect for improvement.
Loan Origination and Commitment Fees: Loan origination fees, net of certain specifically defined direct loan origination costs, are deferred and recognized as an adjustment of the loans' interest yield using the level-yield method over the contractual term of each loan adjusted for actual loan prepayment experience. Net deferred fees or costs related to loans held for sale are recognized in income at the time the loans are sold. Loan commitment fees are deferred until the expiration of the commitment period unless management believes there is a remote likelihood that the underlying commitment will be exercised, in which case the fees are amortized to fee income using the straight-line method over the commitment period. If a loan commitment is exercised, the deferred commitment fee is accounted for in the same manner as a loan origination fee. Deferred commitment fees associated with expired commitments are recognized as fee income.
Real Estate Held for Sale: Property acquired by foreclosure or deed in lieu of foreclosure is recorded at the lower of estimated fair value, less cost to sell, or the carrying value of the defaulted loan. Development, improvement and direct holding costs relating to the property are capitalized. The carrying value of the property is periodically evaluated by management and, if necessary, allowances are established to reduce the carrying value to net realizable value. Gains or losses at the time the property is sold are charged or credited to operations in the period in which they are realized. The amounts the Bank will ultimately recover from real estate held for sale may differ substantially from the carrying value of the assets because of market factors beyond the Bank's control or because of changes in the Bank's strategy for recovering the investment.
Property and Equipment: The provision for depreciation is based upon the straight-line method applied to individual assets and groups of assets acquired in the same year at rates adequate to charge off the related costs over their estimated useful lives:
Buildings and leased improvements 10-30 years
Furniture and equipment 3-10 years
Routine maintenance, repairs and replacement costs are expensed as incurred. Expenditures which significantly increase values or extend useful lives are capitalized. The Company reviews buildings, leasehold improvements and equipment for impairment whenever events or changes in 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.
Goodwill and Other Intangible Assets: Goodwill and other intangible assets represent the excess of purchase price over the fair value of net assets acquired by the Company. The excess cost over fair value of net assets acquired consists of goodwill and core deposit premiums. Prior to January 1, 2002, the Company's goodwill was being amortized using the straight-line method over 14 years. Other intangible assets are amortized over their estimated useful lives. As of January 1, 2002, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, which eliminated the amortization of goodwill relating to past and future acquisitions. See further discussion in Note 21.
<PAGE>
Mortgage Servicing Rights: Servicing assets are recognized as separate assets when rights are acquired through purchase or through sale of loans. Generally, purchased servicing rights are capitalized at the cost to acquire the rights. For sales of mortgage loans, a portion of the cost of originating the loan is allocated to the servicing right based on relative fair value. Fair value is based on market prices for comparable mortgage servicing contracts. Capitalized servicing rights are reported in other assets and are amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets.
Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights into tranches based on predominant risk characteristics, such as interest rate, balance outstanding, loan type, age and remaining term, and investor type. Impairment is recognized through a valuation allowance for an individual tranche, to the extent that fair value is less than the capitalized amount for the tranche. If the Company later determines that all or a portion of the impairment no longer exists for a particular tranche, a reduction of the allowance may be recorded as in increase to income.
Servicing fee income is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal or a fixed amount per loan and are recorded as income when earned. The amortization of mortgage servicing rights is netted against loan servicing fee income.
Derivative Instruments: In June 1998 the Financial Accounting Standards Board (FASB) issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended. The Company adopted SFAS No. 133 effective January 1, 2001. Derivatives include "off-balance-sheet" financial products, the value of which is dependent on the value of underlying financial assets, such as stock, bonds, foreign currency, or a reference rate or index. Such derivatives include "forwards," "futures," "options" or "swaps." The Company and the Bank generally have not invested in "off-balance-sheet" derivative instruments, although investment policies authorize such investments. However, as a part of mortgage banking activities, the Bank issues "rate lock" commitments to borrowers and obtains offsetting "best efforts" delivery commitments from purchasers of loans. While not providing any trading or net settlement mechanisms, these off-balance-sheet commitments do have many of the prescribed characteristics of derivatives and as a result are accounted for as such in accordance with SFAS No. 133, as amended. Accordingly, on December 31, 2004, the Company recorded in other assets an asset for $50,000 related to rate locks issued and recorded in other liabilities a liability of $50,000 related to rate locks received. These amounts represent the estimated market value of those commitments. On December 31, 2003, the Company and the Bank had no other investment related off-balance-sheet derivatives. The adoption of SFAS No. 133 did not have a material impact on the Company's consolidated results of operations, financial position or cash flows.
Transfers of Financial Assets: Transfers of financial assets 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.
Advertising Expenses: Advertising costs are expensed as incurred. Costs related to production of advertising are considered incurred when the advertising is first used.
Income Taxes: The Company files a consolidated income tax return including all of its wholly owned subsidiaries on a calendar year basis. Income taxes are accounted for using the asset and liability method. Under this method, a deferred tax asset or liability is determined based on the enacted tax rates which will be in effect when the differences between the financial statement carrying amounts and tax bases of existing assets and liabilities are expected to be reported in the Company's income tax returns. The effect on deferred taxes of a change in tax rates is recognized in income in the period of change. Where state income tax laws do not permit consolidated income tax returns, applicable state income tax returns are filed.
Stock Compensation Plans: The Company loaned the Employees Stock Ownership Plan (ESOP) the funds necessary to fund the purchase of 8% of the Company's initial public offering of common stock. The loan to the ESOP will be repaid principally from the Company's contribution to the ESOP, and the collateral for the loan is the Company's common stock purchased by the ESOP. As the debt is repaid, shares are released from collateral based on the proportion of debt service paid in the year and allocated to participants' accounts. As shares are released from collateral, compensation expense is recorded equal to the average current market price of the shares, and the shares become outstanding for earnings-per-share calculations. Stock and cash dividends on allocated shares are recorded as a reduction of retained earnings and paid or distributed directly to participants' accounts. Stock and cash dividends on unallocated shares are recorded as a reduction of debt and accrued interest (see additional discussion in Note 16). The Company stock purchased for a Rabbi Trust obligation and the related liability for deferred compensation are recorded at acquisition cost.
<PAGE>
The Company measures its employee stock-based compensation arrangements under the provisions outlined in Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. Accordingly, no compensation cost has been recognized for its stock option plans. If the compensation cost for the Company's compensation plans had been determined consistent with SFAS No. 123, Accounting for Stock-Based Compensation, as amended, the Company's net income available to diluted common stockholders and diluted earnings per common share would have been reduced to the pro forma amounts indicated below (in thousands except per share amounts):
The compensation expense included in the pro forma net income attributable to diluted common stockholders and diluted earnings per common share is not likely to be representative of the effect on reported net income for future years because options vest over several years and additional awards generally are made each year.
The fair value of options granted under the Company's stock option plans is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants:
Wholesale Repurchase Agreements: The Company enters into agreements under which it sells securities subject to an obligation to repurchase the same or similar securities. Under these arrangements, the Company transfers legal control over the assets but still retains effective control through an agreement that both entitles and obligates the Company to repurchase the assets. As a result, repurchase agreements are accounted for as financing arrangements and not as a sale and subsequent repurchase of securities. The obligation to repurchase the securities is reflected as a liability in the Consolidated Statements of Financial Condition while the dollar amount of securities underlying the agreements remains in the respective asset accounts. Those securities are classified as encumbered. (See Note 13.)
Comprehensive Income: Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. In addition, certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the statement of financial condition, and such items, along with net income, are components of comprehensive income which is reported in the Consolidated Statements of Comprehensive Income.
Average Balances: Average balances are obtained from the best available daily, weekly or monthly data, which the Company's management believes approximate the average balances calculated on a daily basis.
Reclassification: Certain amounts in the prior periods' financial statements have been reclassified to conform to the current period's presentation.
<PAGE>
Note 2: RECENT DEVELOPMENTS AND SIGNIFICANT EVENTS
In January 2003, the FASB issued Financial Interpretation No. (FIN) 46, Consolidation of Certain Variable Interest Entities - An Interpretation of ARB No. 51, to clarify when an entity should consolidate another entity known as a variable interest entity (VIE), more commonly referred to as a special purpose entity or SPE. A VIE is an entity in which equity investors do not have characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties, and may include many types of SPEs. FIN 46 requires an entity to consolidate a VIE if that enterprise has a variable interest that will absorb a majority of the VIE's expected losses if they occur, receive a majority of the VIE's expected residual returns if they occur, or both. FIN 46 was effective for newly created VIEs beginning February 1, 2003 and for existing VIEs as of the third quarter of 2003. Effective October 10, 2003, FASB deferred the effective date of FIN 46 from July 1, 2003 to the first interim period ending after December 15, 2003 for VIEs originated prior to February 1, 2003. The Company elected to adopt FIN 46 early, which resulted in the deconsolidation of the special purpose business trusts effective December 31, 2003. This increased the Bank's held-to-maturity investments and related borrowings by $1.7 million as detailed below. Effective July 1, 2004 the $1.7 million investment in VIE common stock was reclassified to other assets.
Junior Subordinated Debentures and Mandatorily Redeemable Trust Preferred Securities: At December 31, 2003, three wholly-owned subsidiary grantor trusts, Banner Capital Trust I, II, and III (collectively, Trusts), established by the Company had issued $55 million of pooled trust preferred securities. In addition, as noted below, in March 2004 the Company established a fourth wholly-owned subsidiary grantor trust called Banner Capital Trust IV to facilitate the issuance of an additional $15 million of trust preferred securities. Trust preferred securities accrue and pay distributions periodically at specified annual rates as provided in the related indentures. The Trusts used the net proceeds from the offerings to purchase a like amount of junior subordinated debentures (Debentures) of the Company. The Debentures are the sole assets of the Trusts. The Company's obligations under the Debentures and related documents, taken together, constitute a full and unconditional guarantee by the Company of the obligations of the Trusts. The trust preferred securities are mandatorily redeemable upon the maturity of the Debentures, or may be redeemed earlier as provided in the indentures. The Company has the right to redeem the Debentures in whole (but not in part) on or after specific dates, at a redemption price specified in the indentures plus any accrued but unpaid interest to the redemption date.
Prior to adoption of FIN 46, the Trusts were considered consolidated subsidiaries of the Company. At December 31, 2002, $40 million of trust preferred securities were included in the Company's Consolidated Statement of Financial Position in the liabilities section, under the caption, "Trust preferred securities," and the $1.2 million common capital securities of the issuer retained by the Company were eliminated against the Company's investment in the Trusts. Distributions on these trust preferred securities were recorded as interest expense on the consolidated statements of income.
As a result of the adoption of FIN 46, the Company deconsolidated all three Trusts as of December 31, 2003. As a result, the Debentures issued by the Company to the Trusts, totaling $56.7 million, were reflected in the Company's consolidated Statement of Financial Position in the liabilities section at December 31, 2003 under the caption, "Junior subordinated debentures." At September 30, 2004, Debentures totaling $72.2 million were reflected in the Company's consolidated Statement of Financial Position, as discussed in more detail below. Beginning January 1, 2004, the Company has recorded interest expense for the corresponding junior subordinated debentures in its consolidated statements of income. The Company recorded $1.7 million of the common capital securities issued by the Trusts in the securities held-to-maturity in its consolidated balance sheet at December 31, 2003. Effective July 1, 2004, the $1.7 million investment in the Trusts' common capital securities was reclassified from securities held-to-maturity to other assets.
Sale of $15 Million of Trust Preferred Securities: In March 2004, the Company completed the issuance of an additional $15.5 million of Debentures in connection with a private placement of pooled trust preferred securities called Banner Capital Trust IV. The trust preferred securities were issued by a special purpose business trust owned by the Company and sold to pooled investment vehicles sponsored and marketed by investment banking firms. The Debentures have been recorded as a liability on the statement of financial condition but, subject to limitations under current Federal Reserve guidelines, qualify as Tier 1 capital for regulatory capital purposes. The proceeds from this offering are being used primarily to support growth, including acquisitions, by augmenting the Bank's regulatory capital. Under the terms of the transaction, the trust preferred securities and Debentures have a maturity of 30 years and are redeemable after five years with certain exceptions. The holders of the trust preferred securities and Debentures are entitled to receive cumulative cash distributions at a variable annual rate. The interest rate is reset quarterly to equal three-month LIBOR plus 2.85%.
Note 3: ACCOUNTING STANDARDS RECENTLY ADOPTED OR ISSUED
In December 2004, the FASB issued Statement No. 123(Revised 2004), Share-Based Payment. This Statement replaces FASB Statement No. 123, Accounting for Stock Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. Statement No. 123(R) requires that the compensation cost relating to share-based payment transactions (for example, stock options granted to employees of the Company) be recognized in the Company's financial statements. That cost will be measured based on the fair value of the equity or liability instruments used. Statement No. 123 (R) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. Public entities (other than those filing as small business issuers) will be required to apply Statement No. 123(R) as of the first interim or annual reporting period beginning after June 15, 2005. The Company plans to adopt the provisions of FASB Statement No. 123(R) effective July 1, 2005, and is in the process of evaluating the impact on its consolidated financial position or consolidated results of operations.
In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets - An Amendment of APB Opinion No. 29. Guidance under APB Opinion No. 29, Accounting for Nonmonetary Transactions, is based on the principal that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. SFAS No. 153 amends Opinion No. 29 to eliminate the exception for nonmonetary
<PAGE>
exchanges of similar productive assets and replaces it with a general exemption for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange is considered to have commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The adoption of SFAS No. 153 is not expected to have any impact on the Company's current financial condition or results of operations.
In December 2003, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer. The SOP addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities acquired in a transfer if those differences are attributable, at least in part to credit quality. The SOP does not apply to loans originated by the Company. Provisions of the SOP limit the yield that may be accreted to the excess of the investor's estimate at acquisition of expected cash flows to be collected over the investor's initial investment in the loan. Additionally, the SOP prohibits the recognition of this excess as an adjustment of yield, loss accrual or valuation allowance. Subsequent increases in cash flows expected to be collected are generally to be recognized prospectively through adjustment of the loan's yield over its remaining life. Decreases in cash flows expected to be collected should be recognized as impairment. The SOP prohibits "carrying over" or creation of valuation allowance in the initial accounting of all loans acquired in a transfer.
The SOP is effective for loans acquired in fiscal years beginning after December 15, 2004.
Note 4: CASH, DUE FROM BANKS AND CASH EQUIVALENTS
For the purpose of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, overnight investments and short-term deposits with original maturities of less than 90 days.
FRB regulations require depository institutions to maintain certain minimum reserve balances. Included in cash and demand deposits were reserves required by the FRB of $6 million and $35 million at December 31, 2004 and 2003, respectively.
<PAGE>
Note 5: SECURITIES AVAILABLE FOR SALE
The amortized cost and estimated fair value of securities available for sale are summarized as follows (dollars in thousands):
Proceeds from sales of securities during the year ended December 31, 2004 were $49,421,000. Gross gains of $633,000 and gross losses of $492,000 were realized on those sales.
<PAGE>
Note 5: SECURITIES AVAILABLE FOR SALE (continued)
Proceeds from sales of securities during the year ended December 31, 2003 were $49,287,000. Gross gains of $384,000 and gross losses of $321,000 were realized on those sales.
Proceeds from sales of securities during the year ended December 31, 2002 were $4,670,000. Gross gains of $27,000 and no gross losses were realized on those sales.
At December 31, 2004 and 2003, the Company's investment portfolio did not contain any securities of an issuer (other than the U.S. Government, its agencies and U.S. Government sponsored entities) which had an aggregate book value in excess of 10% of the Company's stockholders' equity at that date.
At December 31, 2004, an aging of unrealized losses and fair value of related available-for-sale securities were as follows (in thousands):
<PAGE>
Management does not believe that any individual unrealized loss as of December 31, 2004 represents an other-than-temporary impairment. The decline in fair market value of these securities is generally due to changes in interest rates and changes in market-desired spreads subsequent to their purchase. There were 62 and 66 available for sale securities with unrealized losses at December 31, 2004 and 2003, respectively.
The amortized cost and estimated fair value of securities available for sale at December 31, 2004 and 2003, by contractual maturity, are shown below (in thousands). Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Note 6: SECURITIES HELD TO MATURITY
The amortized cost and estimated fair value of securities held to maturity are summarized as follows (dollars in thousands):
<PAGE>
Note 6: SECURITIES HELD TO MATURITY(continued)
(1) Effective July 1, 2004, these securities were reclassified to other assets for financial statement presentation purposes.
At December 31, 2004, an aging of unrealized losses and fair value of related held-to-maturity securities were as follows (in thousands):
Management does not believe that any individual unrealized loss as of December 31, 2004 represents an other-than-temporary impairment. The decline in fair market value of these securities is generally due to changes in interest rates and changes in market-desired spreads subsequent to their purchase. There were 22 and 8 held-to-maturity securities with unrealized losses at December 31, 2004 and 2003, respectively.
The amortized cost and estimated fair value of securities held to maturity at December 31, 2004 and 2003, by contractual maturity, are shown below (in thousands). Expected maturities will differ from contractual maturities because borrowers may have the right to prepay obligations with or without call or prepayment penalties.
Note 7: ADDITIONAL INFORMATION REGARDING INTEREST INCOME FROM SECURITIES AND CASH EQUIVALENTS
The following table sets forth the composition of income from securities and cash equivalents for the periods indicated (in thousands):
<PAGE>
Note 8: LOANS RECEIVABLE
Loans receivable at December 31, 2004 and 2003 are summarized as follows (dollars in thousands) (includes loans held for sale):
Loan amounts are net of unearned, unamortized loan fees of $8,882,000 and $6,754,000 at December 31, 2004 and 2003, respectively.
Loans receivable includes $472,000 and $421,000 of loans at December 31, 2004 and 2003, respectively, that were more than 90 days delinquent and still on accrual of interest.
Loans serviced for others totaled $250,707,000 and $278,185,000 at December 31, 2004 and 2003, respectively. Custodial accounts maintained in connection with this servicing totaled $2,569,000 and $3,840,000 at December 31, 2004 and 2003, respectively.
The Company's outstanding loan commitments totaled $633,430,000 and $546,319,000 at December 31, 2004 and 2003, respectively. In addition, the Company had outstanding commitments to sell loans of $33,226,000 and $33,565,000 at December 31, 2004 and 2003, respectively.
A substantial portion of the loans are to borrowers in the states of Washington, Oregon and Idaho. Accordingly, their ultimate collectibility is particularly susceptible to, among other things, changes in market and economic conditions within these states.
The Company's loans by geographic concentration at December 31, 2004 were as follows (in thousands):
Washington
Oregon
Idaho
Other
Total
Loans:
Commercial real estate
$
377,685
$
118,941
$
23,571
$
27,377
$
547,574
Multifamily real estate
86,499
10,774
1,574
8,898
107,745
Construction and land
228,721
249,665
10,823
16,928
506,137
Commercial business
288,163
44,075
56,070
6,941
395,249
Agricultural business,
including secured by farmland
50,810
67,411
29,667
148,343
One-to four-family real estate
266,982
29,491
4,104
7,409
307,986
Consumer
21,528
12,750
1,254
1,024
36,556
Consumer secured by one- to
four-family real estate
34,917
6,356
1,840
43,258
Total consumer
56,445
19,106
3,094
1,169
79,814
$
1,355,329
$
539,463
$
128,903
$
69,177
$
2,092,848
<PAGE>
The Company's loans to directors and officers are on substantially the same terms and underwriting as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than normal risk of collectability. Such loans had the following balances and activity during 2004 and 2003 (dollars in thousands):
The amount of impaired loans and the related allocated reserve for loan losses were as follows (in thousands):
As of December 31, 2004, the Company was committed to advance $438,000 in funds on its impaired loans.
The average balance of impaired loans and the related interest income recognized were as follows:
For the years ended December 31, 2004, 2003 and 2002, additional interest income of $772,000, $2,852,000 and $1,842,000, respectively, would have been recorded had non-accrual loans been current.
The Company originates both adjustable- and fixed-rate loans. At December 31, 2004 and 2003, the maturity and repricing composition of those loans, less undisbursed amounts and deferred fees, were as follows (in thousands):
<PAGE>
The adjustable-rate loans have interest rate adjustment limitations and are generally indexed to various prime (The Wall Street Journal) or LIBOR rates, One to Five Year Constant Maturity Treasury Indices, the FHLB's National Cost of Funds or 11th District Cost of Funds. Future market factors may affect the correlation of the interest rate adjustment with the rates the Bank pays on the short-term deposits that primarily have been utilized to fund these loans.
The Bank has invested, as of December 31, 2004, $446,000 in three limited partnerships, Homestead Equity Fund II, III and IV (HEF), that develop low income housing projects. The Bank's partnership interests commit it to invest up to $9,000,000 in the partnership. In connection with HEF II's initial development of a project, the Bank has made a commercial loan to the partnership that has an outstanding balance of $5,029,000 at December 31, 2004. The Bank is committed on this loan to advance up to $6,930,000. The loan is secured by notes from the limited partners, which includes the Bank, to make capital contributions to the partnership.
Note 9: ALLOWANCE FOR LOAN LOSSES
An analysis of the changes in the allowance for loan losses is as follows (dollars in thousands):
<PAGE>
Note 10: PROPERTY AND EQUIPMENT
Land, buildings and equipment owned by the Company and its subsidiaries at December 31, 2004 and 2003 are summarized as follows (in thousands):
The Bank's depreciation expense related to property and equipment was $3,948,000, $3,220,000 and $3,085,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
The Bank's rental expense was as follows: 2004, $3,315,000; 2003, $2,793,000 and 2002, $2,068,000.
The Bank's obligation under long-term property leases over the next five years is as follows: 2005, $3,150,000; 2006, $2,755,000; 2007, $2,218,000; 2008, $1,471,000; 2009, $1,139,000; and thereafter, $2,759,000.
At December 31, 2004, the Company had entered into various contractual obligations, generally related to the construction or remodel of various premises. Total commitments related to those contractual obligations were $1.6 million, with $695,000 remaining unpaid against those commitments at year end.
<PAGE>
Note 11: DEPOSITS
Deposits consist of the following at December 31, 2004 and 2003 (dollars in thousands):
Deposits at December 31, 2004 and 2003 included public funds of $144,682,000 and $152,035,000, respectively. Securities with a carrying value of $22,947,000 and $33,222,000 were pledged as collateral on these deposits at December 31, 2004 and 2003, respectively, which exceeded the minimum collateral requirements established by state regulations.
Deposits at December 31, 2004 and 2003 included deposits from directors and executive officers of the Company and entities related to the directors and executive officers totaling $4,376,000 and $3,360,000, respectively.
Scheduled maturities of certificate accounts at December 31, 2004 and 2003 are as follows (in thousands):
Included in deposits are deposit accounts in excess of $100,000 of $611,524,000 and $546,656,000 at December 31, 2004 and 2003, respectively. Interest on deposit accounts in excess of $100,000 totaled $15,543,000 for the year ended December 31, 2004 and $15,090,000 for the year ended December 31, 2003.
<PAGE>
The following table sets forth the deposit activities of the Bank for the periods indicated (in thousands):
Note 12: ADVANCES FROM FEDERAL HOME LOAN BANK OF SEATTLE
The Bank has entered into borrowing arrangements with the FHLB to borrow funds under a short-term floating rate cash management advance program and fixed-term loan agreements. All borrowings are secured by stock of, and cash held by, the FHLB. Additionally, specific securities with a carrying value of $292,151,000 at December 31, 2004 are pledged as security for the loans along with a blanket pledge of qualifying loans receivable. At December 31, 2004, FHLB advances were scheduled to mature as follows; however, certain advances totaling $137,000,000 and due after one year have provisions for early termination exercisable at the discretion of the FHLB (dollars in thousands):
* Weighted average interest rate
The maximum and average outstanding balances and average interest rates on advances from the FHLB were as follows for the years ended December 31, 2004, 2003 and 2002 (dollars in thousands):
As of December 31, 2004, the Bank has established a borrowing line with the FHLB to borrow up to the lesser of 35% of its total assets or the total blanket pool of unpledged eligible collateral which would give it a maximum total credit line of $870,227,000 at December 31, 2004.
<PAGE>
Note 13: OTHER BORROWINGS
Other borrowings consist of retail repurchase agreements, wholesale repurchase agreements and other short-term borrowings.
Retail Repurchase Agreements: At December 31, 2004, retail repurchase agreements carry interest rates ranging from 0.75% to 5.00%, payable at maturity, and are secured by the pledge of certain mortgage-backed and agency securities with a carrying value of $41,467,000. The Bank has the right to pledge or sell these securities, but they must replace them with substantially the same security.
A summary of retail repurchase agreements at December 31, 2004 and 2003 by the period remaining to maturity is as follows (dollars in thousands):
The maximum and average outstanding balances and average interest rates on retail repurchase agreements and other short-term borrowings, such as Fed Funds, were as follows for the years ended December 31, 2004, 2003 and 2002, respectively (dollars in thousands):
Wholesale Repurchase Agreements: The table below outlines the wholesale repurchase agreements as of December 31, 2004 and 2003. The agreements to repurchase are secured by mortgage-backed securities with a carrying value of $31,096,000 at December 31, 2004. The broker holds the security while the Bank continues to receive the principal and interest payments from the security. Upon maturity of the agreement, the pledged securities will be returned to the Bank.
A summary of wholesale repurchase agreements at December 31, 2004 and 2003 by the period remaining to maturity is as follows (dollars in thousands):
The maximum and average outstanding balances and average interest rates on wholesale repurchase agreements were as follows for the years ended December 31, 2004, 2003 and 2002 (dollars in thousands):	
<PAGE>
Junior Subordinated Debentures and Mandatorily Redeemable Trust Preferred Securities:
At December 31, 2004, four wholly-owned subsidiary grantor trusts, Banner Capital Trust I, II, III and IV (BCT I, II, III and IV), established by the Company had issued $70 million of pooled trust preferred securities as well as $2.168 million of common capital securities which were issued to the Company. Trust preferred securities and common capital securities accrue and pay distributions periodically at specified annual rates as provided in the indentures. The trusts used the net proceeds from the offerings to purchase a like amount of junior subordinated debentures (the "Debentures") of the Company. The Debentures are the sole assets of the trusts. The Company's obligations under the debentures and related documents, taken together, constitute a full and unconditional guarantee by the Company of the obligations of the trusts. The trust preferred securities are mandatorily redeemable upon the maturity of the Debentures, or upon earlier redemption as provided in the indentures. The Company has the right to redeem the Debentures in whole on or after specific dates, at a redemption price specified in the indentures plus any accrued but unpaid interest to the redemption date.
BCT I, the initial issue of $25 million, has a current interest rate of 6.00%, which is reset semi-annually to equal six-month LIBOR plus 3.70%. BCT II, the second issue, for $15 million, has a current interest rate of 5.42%, which is reset quarterly to equal three-month LIBOR plus 3.35%. BCT III, the third issue, also for $15 million, has a current interest rate 4.97, which is reset quarterly to equal three-month LIBOR plus 2.90%. BCT IV, the fourth issue, also for $15 million has a current interest rate of 4.92% which is reset quarterly to equal three-month LIBOR plus 2.85%.
The following tables are a summary of current trust preferred securities at December 31, 2004 and 2003 (dollars in thousands):
The following table is a summary of current trust preferred securities at December 31, 2003 (dollars in thousands):
Additional Credit Line: The Bank also has established a $26,000,000 Fed Funds credit line with a correspondent bank that will expire in July 2005. There were no balances outstanding under this credit line at December 31, 2004 and 2003.
<PAGE>
Note 14: INCOME TAXES
Provisions of the Small Business Job Protection Act of 1996 (the Job Protection Act) significantly altered the Company's tax bad debt deduction method and the circumstances that would require a tax bad debt reserve recapture. Prior to enactment of the Job Protection Act, savings institutions were permitted to compute their tax bad debt deduction through use of either the reserve method or the percentage of taxable income method. The Job Protection Act repealed both of these methods for large savings institutions and allows bad debt deductions based only on actual current losses. While repealing the reserve method for computing tax bad debt deductions, the Job Protection Act allows savings institutions to retain their existing base year bad debt reserves but requires that reserves in excess of the balance at December 31, 1987, be recaptured into taxable income over six years. As of December 31, 2003, the reserve in excess of the base year (December 31, 1987) had been fully recaptured into taxable income.
The base year reserve is recaptured into taxable income only in limited situations, such as in the event of certain excess distributions, complete liquidation or disqualification as a bank. None of the limited circumstances requiring recapture are contemplated by the Company. The amount of the Company's tax bad debt reserves subject to recapture in these circumstances approximates $5,318,000 at December 31, 2004. Due to the remote nature of events that may trigger the recapture provisions, no tax liability has been established in the accompanying Consolidated Financial Statements.
In addition, as a result of certain acquisitions, the Company is required to recapture certain tax bad debt reserves of the acquired institution. The Company has elected to recapture these reserves into income over a four-year period using the deferral method. The recapture does not result in a charge to earnings as the Company provided for this liability on the acquisition date.
The provision for income taxes for the years ended December 31, 2004, 2003, and 2002 differs from that computed at the statutory corporate tax rate as follows (in thousands):
The provision for income tax expense for the years ended December 31, 2004, 2003 and 2002 is composed of the following (in thousands):
<PAGE>
Income taxes are provided for the temporary differences between the tax basis and financial statement carrying amounts of assets and liabilities. Components of the Company's net deferred tax assets (liabilities) at December 31, 2004 and 2003 consisted of the following (in thousands):
Management has evaluated the weight of available evidence and concluded that it is more likely than not that the Company will realize the net deferred tax asset in future years.
Note 15: EMPLOYEE BENEFIT PLANS
The Bank has its own profit sharing plan for all eligible employees. The plan is funded annually at the discretion of the Board of Directors. Contributions charged to operations for the years ended December 31, 2004, 2003 and 2002 were $796,000, $716,000 and $571,000, respectively.
The Bank has entered into a salary continuation agreement with certain members of its senior management. This program was funded by purchasing single premium life insurance contracts. The program provides for aggregate continued annual compensation for all participants totaling $221,000 for life with a 15-year guarantee. Participants vest ratably each plan year until retirement, termination, death or disability. The Bank is recording the salary continuation obligation over the estimated remaining service lives of the participants. Expenses related to this program for the years ended December 31, 2004, 2003 and 2002 were $191,000, $181,000 and $175,500, respectively. The plan's projected benefit obligation is $2,145,000, of which $1,555,100 was vested at December 31, 2004. At December 31, 2004, an accumulated benefit obligation of $1,555,100 and cash value of life insurance of $2,998,100 were recorded. At December 31, 2003, an obligation of $1,409,600 and cash value of life insurance of $2,900,200 were recorded. Increases in cash surrender value and related net earnings from the life insurance contracts partially offset the expenses of this program.
The Bank also has a non-qualified, non-contributory retirement compensation plan for certain employees whose benefits are based upon a percentage of defined participant compensation. Expenses related to the plan included in the years ended December 31, 2004, 2003 and 2002 results of operations were $48,000, $65,000 and $45,000, respectively. The recorded liability under this plan was $846,100 and $869,800 on December 31, 2004 and 2003, respectively. The Bank is carrying life insurance on these employees to partially offset the cost of the plan. The policies had recorded cash surrender values of $568,000 and $471,000 at December 31, 2004 and 2003, respectively.
The Company and the Bank also offer non-qualified deferred compensation plans to members of their Boards of Directors and certain employees. The plans permit each participant to defer a portion of director fees, non-qualified retirement contributions, salary or bonuses until the future. Compensation is charged to expense in the period earned. In order to fund the plans' future obligations the Company has purchased life insurance polices, contributed to money market investments and purchased common stock of the Company which are held in a "Rabbi Trust." As the Company is the owner of the investments and beneficiary of life insurance contracts, and in order to reflect the Company's policy to pay benefits equal to accumulations, the assets and liabilities under the plans are reflected in the consolidated balance sheets of the Company. Common stock of the Company held for such plans is reported as a contra-equity account and was recorded at original cost of $5,552,000 at December 31, 2004 and $3,091,000 at December 31, 2003. The money market investments and cash surrender value of the life insurance policies are included in other assets.
<PAGE>
During the year ended December 31, 2001, the Company adopted a Supplemental Executive Retirement Program (SERP) for selected senior executives. At termination of employment at or after attaining age 62 with at least 15 years of service or age 65, an executive's annual benefit under the SERP would be computed as the product of 3% of the executive's final average compensation (defined as the three calendar years of executive's annual cash compensation, including bonuses, which produce the highest average within the executive's final eight full calendar years of employment) and the executive's annual years of service, reduced by certain amounts, such as the amount payable to the executive under the Company's 401(k) profit sharing plan and its ESOP, employer-contributed deferred compensation, and any amount payable to the executive under the salary continuation agreements described above. The maximum benefit would be 60% of final average compensation, less applicable reductions. A reduced benefit is payable at termination of employment at or after attaining age 59 1/2 with at least 15 years of service. Expenses relating to this SERP totaled $660,000, $600,000 and $510,000 for the years ended December 31, 2004, 2003 and 2002, respectively. The recorded liability relating to this SERP was $1,950,000 and $1,290,000 at December 31, 2004 and December 31, 2003, respectively.
Note 16: EMPLOYEE STOCK OWNERSHIP PLAN AND TRUST
The Company established for eligible employees an ESOP and related trust that became effective upon the former mutual holding company's conversion to a stock-based holding company. Eligible employees of the Bank as of January 1, 1995 and eligible employees of the Bank or Company employed after such date who have been credited with at least 1,000 hours during a twelve-month period are participants.
The ESOP borrowed $8,728,500 from the Company in order to purchase the common stock. The loan will be repaid principally from the Company's contributions to the ESOP over a period not to exceed 25 years, and the collateral for the loan is the unreleased, restricted common stock purchased by the ESOP. Contributions to the ESOP are discretionary; however, the Company intends to make annual contributions to the ESOP in an aggregate amount at least equal to the principal and interest requirements of the debt. The interest rate for the loan is 8.75%. Shares are released to participants for allocation based on the cumulative debt service paid to the Company by the ESOP divided by cumulative debt service paid to date plus the scheduled debt service remaining. Dividends on allocated shares are distributed to the participants as additional earnings. Dividends on unallocated shares are used to reduce the Company's contribution to the ESOP.
Participants generally become 100% vested in their ESOP account after seven years of credited service or if their service was terminated due to death, early retirement, permanent disability or a change in control of the Company. Prior to the completion of one year of credited service, a participant who terminates employment for reasons other than death, retirement, disability or change in control of the Company will not receive any benefit. Forfeitures will be reallocated among remaining participating employees in the same proportion as contributions. Benefits are payable upon death, retirement, early retirement, disability or separation from service. The contributions to the ESOP are not fixed, so benefits payable under the ESOP cannot be estimated. ESOP compensation expense for the years ended December 31, 2004, 2003 and 2002 was $1,745,000, $1,676,000 and $1,259,000, respectively.
A summary of key transactions for the ESOP follows:
As of December 31, 2004, the Company has 374,595 unearned, restricted shares remaining to be released to the ESOP. The fair value of unearned, restricted shares held by the ESOP trust was $11,684,000 at December 31, 2004. The ESOP held 583,647 allocated, earned shares at December 31, 2004.
<PAGE>
Note 17: STOCK-BASED COMPENSATION PLANS AND STOCK OPTIONS
The Company operates the following stock-based compensation plans as approved by the shareholders: the 1996 Management Recognition and Development Plan (MRP), the 1996 Stock Option Plan, the 1998 Stock Option Plan and the 2001 Stock Option Plan (together, SOPs).
Under the MRP, the Company is authorized to grant up to 528,075 shares of restricted stock to its directors, officers and employees of BANR. Shares granted under the MRP vest ratably over a five-year period. The consolidated statements of income for the year ended December 31, 2004, 2003 and 2002, reflect an accrual of $149,000, $132,000 and $51,000, respectively, in compensation expense for the MRP including $22,000, $7,100 and $8,300, respectively, of expense for dividends on the allocated, restricted stock. A summary of the changes in the granted, but not vested, MRP shares for the years ended December 31, 2004, 2003 and 2002 follows:
Under the 1996, 1998 and 2001 SOPs, the Company has reserved 2,284,186 shares for issuance pursuant to the exercise of stock options which may be granted to directors and employees. The exercise price of the stock options is set at 100% of the fair market value of the stock price at date of grant. Such options vest ratably over a five-year period and any unexercised options will expire ten years after date of grant or 90 days after employment or service ends.
Details of stock options granted, vested, exercised, forfeited or terminated are as follows:
<PAGE>
Financial data pertaining to outstanding stock options granted or assumed as a result of certain acquisitions at December 31, 2004 were as follows:
Note 18: REGULATORY CAPITAL REQUIREMENTS
The Company is a bank holding company registered with the Federal Reserve. Bank holding companies are subject to capital adequacy requirements of the Federal Reserve under the Bank Holding Company Act of 1956, as amended (BHCA), and the regulations of the Federal Reserve. Banner Bank is a state-chartered federally insured institution subject to the capital requirements established by the FDIC.
The capital adequacy requirements are quantitative measures established by regulation that require the Company and the Bank to maintain minimum amounts and ratios of capital. The Federal Reserve requires the Company to maintain capital adequacy that generally parallels the FDIC requirements. The FDIC requires the Bank to maintain minimum ratios of total capital and Tier 1 capital to risk-weighted assets as well as Tier 1 leverage capital to average assets.
The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) created a statutory framework that increased the importance of meeting applicable capital requirements. For the Bank, FDICIA established five capital categories: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. An institution's category depends upon where its capital levels are in relation to relevant capital measures, which include a risk-based capital measure, a leverage ratio capital measure, and certain other factors. The federal banking agencies (including the FDIC) have adopted regulations that implement this statutory framework. Under these regulations, an institution is treated as well-capitalized if its ratio of total capital to risk-weighted assets is 10.00% or more, its ratio of core capital to risk-weighted assets is 6.00% or more, its ratio of core capital to adjusted total assets is 5.00% or more and it is not subject to any federal supervisory order or directive to meet a specific capital level. In order to be adequately capitalized, an institution must have a total risk-based capital ratio of not less than 8.00%, a Tier 1 risk-based capital ratio of not less than 4.00%, and leverage ratio of not less than 4.00%. Any institution which is neither well-capitalized nor adequately capitalized will be considered undercapitalized.
Undercapitalized institutions are subject to certain prompt corrective action requirements, regulatory controls and restrictions which become more extensive as an institution becomes more severely undercapitalized. Failure by the Bank to comply with applicable capital requirements would, if unremedied, result in restrictions on its activities and lead to enforcement actions against it by the FDIC, including, but not limited to, the issuance of a capital directive to ensure the maintenance of required capital levels. FDICIA requires the federal banking regulators to take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. Additionally, FDIC approval of any regulatory application filed for its review may be dependent on compliance with capital requirements.
FDIC regulations recognize two types or tiers of capital: core (Tier 1) capital and supplementary (Tier 2) capital. Tier 1 capital generally includes common stockholders' equity and noncumulative perpetual preferred stock, less most intangible assets. Tier 2 capital, which is limited to 100% of Tier 1 capital, includes such items as qualifying general loan loss reserves, cumulative perpetual preferred stock, mandatory convertible debt, term subordinated debt and limited life preferred stock; however, the amount of term subordinated debt and intermediate term preferred stock (original maturity of at least five years but less than 20 years) that may in included in Tier 2 capital is limited to 50% of Tier 1 capital.
The FDIC currently measures an institution's capital using a leverage limit together with certain risk-based ratios. The FDIC's minimum leverage capital requirement specifies a minimum ratio of Tier 1 capital to average total assets. Most banks are required to maintain a minimum leverage ratio of at least 4% to 5% of total assets. The FDIC retains the right to require a particular institution to maintain a higher capital level based on an institution's particular risk profile.
FDIC regulations also establish a measure of capital adequacy based on ratios of qualifying capital to risk-weighted assets. Assets are placed in
<PAGE>
one of four categories and given a percentage weight - 0%, 20%, 50% or 100% - based on the relative risk of the category. In addition, certain off-balance-sheet items are converted to balance-sheet credit equivalent amounts, and each amount is then assigned to one of the four categories. Under the guidelines, the ratio of total capital (Tier 1 capital plus Tier 2 capital) to risk-weighted assets must be at least 8%, and the ratio of Tier 1 capital to risk-weighted assets must be at least 4%. In evaluating the adequacy of a bank's capital, the FDIC may also consider other factors that may affect the bank's financial condition. Such factors may include interest rate risk exposure, liquidity, funding and market risks, the quality and level of earnings, concentration of credit risk, risks arising from nontraditional activities, loan and investment quality, the effectiveness of loan and investment policies, and management's ability to monitor and control financial operating risks.
FDIC capital requirements are designated as the minimum acceptable standards for banks whose overall financial condition is fundamentally sound, which are well-managed and have no material or significant financial weaknesses. The FDIC capital regulations state that, where the FDIC determines that the financial history or condition, including off-balance-sheet risk, managerial resources and/or the future earnings prospects of a bank are not adequate and/or a bank has a significant volume of assets classified substandard, doubtful or loss or otherwise criticized, the FDIC may determine that the minimum adequate amount of capital for the bank is greater than the minimum standards established in the regulation.
The Company believes that, under the current regulations, the Bank exceeds its minimum capital requirements. However, events beyond the control of the Bank, such as weak or depressed economic conditions in areas where the Bank has most of its loans, could adversely affect future earnings and, consequently, the ability of the Bank to meet is capital requirements.
The Company may not declare or pay cash dividends on, or repurchase, any of its shares of common stock if the effect thereof would cause equity to be reduced below applicable regulatory capital maintenance requirements or if such declaration and payment would otherwise violate regulatory requirements.
The following table shows the regulatory capital ratios of the Company and the Bank and the minimum regulatory requirements:
Company management believes that under the current regulations as of December 31, 2004, the Company and the Bank individually met all capital adequacy requirements to which they were subject. Further, there have been no conditions or events since that date that have materially adversely changed the Tier 1 or Tier 2 capital of the Company or the Bank.
Note 19: CONTINGENCIES
In the normal course of business, the Company and/or its subsidiaries have various legal proceedings and other contingent matters outstanding. These proceedings and the associated legal claims are often contested and the outcome of individual matters is not always predictable. These claims and counter-claims typically arise during the course of collection efforts on problem loans or with respect to action to enforce liens on properties in
<PAGE>
which the Bank holds a security interest. Based upon the information known to management at this time, the Company and the Bank are not a party to any legal proceedings that management believes would have a material adverse effect on the results of operations or consolidated financial position at December 31, 2004.
In connection with certain asset sales, the Bank typically makes representations and warranties about the underlying assets conforming to specified guidelines. If the underlying assets do not conform to the specifications, the Bank may have an obligation to repurchase the assets or indemnify the purchaser against any loss. The Bank believes that the potential for loss under these arrangements is remote. Accordingly, the fair value of such obligations is not material.
Note 20: INTEREST RATE RISK
The financial condition and operation of the Company are influenced significantly by general economic conditions, including the absolute level of interest rates as well as changes in interest rates and the slope of the yield curve. The Company's profitability is dependent to a large extent on its net interest income, which is the difference between the interest received from its interest-earning assets and the interest expense incurred on its interest-bearing liabilities.
The activities of the Company, like all financial institutions, inherently involve the assumption of interest rate risk. Interest rate risk is the risk that changes in market interest rates will have an adverse effect on the institution's earnings and underlying economic value. Interest rate risk is determined by the maturity and repricing characteristics of an institution's assets, liabilities and off-balance-sheet contracts. Interest rate risk is measured by the variability of financial performance and economic value resulting from changes in interest rates. Interest rate risk is the primary market risk impacting the Company's financial performance.
The greatest source of interest rate risk to the Company results from the mismatch of maturities or repricing intervals for rate-sensitive assets, liabilities and off-balance-sheet contracts. Additional interest rate risk results from mismatched repricing indices and formulae (basis risk and yield curve risk), product caps and floors, and early repayment or withdrawal provisions (option risk), which may be contractual or market driven, that are generally more favorable to customers than to the Company.
The Company's primary monitoring tool for assessing interest rate risk is "asset/liability simulation modeling," which is designed to capture the dynamics of balance sheet, interest rate and spread movements, and to quantify variations in net interest income and net market value resulting from those movements under different rate environments. Another monitoring tool used by the Company to assess interest rate risk is "gap analysis." The matching of repricing characteristics of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are "interest sensitive" and by monitoring the Company's interest sensitivity "gap." Management is aware of the sources of interest rate risk and in its opinion actively monitors and manages it to the extent possible, and considers that the Company's current level of interest rate risk is reasonable.
Note 21: GOODWILL AND INTANGIBLES
The Company accounts for intangible assets in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. Goodwill is no longer amortized but is reviewed annually for impairment. Other intangible assets are amortized over their useful lives. The following table provides the gross carrying value and accumulated amortization for intangible assets as of December 31, 2004 and 2003 (in thousands):
<PAGE>
Intangible Assets: The gross carrying amount and accumulated amortization of the Company's intangible assets other than goodwill is as follows (in thousands):
*Amortization of mortgage servicing rights is recorded as a reduction of loan servicing income. Mortgage servicing rights are recorded on an individual basis with the gross carrying amount and accumulated amortization fully written off if the loan repays in full.
Amortization expense for the years ended December 31, 2004, 2003 and 2002 includes $142,000, $199,000 and $255,000, respectively, of expense related to the CDI amortization and $489,000, $1,021,000 and $686,000, respectively, of expense related to the MSR amortization. MSRs capitalized/recognized for the years ended December 31, 2004, 2003 and 2002 were $78,000, $1,576,00 and $1,046,000, respectively.
Estimated amortization expense in future years with respect to existing intangibles (in thousands):
Internet
Year Ended
CDI
MSR
Domain Name
TOTAL
December 31, 2005
$
$
$
$
December 31, 2006
December 31, 2007
--
December 31, 2008
--
December 31, 2009
--
<PAGE>
Note 22: FAIR VALUE OF FINANCIAL INSTRUMENTS
The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, Disclosures About Fair Value of Financial Instruments. The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is necessary to interpret market data in the development of the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The estimated fair value of financial instruments is as follows (in thousands):
Fair value estimates, methods and assumptions are set forth below for the Company's financial and off-balance-sheet instruments:
Cash and due from banks: The carrying amount of these items is a reasonable estimate of their fair value.
Securities: The estimated fair values of investment securities and mortgaged-backed securities available for sale and held to maturity are based on quoted market prices or dealer quotes.
Loans Receivable: Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as multifamily real estate, residential mortgage, nonresidential, commercial/agricultural, consumer and other. Each loan category is further segmented into fixed- and adjustable-rate interest terms and by performing and non-performing categories.
The fair value of performing residential mortgages held for sale is estimated based upon secondary market sources by type of loan and terms such as fixed or variable interest rates. For performing loans held in portfolio, the fair value is based on discounted cash flows using as a discount rate the current rate offered on similar products.
Fair value for significant non-performing loans is based on recent appraisals or estimated cash flows discounted using rates commensurate with risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows and discount rates are judgmentally determined using available market information and specific borrower information.
FHLB Stock: The fair value is based upon the redemption value of the stock which equates to its carrying value.
Deposit Liabilities: The fair value of deposits with no stated maturity, such as savings, checking and NOW accounts, is equal to the amount payable on demand. The market value of certificates of deposit is based upon the discounted value of contractual cash flows. The discount rate is determined using the rates currently offered on comparable instruments.
FHLB Advances and Other Borrowings: The fair value of FHLB advances and other borrowings is estimated based on discounting the estimated future cash flows using rates currently available to the Company for debt with similar remaining maturities.
<PAGE>
Commitments: Commitments to sell loans with notional balances of $23,685,000 and $17,653,000 at December 31, 2004 and 2003, respectively, have a carrying value of ($50,000) and ($19,000), representing the fair value of such commitments. Interest rate lock commitments to originate loans held for sale with notional balances of $23,685,000 and $18,866,000 at December 31, 2004 and 2003, respectively, have a carrying value of $50,000 and $26,000. Other commitments to fund loans totaled $609,744,000 and $527,454,000 at December 31, 2004 and 2003, respectively, and have a carrying value of $0 at both dates, representing the cost of such commitments. There are no commitments to purchase securities at December 31, 2004. Commitments to purchase securities at December 31, 2003, with a notional balance of 1.2 million, have a carrying value of zero, representing the cost of such commitments. There were no commitments to sell securities at December 31, 2004 or 2003
Limitations: The fair value estimates presented herein are based on pertinent information available to management as of December 31, 2004. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date and, therefore, current estimates of fair value may differ significantly from the amounts presented herein.
Fair value estimates are based on existing on- and off-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. Significant assets and liabilities that are not financial instruments include the deferred tax assets/liabilities; land, buildings and equipment; costs in excess of net assets acquired; and real estate held for sale.
Note 23: Banner Corporation (BANR)
(PARENT COMPANY ONLY)
Summary financial information is as follows (in thousands):
BANR
Statements of Financial Condition
December 31, 2004 and 2003
<PAGE>
BANR
Statements of Cash Flows
For the years ended December 31, 2004, 2003 and 2002
Note 24: STOCK REPURCHASE
The Company has periodically engaged in stock repurchase activity. During the years ended December 31, 2004 and 2003, the Company repurchased 134,263 and 19,831 shares of its stock at average prices of $31.00 and $23.96 per share, respectively. In both years, these repurchases occurred in connection with the exercise of stock options. On July 22, 2004, the Company's Board of Directors authorized the repurchase of up to 100,000 shares of the Company's outstanding common stock over the next twelve months.
<PAGE>
Note 25: CALCULATION OF WEIGHTED AVERAGE SHARES OUTSTANDING USED TO CALCULATE EARNINGS PER SHARE (in thousands)
Note 26: SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Results of operations on a quarterly basis were as follows (in thousands except for per share data):
<PAGE>
Note 27: BUSINESS SEGMENTS
The Company is managed by legal entity and not by lines of business. The Bank is a community oriented commercial bank chartered in the State of Washington. The Bank's primary business is that of a traditional banking institution, gathering deposits and originating loans for portfolio in its primary market area. The Bank offers a wide variety of deposit products to its consumer and commercial customers. Lending activities include the origination of real estate, commercial/agriculture business and consumer loans. The Bank is also an active participant in the secondary market, originating residential loans for sale on both a servicing released and servicing retained basis. In addition to interest income on loans and investment securities, the Bank receives other income from deposit service charges, loan servicing fees and from the sale of loans and investments. The performance of the Bank is reviewed by the Company's executive management and Board of Directors on a monthly basis. All of the executive officers of the Company are members of the Bank's management team.
Generally accepted accounting principles establish standards to report information about operating segments in annual financial statements and require reporting of selected information about operating segments in interim reports to stockholders. The Company has determined that its current business and operations consist of a single business segment.
Note 28: FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK
The Bank has financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheets.
The Bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument from commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as for on-balance sheet instruments. As of December 31, 2004, outstanding commitments for which no liability has been recorded consist of the following:
<PAGE>
Commitments to extend credit are agreements to lend to a customer, as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Many of the commitments may expire without being drawn upon, therefore the total commitment amounts do not necessarily represent future cash requirements. Each customer's creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management's credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, and income producing commercial properties.
Standby letters of credit are conditional commitments issued to guarantee a customer's performance or payment to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.
Interest rates on residential one- to four-family mortgage loan applications are typically rate locked (committed) to customers during the application stage for periods ranging from 15 to 45 days, the most typical period being 30 days. Typically, pricing for the sale of these loans is locked with various qualified investors under a best-efforts delivery program at or near the time the interest rate is locked with the customer. The Bank makes every effort to deliver these loans before their rate locks expire. This arrangement generally requires the Bank to deliver the loans prior to the expiration of the rate lock. Delays in funding the loans can require a lock extension. The cost of a lock extension at times is borne by the customer and at times by the Bank. These lock extension costs paid by the Bank are not expected to have a material impact to operations. This activity is managed daily. Changes in the value of rate lock commitments are recorded as assets and liabilities as explained in the Note 1: "Derivatives."
<PAGE>
Banner Corporation
Index of Exhibits
Exhibit
3{a}
Articles of Incorporation of Registrant [incorporated by reference to Exhibit B to the Proxy Statement for the Annual Meeting of Stockholders dated June 10, 1998].
3{b}
Bylaws of Registrant [incorporated by reference to Exhibit 3.2 filed with the Current Report on Form 8-K dated July 24, 1998 (file No. 0-26584)].
10{a}
Employment Agreement with Gary L. Sirmon, dated as of January 1, 2004 [incorporated by reference to exhibits filed with the Annual Report on Form 10-K for the year ended December 31, 2003 (File No. 0-26584)].
10{b}
Executive Salary Continuation Agreement with Gary L. Sirmon [incorporated by reference to exhibits filed with the Annual Report on Form 10-K for the year ended March 31, 1996 (File No. 0-26584)].
10{c}
Employment Agreement with Michael K. Larsen [incorporated by reference to exhibits filed with the Annual Report on Form 10-K for the year ended March 31, 1996 (File No. 0-26584)].
10{d}
Executive Salary Continuation Agreement with Michael K. Larsen [incorporated by reference to exhibits filed with the Annual Report on Form 10-K for the year ended March 31, 1996 (File No. 0-26584)].
10{e}
1996 Stock Option Plan [incorporated by reference to Exhibit A to the Proxy Statement for the Annual Meeting of Stockholders dated June 10, 1996].
10{f}
1996 Management Recognition and Development Plan [incorporated by reference to Exhibit B to the Proxy Statement for the Annual Meeting of Stockholders dated June 10, 1996].
10{g}
Consultant Agreement with Jesse G. Foster, dated as of December 19, 2003. [incorporated by reference to exhibits filed with the Annual Report on Form 10-K for the year ended December 31, 2003 (File No. 0-23584)].
10{h}
Supplemental Retirement Plan as Amended with Jesse G. Foster [incorporated by reference to exhibits filed with the Annual Report on Form 10-K for the year ended March 31, 1997 (file No. 0-26584)].
10{i}
Towne Bank of Woodinville 1992 Stock Option Plan [incorporated by reference to exhibits filed with the Registration Statement on Form S-8 dated April 2, 1998 (file No. 333-49193)].
10{j}
Whatcom State Bank 1991 Stock Option Plan [incorporated by reference to exhibits filed with the Registration Statement on Form S-8 dated February 2, 1999 (file No. 333-71625)].
10{k}
Employment Agreement with Lloyd W. Baker [incorporated by reference to exhibits filed with the Annual Report on Form 10-K for the year ended December 31, 2001 (file No. 0-26584)].
10{l}
Employment Agreement with D. Michael Jones [incorporated by reference to exhibits filed with the Annual Report on Form 10-K for the year ended December 31, 2001 (file No. 0-26584)].
10{m}
Supplemental Executive Retirement Program Agreement with D. Michael Jones [incorporated by reference to exhibits filed with the Annual Report on Form 10-K for the year ended December 31, 2003 (file No. 0-26584)].
10{n}
Form of Supplemental Executive Retirement Program Agreement with Gary Sirmon, Michael K. Larsen, Lloyd W. Baker and Cynthia D. Purcell [incorporated by reference to exhibits filed with the Annual Report on Form 10-K for the year ended December 31, 2001 (file No. 0-26584)].
10{o}
1998 Stock Option Plan [incorporated by reference to Exhibit A to the Proxy Statement for the Annual Meeting of Stockholders dated June 10, 1998].
10{p}
2001 Stock Option Plan [incorporated by reference to Exhibit B to the Proxy Statement of the Annual Meeting of Stockholders dated March 16, 2001].
10{q}
Form of Employment Contract entered into with Cynthia D. Purcell, Richard B. Barton, Paul E. Folz, John R. Neill and Douglas M. Bennett [incorporated by reference to exhibits filed with the Annual Report on Form 10-K for the year ended December 31, 2003 (File No. 0-26584)].
Code of Ethics [incorporated by reference to exhibits filed with the Annual Report on Form 10-K for the year ended December 31, 2003 (File No. 0-26584)].
Subsidiaries of the Registrant.
23.1
Consent of Registered Independent Public Accounting Firm - Moss Adams LLP.
23.2
Consent of Registered Independent Public Accounting Firm - Deloitte & Touche LLP.
31.1
Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
<PAGE>
EXHIBIT 21
SUBSIDIARIES OF THE REGISTRANT
(1) Wholly owned by Banner Corporation
(2) Wholly owned by Banner Bank
<PAGE>
EXHIBIT 23.1
Consent of Registered Independent Public Accounting Firm
We consent to the incorporation by reference in Registration Statement Nos. 333-10819, 333-49193, 333-71625, and 333-67168 of Banner Corporation on Form S-8 of our report dated February 4, 2005, appearing in the Annual Report on Form 10-K of Banner Corporation for the year ended December 31, 2004.
/s/ Moss Adams LLP
Spokane, Washington
March 11, 2005
<PAGE>
EXHIBIT 23.2
CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
We consent to the incorporation by reference in Registration Statement Nos. 333-10819, 333-49193, 333-71625, and 333-67168 on Forms S-8 of our report dated March 11, 2005, appearing in this Annual Report on Form 10-K of Banner Corporation and subsidiaries for the year ended December 31, 2004.
/s/ Deloitte & Touche LLP
Seattle, Washington
March 11, 2005
<PAGE>
EXHIBIT 31.1
CERTIFICATION OF CHIEF EXECUTIVE OFFICER OF BANNER CORPORATION
PURSUANT TO RULES 13a-14(a) AND 15d-14(a) UNDER THE SECURITIES ACT OF 1934
I, D. Michael Jones, certify that:
1.
I have reviewed this Annual Report on Form 10-K of Banner Corporation;
2.
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.
The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f) for the registrant and have:
a)
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b)
Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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;
c)
Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d)
Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and
5.
The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions):
a)
All significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and
b)
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.
March 11, 2005
/s/D. Michael Jones
D. Michael Jones
Chief Executive Officer
<PAGE>
EXHIBIT 31.2
CERTIFICATION OF CHIEF FINANCIAL OFFICER OF BANNER CORPORATION
PURSUANT TO RULES 13a-14(a) AND 15d -14(a) UNDER THE SECURITIES ACT OF 1934
I, Lloyd W. Baker, certify that:
1.
I have reviewed this Annual Report on Form 10-K of Banner Corporation;
2.
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f) for the registrant and have:
a)
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b)
Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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;
c)
Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d)
Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and
5.
The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions):
a)
All significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and
b)
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.
March 11, 2005
/s/Lloyd W. Baker
Lloyd W. Baker
Chief Financial Officer
<PAGE>
EXHIBIT 32
CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER
OF BANNER CORPORATION
PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
The undersigned hereby certify, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and in connection with this Annual Report on Form 10-K, that:
* the report fully complies with the requirements of Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, and
* the information contained in the report fairly presents, in all material respects, the Company's financial condition and results of operations.
March 11, 2005
/s/D. Michael Jones
D. Michael Jones
Chief Executive Officer
March 11, 2005
/s/Lloyd W. Baker
Lloyd W. Baker
Chief Financial Officer