Item 1. Business
General
Timberland Bancorp, Inc. (“Timberland Bancorp" or the "Company”), a Washington corporation, was organized on September 8, 1997 for the purpose of becoming the holding company for Timberland Bank (the "Bank"). At September 30, 2017, on a consolidated basis, the Company had total assets of $952.0 million, total deposits of $837.9 million and total shareholders’ equity of $111.0 million. The Company’s business activities generally are limited to passive investment activities and oversight of its investment in the Bank. Accordingly, the information set forth in this report, including consolidated financial statements and related data, relates primarily to the Bank and its subsidiary, Timberland Service Corporation.
The Bank opened for business in 1915 and serves consumers and businesses across Grays Harbor, Thurston, Pierce, King, Kitsap and Lewis counties, Washington with a full range of lending and deposit services through its 22 branches (including its main office in Hoquiam). The Bank’s deposits are insured up to applicable legal limits by the Federal Deposit Insurance Corporation (“FDIC”). The Bank has been a member of the Federal Home Loan Bank System since 1937. The Bank is regulated by the Washington Department of Financial Institutions, Division of Banks (“Division” or “DFI”) and the FDIC. The Company is regulated by the Board of Governors of the Federal Reserve System ("Federal Reserve").
The Bank is a community-oriented bank which has traditionally offered a variety of savings products to its retail customers while concentrating its lending activities on real estate mortgage loans. Lending activities have been focused primarily on the origination of loans secured by real estate, including residential construction loans, one- to four-family residential loans, multi-family loans, commercial real estate loans and land loans. The Bank originates adjustable-residential mortgage loans that do not qualify for sale in the secondary market. The Bank also originates commercial business loans and other consumer loans.
The Company maintains a website at www.timberlandbank.com. The information contained on that website is not included as a part of, or incorporated by reference into, this Annual Report on Form 10-K. Other than an investor’s own internet access charges, the Company makes available free of charge through that website the Company’s Annual Report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to these reports, as soon as reasonably practicable after these materials have been electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”).
Market Area
The Bank considers Grays Harbor, Pierce, Thurston, Kitsap, King and Lewis counties, Washington as its primary market areas. The Bank conducts operations from:
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its main office in Hoquiam (Grays Harbor County);
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five branch offices in Grays Harbor County (Ocean Shores, Montesano, Elma and two branches in Aberdeen);
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five branch offices in Pierce County (Edgewood, Puyallup, Spanaway, Tacoma and Gig Harbor);
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five branch offices in Thurston County (Olympia, Yelm, Tumwater and two branches in Lacey);
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two branch offices in Kitsap County (Poulsbo and Silverdale);
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a branch office in King County (Auburn); and
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three branch offices in Lewis County (Winlock, Toledo and Chehalis).
For additional information, see “Item 2. Properties.”
Hoquiam, with a population of approximately 8,400, is located in Grays Harbor County which is situated along Washington State’s central Pacific coast. Hoquiam is located approximately 110 miles southwest of Seattle, Washington and 145 miles northwest of Portland, Oregon.
The Bank considers its primary market area to include six sub-markets: primarily rural Grays Harbor County with its historical dependence on the timber and fishing industries; Thurston and Kitsap counties with their dependence on state and federal government; Pierce and King counties with their broadly diversified economic bases; and Lewis County with its dependence on retail trade, manufacturing, industrial services and local government. Each of these markets presents operating risks to the
Bank. The Bank’s expansion into Pierce, Thurston, Kitsap, King and Lewis counties represents the Bank’s strategy to diversify its primary market area to become less reliant on the economy of Grays Harbor County.
Grays Harbor County has a population of 71,600 according to the United States ("U.S.") Census Bureau 2016 estimates and a median family income of $62,100 according to 2017 estimates from the Department of Housing and Urban Development (“HUD”). The economic base in Grays Harbor County has been historically dependent on the timber and fishing industries. Other industries that support the economic base are tourism, agriculture, shipping, transportation and technology. According to the Washington State Employment Security Department, the unemployment rate in Grays Harbor County decreased to 6.1% at September 30, 2017 from 8.2% at September 30, 2016. The median price of a resale home in Grays Harbor County for the quarter ended September 30, 2017 increased 18.2% to $167,600 from $141,800 for the comparable prior year period. The number of home sales increased 16.7% for the quarter ended September 30, 2017 compared to the same quarter one year earlier. The Bank has six branches (including its home office) located throughout the county.
Pierce County is the second most populous county in the state and has a population of 861,300 according to the U.S. Census Bureau 2016 estimates. The county’s median family income is $74,500 according to 2017 HUD estimates. The economy in Pierce County is diversified with the presence of military related government employment (Joint Base Lewis-McChord), transportation and shipping employment (Port of Tacoma), and aerospace related employment. According to the Washington State Employment Security Department, the unemployment rate for the Pierce County area decreased to 4.8% at September 30, 2017 from 6.0% at September 30, 2016. The median price of a resale home in Pierce County for the quarter ended September 30, 2017 increased 28.1% to $338,400 from $264,200 for the comparable prior year period. The number of home sales increased 13.6% for the quarter ended September 30, 2017 compared to the same quarter one year earlier. The Bank has five branches in Pierce County, and these branches have historically been responsible for a substantial portion of the Bank’s construction lending activities.
Thurston County has a population of 275,000 according to the U.S. Census Bureau 2016 estimates and a median family income of $76,300 according to 2017 HUD estimates. Thurston County is home of Washington State’s capital (Olympia), and its economic base is largely driven by state government related employment. According to the Washington State Employment Security Department, the unemployment rate for the Thurston County area decreased to 4.5% at September 30, 2017 from 5.7% at September 30, 2016. The median price of a resale home in Thurston County for the quarter ended September 30, 2017 increased 12.5% to $289,800 from $257,700 for the same quarter one year earlier. The number of home sales increased 20.5% for the quarter ended September 30, 2017 compared to the same quarter one year earlier. The Bank has five branches in Thurston County. This county has historically had a stable economic base primarily attributable to the state government presence.
Kitsap County has a population of 265,000 according to the U.S. Census Bureau 2016 estimates and a median family income of $77,100 according to 2017 HUD estimates. The Bank has two branches in Kitsap County. The economic base of Kitsap County is largely supported by military related government employment through the U.S. Navy. According to the Washington State Employment Security Department, the unemployment rate for the Kitsap County area decreased to 4.6% at September 30, 2017 from 5.7% at September 30, 2016. The median price of a resale home in Kitsap County for the quarter ended September 30, 2017 increased 22.2% to $326,500 from $267,100 for the same quarter one year earlier. The number of home sales increased 13.5% for the quarter ended September 30, 2017 compared to the same quarter one year earlier.
King County is the most populous county in the state and has a population of 2.2 million according to the U.S. Census Bureau 2016 estimates. The Bank has one branch in King County. The county’s median family income is $96,000 according to 2017 HUD estimates. King County’s economic base is diversified with many industries including shipping, transportation, aerospace, computer technology and biotech. According to the Washington State Employment Security Department, the unemployment rate for the King County area decreased to 3.9% at September 30, 2017 from 4.0% at September 30, 2016. The median price of a resale home in King County for the quarter ended September 30, 2017 increased 19.2% to $658,400 from $552,400 for the same quarter one year earlier. The number of home sales increased 8.1% for the quarter ended September 30, 2017 compared to the same quarter one year earlier.
Lewis County has a population of 77,000 according to the U.S. Census Bureau 2016 estimates and a median family income of $62,100 according to 2017 HUD estimates. The economic base in Lewis County is supported by manufacturing, retail trade, local government and industrial services. According to the Washington State Employment Security Department, the unemployment rate in Lewis County decreased to 5.7% at September 30, 2017 from 7.7% at September 30, 2016. The median price of a resale home in Lewis County for the quarter ended September 30, 2017 increased 17.1% to $211,100 from $180,200 for the same quarter one year earlier. The number of home sales increased 13.5% for the quarter ended September 30, 2017 compared to the same quarter one year earlier. The Bank currently has three branches located in Lewis County.
Lending Activities
General. Historically, the principal lending activity of the Bank has consisted of the origination of loans secured by first mortgages on owner-occupied, one- to four-family residences, or by commercial real estate and loans for the construction of one- to four-family residences. The Bank’s net loans receivable totaled $690.4 million at September 30, 2017, representing 72.5% of consolidated total assets, and at that date commercial real estate, construction (including undisbursed loans in process), and land loans were $521.4 million, or 66.4% of total loans. In addition, multi-family loans totaled $58.6 million, or 7.5% of total loans at September 30, 2017. Commercial real estate, construction, multi-family, and land loans typically have higher rates of return than one- to four-family loans; however, they also present a higher degree of risk.
The Bank’s internal loan policy limits the maximum amount of loans to one borrower to 20% of its capital plus surplus. According to the Washington Administrative Code, capital and surplus are defined as a bank's Tier 1 capital, Tier 2 capital and the balance of a bank's allowance for loan losses not included in the bank's Tier 2 capital as reported in the bank's call report. At September 30, 2017, the maximum amount which the Bank could have lent to any one borrower and the borrower’s related entities was approximately $22.8 million under this policy. At September 30, 2017, the largest amount outstanding to any one borrower and the borrower’s related entities was $18.6 million, which was secured by multi-family properties and commercial buildings located in King, Benton and Grant counties. These loans were all performing according to their loan repayment terms at September 30, 2017. The next largest amount outstanding to any one borrower and the borrower’s related entities was $13.1 million (including $963,000 in undisbursed loans in process). These loans were secured by commercial real estate properties located in Pierce and Kitsap counties and were performing according to their loan repayment terms at September 30, 2017.
Loan Portfolio Analysis. The following table sets forth the composition of the Bank’s loan portfolio by type of loan at the dates indicated.
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(1)
Does not include loans held-for-sale of $3,515, $3,604, $3,051, $899 and $1,911 at September 30, 2017, 2016, 2015, 2014 and 2013, respectively.
(2) Does not include loans held-for-sale of $84 at September 30, 2017.
Residential One- to Four-Family Lending. At September 30, 2017, $118.1 million, or 15.1%, of the Bank’s loan portfolio consisted of loans secured by one- to four-family residences. The Bank originates both fixed-rate loans and adjustable-rate loans.
Generally, one- to four-family fixed-rate loans and five and seven year balloon reset loans (which are loans that are originated with a fixed interest rate for the initial five or seven years, and thereafter incur one interest rate change in which the new rate remains in effect for the remainder of the loan term) are originated to meet the requirements for sale in the secondary market to the Federal Home Loan Mortgage Corporation ("Freddie Mac"). From time to time, however, a portion of these fixed-rate loans and five and seven year balloon reset loans may be retained in the loan portfolio to meet the Bank’s asset/liability management objectives. The Bank uses an automated underwriting program, which preliminarily qualifies a loan as conforming to Freddie Mac underwriting standards when the loan is originated. At September 30, 2017, $29.0 million, or 24.5%, of the Bank’s one- to four-family loan portfolio consisted of fixed-rate and five and seven year balloon reset mortgage loans.
The Bank also offers adjustable-rate mortgage (“ARM”) loans. All of the Bank’s ARM loans are retained in its loan portfolio. The Bank offers several ARM products which adjust annually after an initial period ranging from one to five years and are typically subject to a limitation on the annual interest rate increase of 2% and an overall limitation of 6%. These ARM products generally are priced utilizing the weekly average yield on one year U.S. Treasury securities adjusted to a constant maturity of one year plus a margin of 2.88% to 4.00%. The Bank also offers ARM loans tied to The Wall Street Journal prime lending rate ("Prime Rate") or to the London Inter-Bank Offered Rate (“LIBOR”) indices which typically do not have periodic or lifetime adjustment limits. Loans tied to these indices normally have margins ranging up to 3.5%. ARM loans held in the Bank’s portfolio do not permit negative amortization of principal. 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. The relative amount of fixed-rate mortgage loans and ARM loans that can be originated at any time is largely determined by the demand for each in a competitive environment. At September 30, 2017, $89.1 million, or 75.5%, of the Bank’s one- to four- family loan portfolio consisted of ARM loans.
A portion of the Bank’s ARM loans are “non-conforming”, because they do not satisfy acreage limits or various other requirements imposed by Freddie Mac. Some of these loans are also originated to meet the needs of borrowers who cannot otherwise satisfy Freddie Mac credit requirements because of personal and financial reasons (i.e., divorce, bankruptcy, length of time employed, etc.), and other aspects, which do not conform to Freddie Mac’s guidelines. Such borrowers may have higher debt-to-income ratios, or the loans are secured by unique properties in rural markets for which there are no sales of comparable properties to support the value according to secondary market requirements. These loans are known as non-conforming loans, and the Bank may require additional collateral or lower loan-to-value ratios to reduce the risk of these loans. The Bank believes that these loans satisfy a need in its local market area. As a result, subject to market conditions, the Bank intends to continue to originate these types of loans.
The retention of ARM loans in the Bank’s loan portfolio helps reduce the Bank’s exposure to changes in interest rates. There are, however, unquantifiable credit risks resulting from the potential of increased interest to be paid by the customer as a result of increases in interest rates. It is possible that during periods of rising interest rates the risk of default on ARM loans may increase as a result of repricing and the increased costs to the borrower. The Bank attempts to reduce the potential for delinquencies and defaults on ARM loans by qualifying the borrower based on the borrower’s ability to repay the ARM loan assuming that the maximum interest rate that could be charged was in effect during the loan term. Another consideration is that although ARM loans allow the Bank to increase the sensitivity of its asset base due to changes in the interest rates, the extent of this interest sensitivity is limited by the periodic and lifetime interest rate adjustment limits. Because of these considerations, the Bank has no assurance that yield increases on ARM loans will be sufficient to offset increases in the Bank’s cost of funds.
While fixed-rate, single-family residential mortgage loans are normally originated with 15 to 30 year terms to maturity, these loans typically remain outstanding for substantially shorter periods because borrowers often prepay their loans in full upon sale of the property pledged as security or upon refinancing the original loan. In addition, substantially all mortgage loans in the Bank’s loan portfolio contain due-on-sale clauses providing that the Bank may declare the unpaid amount due and payable upon the sale of the property securing the loan. Typically, the Bank enforces these due-on-sale clauses to the extent permitted by law and as business judgment dictates. Thus, average loan maturity is a function of, among other factors, the level of purchase and sale activity in the real estate market, prevailing interest rates and the interest rates received on outstanding loans.
The Bank requires that fire and extended coverage casualty insurance be maintained on the collateral for all of its real estate secured loans and flood insurance, if appropriate.
The Bank’s lending policies generally limit the maximum loan-to-value ratio on mortgage loans secured by owner-occupied properties to 95% of the lesser of the appraised value or the purchase price. However, the Bank usually obtains private
mortgage insurance (“PMI”) on the portion of the principal amount that exceeds 80% of the appraised value of the security property. The maximum loan-to-value ratio on mortgage loans secured by non-owner-occupied properties is generally 80% (90% for loans originated for sale in the secondary market to Freddie Mac). At September 30, 2017, seven one- to four-family loans totaling $874,000 were on non-accrual status. See “Lending Activities - Non-performing Loans and Delinquencies.”
Multi-Family Lending. At September 30, 2017, $58.6 million, or 7.5%, of the Bank’s total loan portfolio was secured by multi-family dwelling units (more than four units) located primarily in the Bank’s primary market area. Multi-family loans are generally originated with variable rates of interest ranging from 1.00% to 3.50% over the one-year constant maturity U.S. Treasury Bill Index, the Prime Rate or a matched term Federal Home Loan Bank borrowing, with principal and interest payments fully amortizing over terms of up to 30 years. At September 30, 2017, the Bank’s largest multi-family loan had an outstanding principal balance of $6.7 million and was secured by an apartment building located in Pierce County. At September 30, 2017, this loan was performing according to its repayment terms.
The maximum loan-to-value ratio for multi-family loans is generally limited to not more than 80%. The Bank generally requests its multi-family loan borrowers with loan balances in excess of $750,000 to submit financial statements and rent rolls on the properties securing such loans. The Bank also inspects such properties annually. The Bank generally imposes a minimum debt coverage ratio of approximately 1.20 for loans secured by multi-family properties.
Multi-family mortgage 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 multi-family properties usually are greater in amount, more difficult to evaluate and monitor and, therefore, may involve a greater degree of risk than one- to four-family residential mortgage loans. Because payments on loans secured by multi-family properties are often dependent on the successful operation and management of the properties, repayment of such loans may be affected by adverse conditions in the real estate market or the economy. The Bank seeks to minimize these risks by scrutinizing the financial condition of the borrower, the quality of the collateral and the management of the property securing the loan. If the borrower is other than an individual, the Bank also generally obtains personal guarantees from the principals based on a review of personal financial statements. At September 30, 2017, all multi-family loans were performing according to their repayment terms. See "Lending Activities - Non-performing Loans and Delinquencies."
Commercial Real Estate Lending. Commercial real estate loans totaled $328.9 million, or 41.9%, of the total loan portfolio at September 30, 2017. The Bank originates commercial real estate loans generally at variable interest rates with principal and interest payments fully amortizing over terms of up to 30 years. These loans are secured by properties, such as office buildings, retail/wholesale facilities, mini-storage facilities, motels, nursing homes, restaurants and convenience stores, located in the Bank’s primary market area. At September 30, 2017, the largest commercial real estate loan was secured by an office building in Thurston County, had a balance of $6.1 million and was performing according to its repayment terms. At September 30, 2017, two commercial real estate loans totaling $213,000 were on non-accrual status. See “Lending Activities - Non-performing Loans and Delinquencies.”
The Bank typically requires appraisals of properties securing commercial real estate loans. For loans that are less than $250,000, the Bank may use the tax assessed value and a property inspection in lieu of an appraisal. Appraisals are performed by independent appraisers designated by the Bank. The Bank considers the quality and location of the real estate, the credit history of the borrower, the cash flow of the project and the quality of management involved with the property when making these loans. The Bank generally imposes a minimum debt coverage ratio of approximately 1.20 for loans secured by income producing commercial properties. Loan-to-value ratios on commercial real estate loans are generally limited to not more than 80%. If the borrower is other than an individual, the Bank also generally obtains personal guarantees from the principals based on a review of personal financial statements.
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 such properties usually are greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater degree of risk than one- to four-family residential mortgage loans. Because payments on loans secured by commercial properties often depend upon 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. The Bank seeks to minimize these risks by generally limiting the maximum loan-to-value ratio to 80% and scrutinizing the financial condition of the borrower, the quality of the collateral and the management of the property securing the loan. The Bank also generally requests annual financial information and rent rolls on the subject property from the borrowers on loans over $750,000.
Construction Lending. The Bank currently originates three types of residential construction loans: (i) custom construction loans, (ii) owner/builder construction loans and (iii) speculative construction loans (on a limited basis). The Bank believes that its computer tracking system has enabled it to establish processing and disbursement procedures to meet the needs
of its borrowers while reducing many of the risks inherent with construction lending. The Bank also originates construction loans for the development of multi-family and commercial properties. The Bank's construction loans generally provide for the payment of interest only during the construction phase, which is billed monthly, although during the term of some construction loans no payment from the borrower is required since the accumulated interest is added to the principal of the loan through an interest reserve. At September 30, 2017, the Bank's construction loans totaled $168.5 million, or 21.5% of the Bank's total loan portfolio, including undisbursed loans in process of $82.4 million.
At September 30, 2017 and 2016, the composition of the Bank’s construction loan portfolio was as follows:
Custom construction loans are made to home builders who, at the time of construction, have a signed contract with a home buyer who has a commitment to purchase the finished home. Custom construction loans are generally originated for a term of six to 12 months, with fixed interest rates typically ranging from 4.50% to 6.25% and with loan-to-value ratios of 80% of the appraised estimated value of the completed property or sales price, whichever is less. All of our custom and owner/builder construction loans are structured to convert to permanent mortgage loans once construction is completed.
Owner/builder construction loans are originated to home owners rather than home builders and are typically converted to or refinanced into permanent loans at the completion of construction. The construction phase of an owner/builder construction loan generally lasts up to 12 months with fixed interest rates typically ranging from 4.50% to 6.25% and with loan-to-value ratios of 80% (or up to 95% with PMI) of the appraised estimated value of the completed property. At the completion of construction, the loan is converted to or refinanced into either a fixed-rate mortgage loan, which conforms to secondary market standards, or an ARM loan for retention in the Bank’s portfolio. At September 30, 2017, custom and owner/builder construction loans totaled $117.6 million, or 69.8% of the total construction loan portfolio. At September 30, 2017, the largest outstanding custom and owner/builder construction loan had an outstanding balance of $1.4 million (including $347,000 of undisbursed loans in process) and was performing according to its repayment terms.
Speculative one-to four-family construction loans are made to home builders and are termed “speculative” because the home builder does not have, at the time of loan origination, a signed contract with a home buyer who has a commitment for permanent financing with either the Bank or another lender for the finished home. The home buyer may be identified either during or after the construction period, with the risk that the builder will have to debt service the speculative construction loan and finance real estate taxes and other carrying costs of the completed home for a significant time after the completion of construction until the home buyer is identified and a sale is consummated. Rather than originating lines of credit to home builders to construct several homes at once, the Bank generally originates and underwrites a separate loan for each home. Speculative construction loans are generally originated for a term of 12 months, with current rates generally ranging from 6.00% to 6.50%, and with a loan-to-value ratio of no more than 80% of the appraised estimated value of the completed property. The Bank is currently originating speculative construction loans on a limited basis. At September 30, 2017, speculative construction loans totaled $9.9 million, or 5.9% of the total construction loan portfolio. At September 30, 2017, the largest aggregate outstanding balance to one borrower for speculative construction loans totaled $1.9 million (including $1.3 million of undisbursed loans in process) and was comprised of ten loans that were performing according to their repayment terms.
The Bank also provides construction financing for multi-family and commercial properties. At September 30, 2017, these loans amounted to $41.0 million, or 24.3%, of construction loans compared to $22.0 million, or 17.8%, of construction loans at September 30, 2016. These loans are typically secured by apartment buildings, condominiums, mini-storage facilities, office buildings, hotels and retail rental space predominantly located in the Bank’s primary market area. At September 30, 2017, the largest outstanding multi-family construction loan was secured by an apartment building project in Thurston County and had a balance of $6.7 million (including $6.7 million of undisbursed construction loan proceeds) and was performing according to its repayment terms. At September 30, 2017, the largest outstanding commercial real estate construction loan was secured by an
assisted living facility project in King County and had a balance of $6.1 million (including $2.0 million of undisbursed loans in process). This loan was performing according to its repayment terms at September 30, 2017.
All construction loans must be approved by a member of one of the Bank’s Loan Committees or the Bank’s Board of Directors, or in the case of one- to four-family construction loans that meet Freddie Mac guidelines, by the Regional Manager of Community Lending, the Loan Department Supervisor or a Bank underwriter. See “- Lending Activities - Loan Solicitation and Processing.” Prior to approval of any construction loan application, an independent fee appraiser inspects the site and the Bank reviews the existing or proposed improvements, identifies the market for the proposed project and analyzes the pro-forma data and assumptions on the project. In the case of a speculative or custom construction loan, the Bank reviews the experience and expertise of the builder. After this preliminary review, the application is processed, which includes obtaining credit reports, financial statements and tax returns on the borrowers and guarantors, an independent appraisal of the project, and any other expert reports necessary to evaluate the proposed project. In the event of cost overruns, the Bank generally requires that the borrower increase the funds available for construction by paying the cost of such overruns directly or by depositing its own funds into a secured savings account, the proceeds of which are used to pay construction costs.
Loan disbursements during the construction period are made to the builder, materials supplier or subcontractor, based on a line item budget. Periodic on-site inspections are made by qualified independent inspectors to document the reasonableness of draw requests. For most builders, the Bank disburses loan funds by providing vouchers to borrowers, which when used by the borrower to purchase supplies are submitted by the supplier to the Bank for payment.
The Bank originates construction loan applications primarily through customer referrals, contacts in the business community and occasionally real estate brokers seeking financing for their clients.
Construction lending (including custom, owner/builder and speculative construction loans) affords the Bank the opportunity to achieve higher interest rates and fees with shorter terms to maturity than does its single-family permanent mortgage lending. Construction lending, however, is generally considered to involve a higher degree of risk than single-family permanent mortgage lending because funds are advanced upon the collateral for the project based on an estimate of the costs that will produce a future value at completion. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation on real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the completed project loan-to-value ratio. With regard to loans originated to builders for speculative projects, changes in the demand, such as for new housing and higher than anticipated building costs, may cause actual results to vary significantly for those estimated. A downturn in the housing, or the real estate market, could increase loan delinquencies, defaults, and foreclosures, and significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. Some builders who have borrowed from us to fund construction projects on a speculative basis have more than one loan outstanding with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss.
In addition, during the term of many of our construction loans granted to builders who are building residential units for sale, no payment from the borrower is required since the accumulated interest is added to the principal of the loan through an interest reserve. As a result, these loans often involve the disbursement of funds with repayment substantially dependent on the success of the ultimate project and the ability of the borrower to to sell or lease the property or obtain permanent take-out financing, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of a completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project and may incur a loss. Because construction loans require active monitoring of the building process, including cost comparisons and on-site inspections, these loans are more difficult and costly to monitor. Increases in market rates of interest may have a more pronounced effect on construction loans by rapidly increasing the end-purchasers' borrowing costs, thereby reducing the overall demand for the project. Properties under construction are often difficult to sell and typically must be completed in order to be successfully sold which also complicates the process of working out problem construction loans. This may require us to advance additional funds and/or contract with another builder to complete construction. Furthermore, in the case of speculative construction loans, there is an added risk associated with identifying an end-purchaser for the finished project. At September 30, 2017 all construction loans were performing according to their repayment terms. See "Lending Activities - Non-performing Loans and Delinquencies."
The Bank historically originated loans to real estate developers with whom it had established relationships for the purpose of developing residential subdivisions (i.e., installing roads, sewers, water and other utilities; generally with ten to 50 lots). The Bank is not currently originating any new land development loans and at September 30, 2017, the Bank had no land development loans outstanding. Although the Bank is not currently originating land development loans, it may do so in the future. Historically land development loans were secured by a lien on the property and typically were made for a period of two to five years with fixed or variable interest rates, and were made with loan-to-value ratios generally not exceeding 75%. Land development loans were
generally structured so that the Bank was repaid in full upon the sale by the borrower of approximately 80% of the subdivision lots. In addition, in the case of a corporate borrower, the Bank also generally obtained personal guarantees from corporate principals and reviewed their personal financial statements. Land development loans secured by land under development involve greater risks than one- to four-family residential mortgage loans because these loans are advanced upon the predicted future value of the developed property upon completion. If the estimate of the future value proves to be inaccurate, in the event of default and foreclosure the Bank may be confronted with a property the value of which is insufficient to assure full repayment. The Bank has historically attempted to minimize this risk by generally limiting the maximum loan-to-value ratio on land loans to 75% of the estimated developed value of the secured property.
Land Lending. The Bank has historically originated loans for the acquisition of land upon which the purchaser can then build or make improvements necessary to build or to sell as improved lots. Currently the Bank is originating land loans on a limited basis. At September 30, 2017, land loans totaled $23.9 million, or 3.0%, of the Bank’s total loan portfolio as compared to $21.6 million, or 3.0%, of the Bank’s total loan portfolio at September 30, 2016. Land loans originated by the Bank generally have maturities of five to ten years. The largest land loan is secured by land in Grays Harbor County, had an outstanding balance of $2.7 million and was performing according to its repayment terms at September 30, 2017. At September 30, 2017, five land loans totaling $566,000 were on non-accrual status. See “Lending Activities - Non-performing Loans and Delinquencies.”
Loans secured by undeveloped land or improved lots involve greater risks than one- to four-family residential mortgage loans because these loans are more difficult to evaluate. If the estimate of value proves to be inaccurate, in the event of default and foreclosure the Bank may be confronted with a property the value of which is insufficient to assure full repayment. Land loans also pose additional risk because of the lack of income being produced by the property and potential illiquid nature of the collateral. These risks can be significantly impacted by supply and demand conditions. The Bank attempts to minimize these risks by generally limiting the maximum loan-to-value ratio on land loans to 75%.
Consumer Lending. Consumer loans generally have shorter terms to maturity and higher interest rates than mortgage loans. Consumer loans include home equity lines of credit, second mortgage loans, savings account loans, automobile loans, boat loans, motorcycle loans, recreational vehicle loans and unsecured loans. Consumer loans are made with both fixed and variable interest rates and with varying terms. At September 30, 2017, consumer loans amounted to $42.2 million, or 5.4%, of the Bank's total loan portfolio.
At September 30, 2017, the largest component of the consumer loan portfolio consisted of second mortgage loans and home equity lines of credit, which totaled $38.4 million, or 4.9%, of the Bank's total loan portfolio. Home equity lines of credit and second mortgage loans are made for purposes such as the improvement of residential properties, debt consolidation and education expenses, among others. The majority of these loans are made to existing customers and are secured by a first or second mortgage on residential property. The loan-to-value ratio is typically 80% or less, when taking into account both the first and second mortgage loans. Second mortgage loans typically carry fixed interest rates with a fixed payment over a term between five and 15 years. Home equity lines of credit are generally made at interest rates tied to the Prime Rate or the 26 week U.S. Treasury Bill. Second mortgage loans and home equity lines of credit have greater credit risk than one- to four-family residential mortgage loans in which the Bank is in the first lien position because they are generally secured by mortgages subordinated to the existing first mortgage on the property. For those second mortgage loans and home equity lines credit which the Bank does not hold the existing first mortgage on the property, it is unlikely that the Bank will be successful in recovering all or a portion of the loan balance in the event of default unless the Bank is prepared to repay the first mortgage loan and such repayment and the costs associated with a foreclosure are justified by the value of the property.
Consumer loans entail greater risk than do residential mortgage loans, particularly in the case of consumer loans that 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 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 that can be recovered on such loans. The Bank believes that these risks are not as prevalent in the case of the Bank’s consumer loan portfolio because a large percentage of the portfolio consists of second mortgage loans and home equity lines of credit that are underwritten in a manner such that they result in credit risk that is substantially similar to one- to four-family residential mortgage loans. At September 30, 2017, three consumer loans totaling $258,000 were on non-accrual status. See “Lending Activities - Non-performing Loans and Delinquencies.”
Commercial Business Lending. Commercial business loans totaled $44.4 million, or 5.7%, of the loan portfolio at September 30, 2017. Commercial business loans are generally secured by business equipment, accounts receivable, inventory
and/or other property and are made at variable rates of interest equal to a negotiated margin above the Prime Rate. The Bank also generally obtains personal guarantees from the principals based on a review of personal financial statements. The largest commercial business loan had an outstanding balance of $2.0 million at September 30, 2017 and was performing according to its repayment terms. At September 30, 2017, all commercial business loans were performing according to their repayment terms. See “Lending Activities - Non-performing Loans and Delinquencies.”
The Bank has recently increased commercial business loan originations made under the U.S. Small Business Administration ("SBA") 7(a) program. Loans made by the Bank under the SBA 7(a) program generally are made to small businesses to provide working capital or to provide funding for the purchase of businesses, real estate, or equipment. These loans generally are secured by a combination of assets that may include equipment, receivables, inventory, business real property, and sometimes a lien on the personal residence of the borrower. The terms of these loans vary by purpose and type of underlying collateral. The loans are primarily underwritten on the basis of the borrower's ability to service the loan from income. Under the SBA 7(a) program the loans carry a SBA guaranty up to 85% of the loan. Typical maturities for this type of loan vary up to ten years. SBA 7(a) loans are all adjustable rate loans based on the Prime Rate. Under the SBA 7(a) program, the Bank can sell in the secondary market the guaranteed portion of its SBA 7(a) loans and retain the related unguaranteed portion of these loans, as well as the servicing on such loans, for which it is paid a fee. The loan servicing spread is generally a minimum of 1.00% on all SBA 7(a) loans. The Bank generally offers SBA 7(a) loans within a range of $50,000 to $1.0 million.
Commercial business lending generally involves greater risk than residential mortgage lending and involves risks that are different from those associated with residential and commercial real estate lending. Real estate lending is generally considered to be collateral based lending with loan amounts based on predetermined loan to collateral values, and liquidation of the underlying real estate collateral is viewed as the primary source of repayment in the event of borrower default. Although commercial business loans are often collateralized by equipment, inventory, accounts receivable and/or other business assets, the liquidation of collateral in the event of a borrower default is often an insufficient source of repayment because accounts receivable may be uncollectible and inventories and equipment may be obsolete or of limited use, among other things. Accordingly, the repayment of a commercial business loan depends primarily on the creditworthiness of the borrower (and any guarantors), while liquidation of collateral is a secondary and often insufficient source of repayment.
Loan Maturity. The following table sets forth certain information at September 30, 2017 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. Loans having no stated maturity and overdrafts are reported as due in one year or less.
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(1) Includes $117.6 million of construction/permanent loans, a portion of which may convert to permanent mortgage loans once construction is completed.
The following table sets forth the dollar amount of all loans due after one year from September 30, 2017, which have fixed interest rates and have floating or adjustable interest rates.
Scheduled contractual principal repayments of loans do not reflect the actual life of these assets. The average life of loans is substantially less than their contractual terms because of 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, among other things, 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 when current mortgage loan interest rates are substantially higher than interest rates on existing mortgage loans and, conversely, decrease when interest rates on existing mortgage loans are substantially higher than current mortgage loan interest rates.
Loan Solicitation and Processing. Loan originations are obtained from a variety of sources, including walk-in customers and referrals from builders and realtors. Upon receipt of a loan application from a prospective borrower, a credit report and other data are obtained to verify specific information relating to the loan applicant’s employment, income and credit standing. An appraisal of the real estate offered as collateral generally is undertaken by a certified appraiser retained by the Bank.
Loan applications are initiated by loan officers and are required to be approved by an authorized loan officer or Bank underwriter, one of the Bank’s Loan Committees or the Bank’s Board of Directors. The Bank’s Consumer Loan Committee consists of several underwriters, each of whom can approve one- to four-family mortgage loans and other consumer loans up to and including the current Freddie Mac single-family limit. Loan officers may also be granted individual approval authority for certain loans up to a maximum of $250,000. The approval authority for individual loan officers is granted on a case by case basis by the Bank's Chief Credit Administrator or President. All construction loans must be approved by a member of one of the Bank's Loan Committees or the Bank's Board of Directors, or in the case of one- to four- family construction loans that meet Freddie Mac guidelines, by the Regional Manager of Community Lending, the Loan Department Supervisor or a Bank underwriter, subject to their individual or Loan Committee loan limit. The Bank’s Commercial Loan Committee, which consists of the Bank’s President, Chief Credit Administrator, Executive Vice President of Lending and Regional Manager of Community Lending, may approve commercial real estate loans and commercial business loans up to and including $1.5 million. The Bank’s President, Chief Credit Administrator and Executive Vice President of Lending also have individual lending authority for loans up to and including $750,000. The Bank’s Board Loan Committee, which consists of two rotating non-employee Directors and the Bank’s President, may approve loans up to and including $3.0 million. Loans in excess of $3.0 million, as well as loans of any amount granted to a single borrower whose aggregate loans exceed $3.0 million, must be approved by the Bank’s Board of Directors.
Loan Originations, Purchases and Sales. During the years ended September 30, 2017, 2016 and 2015, the Bank’s total gross loan originations were $340.6 million, $267.4 million and $262.4 million, respectively. Periodically, the Bank purchases loan participation interests in construction, commercial real estate and multi-family loans, secured by properties generally located in Washington State, from other banks. These participation loans are underwritten in accordance with the Bank’s underwriting guidelines and are without recourse to the seller other than for fraud. During the years ended September 30, 2017, 2016 and 2015, the Bank purchased loan participation interests of $13.1 million, $898,000 and $7.3 million, respectively.
Consistent with its asset/liability management strategy, the Bank’s policy generally is to retain in its portfolio all ARM loans originated and to sell fixed rate one- to four-family mortgage loans in the secondary market to Freddie Mac; however, from time to time, a portion of fixed-rate loans may be retained in the Bank’s portfolio to meet its asset-liability objectives. The Bank also began selling the guaranteed portion of SBA 7(a) loans in the secondary market during the year ended September 30,
2016. Loans sold in the secondary market are generally sold on a servicing retained basis. At September 30, 2017, the Bank’s loan servicing portfolio, which is not included in the Company’s consolidated financial statements, totaled $358.2 million.
The Bank also periodically sells participation interests in construction loans, commercial real estate loans, multi-family and commercial business loans to other lenders. These sales are usually made to avoid concentrations in a particular loan type or concentrations to a particular borrower and to generate fee income. During the years ended September 30, 2017, 2016 and 2015, the Bank sold loan participation interests of $9.3 million, $321,000, and $3.6 million, respectively.
The following table shows total loans originated, purchased, sold and repaid during the periods indicated.
Loan Origination Fees. The Bank receives loan origination fees on many of its mortgage loans and commercial business loans. Loan fees are a percentage of the loan which are charged to the borrower for funding the loan. The amount of fees charged by the Bank is generally up to 2.0% of the loan amount. Accounting principles generally accepted in the United States of America ("GAAP") require fees received and certain loan origination costs for originating loans to be deferred and amortized into interest income over the contractual life of the loan. Net deferred fees or costs associated with loans that are prepaid are recognized as income/expense at the time of prepayment. Unamortized net deferred loan origination fees totaled $2.5 million at September 30, 2017.
Non-performing Loans and Delinquencies. The Bank assesses late fees or penalty charges on delinquent loans of approximately 5% of the monthly loan payment amount. A majority of loan payments are due on the first day of the month; however, the borrower is given a 15 day grace period to make the loan payment. When a mortgage loan borrower fails to make a required payment when due, the Bank institutes collection procedures. A notice is mailed to the borrower 16 days after the date the payment is due. Attempts to contact the borrower by telephone generally begin on or before the 30th day of delinquency. If
a satisfactory response is not obtained, continuous follow-up contacts are attempted until the loan has been brought current. Before the 90th day of delinquency, attempts are made to establish (i) the cause of the delinquency, (ii) whether the cause is temporary, (iii) the attitude of the borrower toward repaying the debt, and (iv) a mutually satisfactory arrangement for curing the default.
If the borrower is chronically delinquent and all reasonable means of obtaining payment on time have been exhausted, foreclosure is initiated according to the terms of the security instrument and applicable law. Interest income on loans in foreclosure is reduced by the full amount of accrued and uncollected interest.
When a consumer loan borrower or commercial business borrower fails to make a required payment on a loan by the payment due date, the Bank institutes similar collection procedures as for its mortgage loan borrowers. All loans becoming 90 days or more past due are placed on non-accrual status, with any accrued interest reversed against interest income, unless they are well secured and in the process of collection.
The Bank’s Board of Directors is informed monthly as to the status of loans that are delinquent by more than 30 days and the status of all foreclosed and repossessed property owned by the Bank.
The following table sets forth information with respect to the Company's non-performing assets at the dates indicated.
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(1) Includes non-accrual one- to four-family properties in the process of foreclosure totaling $100, $138,
$1,105, $1,147 and $3,721 as of September 30, 2017, 2016, 2015, 2014 and 2013, respectively.
(2) Includes foreclosed residential real estate property totaling $875, $1,071, $2,868, $2,903, and $1,752
as of September 30, 2017, 2016, 2015, 2014 and 2013, respectively.
(3) Does not include troubled debt restructured loans on accrual status.
(4) Does not include troubled debt restructured loans totaling $253, $531, $1,233, $2,284 and $4,031
recorded as non-accrual loans as of September 30, 2017, 2016, 2015, 2014 and 2013, respectively.
(5) Loans receivable, net for this table includes the deductions for the undisbursed portion of construction loans in process
and deferred loan origination fees and does not include the deduction for the allowance for loan losses.
The Bank’s non-accrual loans decreased by $1.0 million to $1.9 million at September 30, 2017 from $2.9 million at September 30, 2016, primarily as a result of a $399,000 decrease in commercial real estate loans, a $367,000 decrease in construction loans, and a $174,000 decrease in consumer loans secured by real estate, on non-accrual status. A discussion of the Bank's largest non-performing loans is set forth below under “Asset Classification.”
Additional interest income which would have been recorded for the year ended September 30, 2017 had non-accruing loans been current in accordance with their original terms totaled $548,000.
Other Real Estate Owned and Other Repossessed Assets. Real estate acquired by the Bank as a result of foreclosure or by deed-in-lieu of foreclosure is classified as other real estate owned (“OREO”) until sold. When property is acquired, it is recorded at the estimated fair market value less estimated costs to sell. At September 30, 2017, the Bank had $3.3 million of OREO and other repossessed assets consisting of 15 individual properties and one travel trailer, a decrease of $816,000 from $4.1 million at September 30, 2016. The OREO properties consisted of 11 land parcels totaling $1.9 million, two single family homes totaling $875,000, two commercial real estate properties totaling $533,000, and one travel trailer with a balance of $28,000. The largest OREO property at September 30, 2017 was an undeveloped land parcel with a balance of $948,000 located in Lewis County.
Restructured Loans. Under GAAP, the Bank is required to account for certain loan modifications or restructurings as “troubled debt restructurings” or "troubled debt restructured loans." A troubled debt restructured ("TDR") loan is a loan for which the Company, for reasons related to a borrower's financial difficulties, grants a concession to the borrower that the Company would not otherwise consider. Examples of such concessions include but are not limited to: a reduction in the stated interest rate; an extension of the maturity at an interest rate below current market rates; a reduction in the face amount of the debt; a reduction in the accrued interest; or re-amortizations, extensions, deferrals and renewals. TDR loans are considered impaired and are individually evaluated for impairment. TDR loans are classified as either accrual or non-accrual. TDR loans are classified as non-performing loans unless they have been performing in accordance with their modified terms for a period of at least six months. The Bank had TDR loans at September 30, 2017 and 2016 totaling $3.6 million and $8.2 million, respectively, of which $253,000 and $531,000, respectively, were on non-accrual status. The allowance for loan losses allocated to TDR loans at September 30, 2017 and 2016 was $10,000 and $465,000, respectively.
Impaired Loans. In accordance with GAAP, a loan is considered impaired when based on current information and events it is probable that a creditor will be unable to collect all amounts (principal and interest) when due according to the contractual terms of the loan agreement. Smaller balance homogeneous loans, such as residential mortgage loans and consumer loans, may be collectively evaluated for impairment. When a loan has been identified as being impaired, the amount of the impairment is measured by using discounted cash flows, except when, as an alternative, the current estimated fair value of the collateral, reduced by estimated costs to sell (if applicable), or observable market price is used. The valuation of real estate collateral is subjective in nature and may be adjusted in future periods because of changes in economic conditions. Management considers third-party appraisals, as well as independent fair market value assessments from realtors or persons involved in selling real estate, in determining the estimated fair value of particular properties. In addition, as certain of these third-party appraisals and independent fair market value assessments are only updated periodically, changes in the values of specific properties may have occurred subsequent to the most recent appraisals. Accordingly, the amounts of any such potential changes and any related adjustments are generally recorded at the time such information is received. When the measurement of the impaired loan is less than the recorded investment in the loan (including accrued interest and net deferred loan origination fees or costs), impairment is recognized by creating or adjusting an allocation of the allowance for loan losses and uncollected accrued interest is reversed against interest income. If ultimate collection of principal is in doubt, all cash receipts on impaired loans are applied to reduce the principal balance.
The categories of non-accrual loans and impaired loans overlap, although they are not identical. The Bank considers all circumstances regarding the loan and borrower on an individual basis when determining whether an impaired loan should be placed on non-accrual status, such as the financial strength of the borrower, the collateral value, reasons for delay, payment record,
the amount past due and the number of days past due. At September 30, 2017, the Bank had $7.0 million in impaired loans. For additional information on impaired loans, see Note 4 of the Notes to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
Other Loans of Concern. Loans not reflected in the table above as non-performing, but where known information about possible credit problems of borrowers causes management to have doubts as to the ability of the borrower to comply with present repayment terms and that may result in disclosure of such loans as non-performing assets in the future, are commonly referred to as “other loans of concern” or “potential problem loans.” The amount included in potential problem loans results from an evaluation, on a loan-by-loan basis, of loans classified as “substandard” and “special mention,” as those terms are defined under “Asset Classification” below. The amount of potential problem loans (not included in the table above as non-performing) was $9.1 million at September 30, 2017. The vast majority of these loans are collateralized by real estate. See “Asset Classification” below for additional information regarding the Bank's problem loans.
Asset Classification. Applicable regulations require that each insured institution review and classify its assets on a regular basis. In addition, in connection with examinations of insured institutions, regulatory examiners have authority to identify problem assets and, if appropriate, require them to be classified. There are three classifications for problem assets: substandard, doubtful and loss. Substandard loans are classified as those loans that are inadequately protected by the current net worth and paying capacity of the obligor, or of the collateral pledged. Assets classified as substandard have a well-defined weakness or weaknesses that jeopardize the repayment of the debt. If the weakness or weaknesses are not corrected there is the distinct possibility that some loss will be sustained. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified as loss is considered uncollectible and of such little value that continuance as an asset of the Bank is not warranted. When the Bank classifies problem assets as either substandard or doubtful, it is required to establish allowances for loan losses in an amount deemed prudent by management. These allowances represent loss allowances which have been established to recognize the inherent risk associated with lending activities and the risks associated with particular problem assets. When the Bank classifies problem assets as loss, it charges off the balance of the asset against the allowance for loan losses. Assets which do not currently expose the Bank to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are designated by the Bank as special mention. Special mention loans are defined as those credits deemed by management to have some potential weakness that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in the deterioration of the payment prospects of the loan. Assets in this category are not adversely classified and currently do not expose the Bank to sufficient risk to warrant a substandard classification. The Bank’s determination of the classification of its assets and the amount of its valuation allowances is subject to review by the FDIC and the Division which can require a different classification and the establishment of additional loss allowances.
The aggregate amounts of the Bank’s classified and special mention loans (as determined by the Bank), and of the Bank's allowances for loan losses at the dates indicated, were as follows:
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(1)
For further information concerning the change in classified assets, see “Non-performing Loans and Delinquencies" above.
(2)
Includes non-performing loans.
Loans classified as substandard decreased by $1.8 million to $3.3 million at September 30, 2017 from $5.0 million at September 30, 2016. At September 30, 2017, 26 loans were classified as substandard compared to 34 loans at September 30, 2016. Of the $3.3 million in loans classified as substandard at September 30, 2017, $1.9 million were on non-accrual status. The largest loan classified as substandard at September 30, 2017 had a balance of $524,000 and was secured by a single family home
in Pierce County. This loan was performing according to its restructured payment terms at September 30, 2017. The next largest loan classified as substandard at September 30, 2017 had a balance of $398,000 and was secured by a commercial building in Pierce County. This loan was on non-accrual status at September 30, 2017.
Loans classified as special mention decreased by $7.3 million to $7.8 million at September 30, 2017 from $15.1 million at September 30, 2016, primarily as a result of loans being upgraded to an improved risk grade category and loans being paid off during the year ended September 30, 2017. At September 30, 2017, 19 loans were classified as special mention. The largest loan classified as special mention at September 30, 2017 had a balance of $1.1 million and was secured by an apartment building in Grays Harbor County. This loan was performing according to its payment terms at September 30, 2017. The next largest loan classified as special mention at September 30, 2017 had a balance of $676,000 and was secured by land in Grays Harbor County. This loan was performing according to its payment terms at September 30, 2017.
Allowance for Loan Losses. The allowance for loan losses is maintained to absorb probable losses inherent in the loan portfolio. The Bank has established a comprehensive methodology for the determination of provisions for loan losses that takes into consideration the need for an overall general valuation allowance. The Bank’s methodology for assessing the adequacy of its allowance for loan losses is based on its historic loss experience for various loan segments; adjusted for changes in economic conditions, delinquency rates and other factors. Using these loss estimate factors, management develops a range of probable loss for each loan category. Certain individual loans for which full collectibility may not be assured are evaluated individually with loss exposure based on estimated discounted cash flows or net realizable collateral values. The total estimated range of loss based on these two components of the analysis is compared to the loan loss allowance balance. Based on this review, management will adjust the allowance as necessary.
In originating loans, the Bank 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 creditworthiness 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. The Bank increases its allowance for loan losses by charging provisions for loan losses against the Bank's operating income.
The Board of Directors reviews the adequacy of the allowance for loan losses at least quarterly based on management's assessment of current economic conditions, past loss and collection experience, and risk characteristics of the loan portfolio.
At September 30, 2017, the Bank’s allowance for loan losses totaled $9.6 million. The Bank’s allowance for loan losses as a percentage of total loans receivable and non-performing loans was 1.36% and 499.90%, respectively, at September 30, 2017 and 1.46% and 326.66%, respectively, at September 30, 2016. The decrease in the allowance for loan losses as a percentage of total loans receivable was primarily due to a decrease in non-performing loans and overall improvements in other underlying credit quality metrics in the loan portfolio.
Management believes that the amount maintained in the allowance for loan losses is adequate to absorb probable losses inherent in the portfolio. Although management believes that it uses the best information available to make its determinations, future adjustments to the allowance for loan losses may be necessary, and results of operations could be significantly and adversely affected if circumstances differ substantially from the assumptions used in making the determinations.
While the Bank believes it has established its 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 Bank's financial condition and results of operations.
The following table sets forth an analysis of the Bank's allowance for loan losses for the periods indicated.
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(1)
Loans receivable, net for this table includes the deductions for the undisbursed portion of construction loans in process and net deferred loan origination fees and does not include the deduction for the allowance for loan losses.
The following table sets forth the allocation of the allowance for loan losses by loan category at the dates indicated.
Investment Activities
The investment policies of the Bank are established and monitored by the Board of Directors. The policies are designed primarily to provide and maintain liquidity, to generate a favorable return on investments without incurring undue interest rate and credit risk, and to compliment the Bank’s lending activities. These policies dictate the criteria for classifying securities as either available for sale or held to maturity. The policies permit investment in various types of liquid assets permissible under applicable regulations, which include U.S. Treasury obligations, securities of various federal agencies, certificates of deposit of insured banks, federal funds, mortgage-backed securities, municipal bonds and mutual funds. The Company's investment policy also permits investment in equity securities in certain financial service companies.
At September 30, 2017, the Bank’s investment portfolio totaled $8.4 million, consisting of $6.0 million of U.S. Treasury and U.S. government agency securities held to maturity, $1.1 million of mortgage-backed securities held to maturity, $952,000 of mutual funds available for sale and $289,000 of mortgage-backed securities available for sale. The Bank does not maintain a trading account for any investments. This compares with a total investment portfolio of $8.9 million at September 30, 2016, consisting of $6.0 million of U.S. Treasury and U.S. government agency securities held to maturity, $1.5 million of mortgage-backed securities held to maturity, $366,000 of mortgage-backed securities available for sale and $976,000 of mutual funds available for sale. The composition of the portfolios by type of security at the dates indicated is presented in the following table.
The following table sets forth the maturities and weighted average yields of the securities in the Bank's portfolio at September 30, 2017. Mutual funds, which by their nature do not have maturities, are classified in the one year or less category.
There were no securities which had an aggregate book value in excess of 10% of the Bank’s total equity at September 30, 2017. At September 30, 2017, the Bank had $599,000 of private label mortgage-backed securities in the held to maturity investment securities portfolio of which $533,000 were on non-accrual status. For additional information regarding investment securities, see “Item 1A.
Item 1A. Risk Factors
We assume and manage a certain degree of risk in order to conduct our business strategy. In addition to the risk factors described below, other risks and uncertainties not specifically mentioned, or that are currently known to, or deemed to be immaterial
by management, also may materially and adversely affect our financial position, results of operations and/or cash flows. Before making an investment decision, you should carefully consider the risks described below together with all of the other information included in this Form 10-K and our other filings with the SEC. If any of the circumstances described in the following risk factors actually occur to a significant degree, the value of our common stock could decline, and you could lose all or part of your investment. This report is qualified in its entirety by these risk factors.
Our business may be adversely affected by downturns in the national economy and in the economies in our market areas.
Substantially all of our loans are to businesses and individuals in the state of Washington. A decline in the economies of our local market areas of Grays Harbor, Pierce, Thurston, King, Kitsap and Lewis counties in which we operate, and which we consider to be our primary market areas, could have a material adverse effect on our business, financial condition, results of operations and prospects. Weakness in the global economy has adversely affected many businesses operating in our markets that are dependent upon international trade and it is not known how the recent withdrawal by the United States from the Trans-Pacific Partnership trade agreement may also affect these businesses.
While real estate values and unemployment rates have recently improved, a deterioration in economic conditions in the market areas we serve could result in the following consequences, any of which could have a materially adverse impact on our business, financial condition and results of operations:
•
loan delinquencies, problem assets and foreclosures may increase;
•
the sale of foreclosed assets may slow;
•
demand for our products and services may decline possibly resulting in a decrease in our total loans or assets;
•
collateral for loans made may decline further in value, exposing us to increased risk loans, reducing customers’ borrowing power, and reducing the value of assets and collateral associated with existing loans;
•
the net worth and liquidity of loan guarantors may decline, impairing their ability to honor commitments to us; and
•
the amount of our low-cost or non-interest bearing deposits may decrease and the composition of our deposits may be adversely affected.
A decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose real estate loans are geographically diverse. If we are required to liquidate a significant amount of collateral during a period of reduced real estate values, our financial condition and profitability could be adversely affected.
A return of recessionary conditions could result in increases in our level of non-performing loans and/or reduce demand for our products and services, which could have an adverse effect on our results of operations.
A return of recessionary conditions and/or negative developments in the domestic and international credit markets may significantly affect the markets in which we do business, the value of our loans and investments, and our ongoing operations, costs and profitability. Declines in real estate values and sales volumes and high unemployment levels may result in higher than expected loan delinquencies and a decline in demand for our products and services. These negative events may cause us to incur losses and may adversely affect our capital, liquidity, and financial condition.
Our real estate construction loans expose us to significant risks.
We make real estate construction loans to individuals and builders, primarily for the construction of residential properties. We originate these loans whether or not the collateral property underlying the loan is under contract for sale. At September 30, 2017, construction loans totaled $168.5 million, or 21.5% of our total loan portfolio, of which $148.9 million were for residential real estate projects. This compares to total construction loans of $123.1 million, or 17.0% of our total loan portfolio at September 30, 2016, or an increase of 36.9% during the past year. Approximately $117.6 million of our residential construction loans at September 30, 2017 were made to finance the construction of owner-occupied homes and are structured to be converted to permanent loans at the end of the construction phase. In general, construction lending involves additional risks because funds are advanced upon estimates of costs in relation to values associated with the completed project. Construction lending involves additional risks when compared with permanent residential lending because funds are advances upon the collateral for the project based on an estimate of costs that will produce a future value at completion. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the complete project and the effects of governmental regulation on real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the completed project loan-to-value ratio. Changes in demand for new housing and higher than anticipated building costs may cause actual results to vary significantly from those estimated. For these reasons, this type of lending also typically involves higher loan principal amounts
and may be concentrated with a small number of builders. A downturn in housing, or the real estate market, could increase delinquencies, defaults and foreclosures, and significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. Some of the builders we deal with have more than one loan outstanding with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss. In addition during the term of some of our construction loans, no payment from the borrower is required since the accumulated interest is added to the principal of the loan through an interest reserve. As a result, these loans often involve the disbursement of funds with repayment substantially dependent on the success of the ultimate project and the ability of the borrower to sell or lease the property or obtain permanent take-out financing, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of a completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project and may incur a loss. Because construction loans require active monitoring of the building process, including cost comparisons and on-site inspections, these loans are more difficult and costly to monitor. Increases in market rates of interest may have a more pronounced effect on construction loans by rapidly increasing the end-purchaser's borrowing costs, thereby possibly reducing the homeowner's ability to finance the home upon completion or the overall demand for the project. Properties under construction are often difficult to sell and typically must be completed in order to be successfully sold which also complicates the process of working our problem construction loans. This may require us to advance additional funds and/or contract with another builder to complete construction and assume the market risk of selling the project at a future market price, which may or may not enable us to fully recover unpaid loan funds and associated construction and liquidation costs. Furthermore, in the case of speculative construction loans, there is the added risk associated with identifying an end-purchaser for the finished project. At September 30, 2017, $9.9 million of our construction portfolio was comprised of speculative one- to four-family construction loans. At September 30, 2017, all construction loans were performing in accordance to their terms. A material increase in our non-performing construction loans could have a material adverse effect on our financial condition and results of operation.
Our emphasis on commercial real estate lending may expose us to increased lending risks.
Our current business strategy includes an emphasis on commercial real estate lending. This type of lending activity, while potentially more profitable than single-family residential lending, is generally more sensitive to regional and local economic conditions, making loss levels more difficult to predict. Collateral evaluation and financial statement analysis in these types of loans requires a more detailed analysis at the time of loan underwriting and on an ongoing basis. In our primary market of western Washington, a downturn in the real estate market could increase loan delinquencies, defaults and foreclosures, and significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. Many of our commercial borrowers have more than one loan outstanding with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss.
At September 30, 2017, we had $328.9 million of commercial real estate mortgage loans, representing 41.9% of our total loan portfolio. These loans typically involve higher principal amounts than other types of loans, and repayment is dependent upon income generated, or expected to be generated, by the property securing the loan in amounts sufficient to cover operating expenses and debt service, which may be adversely affected by changes in the economy or local market conditions. For example, if the cash flow from the borrower’s project is reduced as a result of leases not being obtained or renewed, the borrower’s ability to repay the loan may be impaired. Commercial real estate loans also expose a lender to greater credit risk than loans secured by residential real estate because the collateral securing these loans typically cannot be sold as easily as residential real estate. In addition, many of our commercial real estate loans are not fully amortizing and contain large balloon payments upon maturity. Such balloon payments may require the borrower to either sell or refinance the underlying property in order to make the payment, which may increase the risk of default or non-payment.
A secondary market for most types of commercial real estate loans is not readily liquid, so we have less opportunity to mitigate credit risk by selling part or all of our interest in these loans. As a result of these characteristics, if we foreclose on a commercial real estate loan, our holding period for the collateral typically is longer than for one- to four-family residential mortgage loans because there are fewer potential purchasers of the collateral. Accordingly, charge-offs on commercial real estate loans may be larger as a percentage of the total principal outstanding than those incurred with our residential or consumer loan portfolios.
The level of our commercial real estate loan portfolio may subject us to additional regulatory scrutiny.
The FDIC, the Federal Reserve and the Office of the Comptroller of the Currency have promulgated joint guidance on sound risk management practices for financial institutions with concentrations in commercial real estate lending. Under this guidance, a financial institution that, like us, is actively involved in commercial real estate lending should perform a risk assessment to identify concentrations. A financial institution may have a concentration in commercial real estate lending if, among other factors (i) total reported loans for construction, land development and other land represent 100% or more of total capital, or (ii) total reported loans secured by multi-family and non-farm non-residential properties, loans for construction, land development
and other land, and loans otherwise sensitive to the general commercial real estate market, including loans to commercial real estate related entities, represent 300% or more of total capital. The particular focus of the guidance is on exposure to commercial real estate loans that are dependent on the cash flow from the real estate held as collateral and that are likely to be at greater risk to conditions in the commercial real estate market (as opposed to real estate collateral held as a secondary source of repayment or as an abundance of caution). The purpose of the guidance is to guide banks in developing risk management practices and capital levels commensurate with the level and nature of real estate concentrations. The guidance states that management should employ heightened risk management practices including board and management oversight and strategic planning, development of underwriting standards, risk assessment and monitoring through market analysis and stress testing. We have concluded that we have a concentration in commercial real estate lending under the foregoing standards because our balance in commercial real estate loans at September 30, 2017 represents more than 300% of total capital. While we believe we have implemented policies and procedures with respect to our commercial real estate loan portfolio consistent with this guidance, bank regulators could require us to implement additional policies and procedures consistent with their interpretation of the guidance that may result in additional costs to us.
Repayment of our commercial business loans is often dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value.
At September 30, 2017, we had $44.4 million, or 5.7%, of total loans in commercial business loans. Commercial business lending involves risks that are different from those associated with residential and commercial real estate lending. Real estate lending is generally considered to be collateral based lending with loan amounts based on predetermined loan to collateral values and liquidation of the underlying real estate collateral being viewed as the primary source of repayment in the event of borrower default. Our commercial business loans are primarily made based on the cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. The borrowers' cash flow may be unpredictable, and collateral securing these loans may fluctuate in value. Although commercial business loans are often collateralized by equipment, inventory, accounts receivable, or other business assets, the liquidation of collateral in the event of default is often an insufficient source of repayment because accounts receivable may be uncollectible and inventories may be obsolete or of limited use, among other things. Accordingly, the repayment of commercial business loans depends primarily on the cash flow and credit worthiness of the borrower and secondarily on the underlying collateral provided by the borrower.
Our business may be adversely affected by credit risk associated with residential property.
At September 30, 2017, $156.6 million, or 20.0%, of our total loan portfolio was secured by one- to four-family mortgage loans and home equity loans. This type of lending is generally sensitive to regional and local economic conditions that significantly impact the ability of borrowers to meet their loan payment obligations, making loss levels difficult to predict. A decline in residential real estate values resulting from a downturn in the Washington housing market may reduce the value of the real estate collateral securing these types of loans and increase our risk of loss if borrowers default on their loans.
Many of our residential mortgage loans are secured by liens on mortgage properties in which the borrowers have little or no equity because either we originated the loan with a relatively high combined loan-to-value ratio or because of the decline in home values in our market areas subsequent to when the loans were originated. Residential loans with combined higher loan-to-value ratios will be more sensitive to declining property values than those with lower combined loan-to-value ratios and therefore may experience a higher incidence of default and severity of losses. In addition, if the borrowers sell their homes, such borrowers may be unable to repay their loans in full from the sale proceeds. Further, a significant amount of our home equity lines of credit consist of second mortgage loans. For those home equity lines secured by a second mortgage, it is unlikely that we will be successful in recovering all or a portion of our loan proceeds in the event of default unless we are prepared to repay the first mortgage loan and such repayment and the costs associated with a foreclosure are justified by the value of the property. For these reasons, we may experience higher rates of delinquencies, default and losses on our residential loans.
Our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolio.
Lending money is a substantial part of our business, and each loan carries a certain risk that it will not be repaid in accordance with its terms or that any underlying collateral will not be sufficient to assure repayment. This risk is affected by, among other things:
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the cash flow of the borrower and/or the project being financed;
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the changes and uncertainties as to the future value of the collateral, in the case of a collateralized loan;
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the duration of the loan;
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the credit history of a particular borrower; and
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changes in economic and industry conditions.
We maintain an allowance for loan losses, which is a reserve established through a provision for loan losses charged against operating income, which we believe is appropriate to provide for probable losses in our loan portfolio. The amount of this allowance is determined by our management through periodic comprehensive reviews and consideration of several factors, including, but not limited to:
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an ongoing review of the quality, size and diversity of the loan portfolio;
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evaluation of non-performing loans;
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historical default and loss experience;
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existing economic conditions and management's expectations of future events;
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risk characteristics of the various classifications of loans;
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the amount and quality of collateral, including guarantees, securing the loans; and
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regulatory requirements and expectations.
The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. In determining the amount of the allowance for loan losses, we review our loans and the loss experience and evaluate economic conditions and make significant estimates of current credit risks and future trends, all of which may undergo material changes. If our estimates are incorrect, the allowance for loan losses may not be sufficient to cover losses inherent in our loan portfolio, resulting in the need for increases in our allowance for loan losses through the provision for losses on loans which is charged against income. Further, the Financial Accounting Standards Board has adopted a new accounting standard that will be effective for our fiscal year beginning October 1, 2020. This standard, referred to as Current Expected Credit Loss ("CECL") will require financial institutions to determine periodic estimates of lifetime expected credit losses on loans, and recognize the expected credit losses as allowances for credit losses. This will change the current method of providing allowances for credit losses that are probable, which may require us to increase our allowance for loan losses, and may greatly increase the types of data we would need to collect and review to determine the appropriate level of the allowance for credit losses.
Deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may also require an increase in the allowance for loan losses. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different from those of management. If charge-offs in future periods exceed the allowance for loan losses, we will need additional provisions to replenish the allowance for loan losses. Any additional provisions will result in a decrease in net income and possibly capital, and may have a material adverse effect on our financial condition and results of operations.
If our non-performing assets increase, our earnings will be adversely affected.
At September 30, 2017 our non-performing assets (which consist of non-accruing loans, accruing loans 90 days or more past due, non-accrual investment securities, and OREO and other repossessed assets) were $5.7 million, or 0.60% of total assets. Our non-performing assets adversely affect our net income in various ways:
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We do not record interest income on non-accrual loans or non-performing investment securities, except on a cash basis when the collectibility of the principal is not in doubt.
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We must provide for probable loan losses through a current period charge to the provision for loan losses.
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Non-interest expense increases when we must write down the value of properties in our OREO portfolio to reflect changing market values.
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Non-interest income decreases when we must recognize other-than-temporary impairment on non-performing investment securities.
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There are legal fees associated with the resolution of problem assets, as well as carrying costs, such as taxes, insurance, and maintenance costs related to our OREO.
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The resolution of non-performing assets requires the active involvement of management, which can distract them from more profitable activity.
If additional borrowers become delinquent and do not pay their loans and we are unable to successfully manage our non-performing assets, our losses and troubled assets could increase significantly, which could have a material adverse effect on our financial condition and results of operations. In addition to the non-performing loans, there were $3.3 million in loans classified as performing troubled debt restructurings at September 30, 2017.
If our investments in real estate are not properly valued or sufficiently reserved to cover actual losses, or if we are required to increase our valuation allowances, our earnings could be reduced.
We obtain updated valuations in the form of appraisals and broker price opinions when a loan has been foreclosed and the property is taken in as OREO, and at certain other times during the asset's holding period. Our net book value (“NBV”) in the loan at the time of foreclosure and thereafter is compared to the updated estimated market value of the foreclosed property less estimated selling costs (fair value). A charge-off is recorded for any excess in the asset’s NBV over its fair value. If our valuation process is incorrect or if the property declines in value after foreclosure, the fair value of our OREO may not be sufficient to recover our NBV in such assets, resulting in the need for a valuation allowance.
In addition, bank regulators periodically review our OREO and may require us to recognize further valuation allowances. Significant charge-offs to our OREO may have a material adverse effect on our financial condition and results of operations.
Our investment securities portfolio may be negatively impacted by fluctuations in market value and interest rates and result in losses.
Our investment securities portfolio may be impacted by fluctuations in market value, potentially reducing accumulated other comprehensive income (loss) and/or earnings. Fluctuations in market value may be caused by changes in market interest rates, lower market prices for investment securities and limited investor demand. Our investment securities portfolio is evaluated for other-than-temporary-impairment ("OTTI"). If this evaluation shows impairment to the actual or projected cash flows associated with one or more investment securities, a potential loss to earnings may occur. Changes in interest rates can also have an adverse effect on our financial condition, as our available-for-sale investment securities are reported at their estimated fair value, and therefore are impacted by fluctuations in interest rates. We increase or decrease our shareholders' equity by the amount of change in the estimated fair value of the available-for-sale investment securities, net of income taxes.
During the year ended September 30, 2017, we recognized a $33,000 recovery of OTTI charges on private label mortgage backed securities we hold for investment. During the year ended September 30, 2016, we recognized $168,000 of OTTI charges on private label mortgage backed securities we hold for investment. During the year ended September 30, 2015, we recognized $13,000 of OTTI charges on private label mortgage backed securities we hold for investment. At September 30, 2017, our remaining private label mortgage backed securities portfolio totaled $599,000 of which $533,000 was on non-accrual status.
The valuation of our investment securities also is influenced by additional external market and other factors, including implementation of Securities and Exchange Commission and Financial Accounting Standards Board guidance on fair value accounting, default rates on residential mortgage securities and rating agency actions. Accordingly, there can be no assurance that future declines in the market value of our private label mortgage backed securities or other investment securities will not result in additional OTTI of these assets and lead to accounting charges that could have an adverse effect on our results of operations.
An increase in interest rates, change in the programs offered by Freddie Mac or our ability to qualify for their programs may reduce our mortgage revenues, which would negatively impact our non-interest income.
The sale of residential mortgage loans to Freddie Mac provides a significant portion of our non-interest income. Any future changes in their program, our eligibility to participate in such program, the criteria for loans to be accepted or laws that significantly affect the activity of Freddie Mac could, in turn, materially adversely affect our results of operations if we could not find other purchasers. Mortgage banking is generally considered a volatile source of income because it depends largely on the level of loan volume which, in turn, depends largely on prevailing market interest rates. In a rising or higher interest rate environment, the demand for mortgage loans, particularly refinancing of existing mortgage loans, tends to fall and our originations of mortgage loans may decrease, resulting in fewer loans that are available to be sold. This would result in a decrease in mortgage revenues and a corresponding decrease in non-interest income. In addition, our results of operations are affected by the amount of non-interest expense associated with our loan sale activities, such as salaries and employee benefits, occupancy, equipment and data processing expense and other operating costs. During periods of reduced loan demand, our results of operations may be adversely affected to the extent that we are unable to reduce expenses commensurate with the decline in loan originations. In addition, although we sell loans to Freddie Mac or into the secondary market without recourse, we are required to give customary representations and warranties about the loans we sell. If we breach those representations and warranties, we may be required to repurchase the loans and we may incur a loss on the repurchase.
Our real estate lending also exposes us to the risk of environmental liabilities.
In the course of our business, we may foreclose and take title to real estate, and we could be subject to environmental liabilities with respect to these properties. We may be held liable by a governmental entity or by third persons for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, as the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If we ever become subject to significant environmental liabilities, our business, financial condition and results of operations could be materially and adversely affected.
Fluctuating interest rates can adversely affect our profitability.
Our earnings and cash flows are largely dependent upon our net interest income. Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Reserve Board. In an attempt to help the overall economy, the Federal Reserve Board has kept interest rates low through its targeted Fed Funds rate. Beginning in December 2016, the Federal Reserve Board has increased the Fed Funds rate by 75 basis points to a range of 1.00% to 1.25% in September 2017 and indicated a likelihood for a further increase of 25 basis points during 2017 subject to economic conditions. As the Federal Reserve Board increases the Fed Funds rate, overall interest rates will likely rise, which may negatively impact both the housing markets by reducing refinancing activity and new home purchases and the U.S. economic recovery.
Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and investments and the amount of interest we pay on deposits and borrowings, but these changes could also affect: (1) our ability to originate and/or sell loans and obtain deposits; (2) the fair value of our financial assets and liabilities, which could negatively impact shareholders’ equity, and our ability to realize gains from the sale of such assets; (3) our ability to obtain and retain deposits in competition with other available investment alternatives; (4) the ability of our borrowers to repay adjustable or variable rate loans; and (5) the average duration of our investment securities portfolio and other interest-earning assets. If the interest rates paid on deposits and borrowings increase at a faster rate than the interest received on loans and other investments, our net interest income, and therefore earnings, could be adversely affected.
Changes in interest rates could also have a negative impact on our results of operations by reducing the ability of borrowers to repay their current loan obligations or by reducing our margins and profitability. Our net interest margin is the difference between the yield we earn on our assets and the interest rate we pay for deposits and our other sources of funding. Changes in interest rates (up or down) could adversely affect our net interest margin and, as a result, our net interest income. Although the yield we earn on our assets and our funding costs tends to move in the same direction in response to changes in interest rates, one can rise or fall faster than the other, causing our net interest margin to expand or contract. Changes in the slope of the "yield curve", or the spread between short-term and long-term interest rates, could also reduce our net interest margin. Normally the yield curve is upward sloping, meaning short-term rates are lower than long-term rates. Because our liabilities tend to be shorter in duration than our assets, when the yield curve flattens or even inverts, we could experience pressure on our net interest margin as our cost of funds increases relative to the yield we can earn on our assets. Also, interest rate decreases can lead to increased prepayments of loans and mortgage-backed securities as borrowers refinance their loans to reduce borrowing costs. Under these circumstances we are subject to reinvestment risk as we may have to redeploy such repayment proceeds into lower yielding investments, which would likely negatively impact our income.
A sustained increase in market interest rates could adversely affect our earnings. As a result of the exceptionally low interest rate environment, an increasing percentage of our deposits have been comprised of deposits bearing no or a relatively low rate of interest and having a shorter duration than our assets. At September 30, 2017, we had $75.4 million in certificates of deposit that mature within one year and $698.3 million in non-interest bearing, NOW checking, savings and money market accounts. We would incur a higher cost of funds to retain these deposits in a rising interest rate environment. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income, and therefore earnings, could be adversely affected. In addition, a substantial amount of our residential mortgage loans and home equity lines of credit have adjustable interest rates. As a result, these loans may experience a higher rate of default in a rising interest rate environment.
Changes in interest rates also affects the value of our interest-earning assets and in particular our investment securities portfolio. Generally, the fair value of fixed-rate securities fluctuates inversely with changes in interest rates. Unrealized gains and losses on investment securities available for sale are reported as a separate component of equity, net of tax. Decreases in the
fair value of investment securities available for sale resulting from increases in interest rates could have an adverse effect on stockholders' equity.
Any substantial, unexpected or prolonged change in market interest rates could have a material adverse effect on our financial condition, liquidity and results of operations. Also, our interest rate risk modeling techniques and assumptions likely may not fully predict or capture the impact of actual interest rate changes on our balance sheet or projected operating results. For further discussion of how changes in interest rates could impact us, see "Part II, Item 7A. Quantitative and Qualitative Disclosures About Market Risk" for additional information about our interest rate risk management.
The financial services market is undergoing rapid technological changes, and if we are unable to stay current with those changes, we may not be able to effectively compete.
The financial services market, including banking services, is undergoing rapid changes with frequent introductions of new technology-driven products and services. Our future success will depend, in part, on our ability to keep pace with the technological changes and to use technology to satisfy and grow customer demand for our products and services and to create additional efficiencies in our operations. We expect that we will need to make substantial investments in our technology and information systems to compete effectively and to stay current with technological changes. Some of our competitors have substantially greater resources to invest in technological improvements and will be able to invest more heavily in developing and adopting new technologies, which may put us at a competitive disadvantage. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. As a result, our ability to effectively compete to retain or acquire new business may be impaired, and our business, financial condition or results of operations may be adversely affected.
Liquidity risk could impair our ability to fund operations and jeopardize our financial condition, growth and prospects.
Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a substantial negative effect on our liquidity. We rely on customer deposits and borrowings from the FHLB, borrowings from the FRB and other borrowings to fund our operations. At September 30, 2017, we had no FHLB borrowings outstanding and a letter of credit with an available balance of $22.0 million and an additional $360.5 million of available borrowing capacity through the FHLB and the FRB. Deposit flows, calls of wholesale borrowings, and the prepayment of loans and mortgage-related securities are strongly influenced by such external factors as the direction of interest rates, whether actual or perceived, and the competition for deposits and loans in the markets we serve. Further, changes to the FHLB's underwriting guidelines for wholesale borrowings or lending policies may limit or restrict our ability to borrow, and could therefore have a significant adverse impact on our liquidity. Although we have historically been able to replace maturing deposits and borrowings if desired, we may not be able to replace such funds in the future if, among other things, our financial condition, the financial condition of the FHLB or FRB, or market conditions change. Our access to funding sources in amounts adequate to finance our activities or on terms which are acceptable could be impaired by factors that affect us specifically or the financial services industry or economy in general, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry. Additional factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity as a result of a downturn in the Washington markets where our deposits are concentrated or adverse regulatory action against us.
Our financial flexibility will be severely constrained if we are unable to maintain our access to funding or if adequate financing is not available to accommodate future growth at acceptable interest rates. Although we consider our sources of funds adequate for our liquidity needs, we may seek additional debt in the future to achieve our long-term business objectives. Additional borrowings, if sought, may not be available to us or, if available, may not be available on reasonable terms. If additional financing sources are unavailable, or are not available on reasonable terms, our financial condition, results of operations, growth and future prospects could be materially adversely affected. Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our income may not increase proportionately to cover our costs.
We operate in a highly regulated environment and may be adversely affected by changes in federal and state laws and regulations that could increase our costs of operations.
The banking industry is extensively regulated. Federal banking regulations are designed primarily to protect the deposit insurance funds and consumers, not to benefit a company's shareholders. These regulations may sometimes impose significant limitations on our operations. The significant federal and state banking regulations that affect us are described in this report under the heading "Item 1. Business-How We Are Regulated". These regulations, along with the currently existing tax, accounting, securities, insurance, and monetary laws, regulations, rules, standards, policies, and interpretations control the methods by which financial institutions conduct business, implement strategic initiatives and tax compliance, and govern financial reporting and
disclosures. These laws, regulations, rules, standards, policies, and interpretations are constantly evolving and may change significantly over time. Any new regulations or legislation, change in existing regulation or oversight, whether a change in regulatory policy or a change in a regulator's interpretation of a law or regulation, could have a material impact on our operations, increase our costs of regulatory compliance and of doing business and adversely affect our profitability. In this regard, the U.S. Department of the Treasury's Financial Crimes Enforcement Network ("FinCEN"), published guidelines in 2014 for financial institutions servicing state legal marijuana businesses. These guidelines allow us to work with marijuana-related businesses that are operating in accordance with state laws and regulations, so long as we comply with required regulatory oversight of their accounts with us. At September 30, 2017, approximately 1.8% of our total deposits and a portion of our service charges from deposits are from legal marijuana-related businesses. Any adverse change in this FinCEN guidance, any new regulations or legislation, any change in existing regulations or oversight, whether a change in regulatory policy or a change in a regulator's interpretation of a law or regulation, could have a negative impact on our non-interest income, as well as the cost of our operations, increasing our cost of regulatory compliance and of doing business and/or otherwise affect us, which may materially affect our profitability.
Non-compliance with the USA PATRIOT Act, Bank Secrecy Act, or other laws and regulations could result in fines or sanctions and limit our ability to get regulatory approval of acquisitions.
The USA PATRIOT and Bank Secrecy Acts require financial institutions to develop programs to prevent financial institutions from being used for money laundering and terrorist activities. If such activities are detected, financial institutions are obligated to file suspicious activity reports with FinCEN. These rules require financial institutions to establish procedures for identifying and verifying the identity of customers seeking to open new financial accounts. Failure to comply with these regulations could result in fines or sanctions and limit our ability to get regulatory approval of acquisitions. Recently several banking institutions have received large fines for non-compliance with these laws and regulations. While we have developed policies and procedures designed to assist in compliance with these laws and regulations, no assurance can be given that these policies and procedures will be effective in preventing violations of these laws and regulations.
Our growth or future losses may require us to raise additional capital in the future, but that capital may not be available when it is needed or the cost of that capital may be very high.
We are required by federal regulatory authorities to maintain adequate levels of capital to support our operations. At some point, we may need to raise additional capital to support our growth or replenish future losses. Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial condition and performance. If we are able to raise capital it may not be on terms that are acceptable to us. Accordingly, we cannot make assurances that we will be able to raise additional capital. If we cannot raise additional capital when needed, our operations could be materially impaired and our financial condition and liquidity could be materially and adversely affected. As a result, we may have to raise additional capital on terms that may be dilutive to our shareholders.
We may experience future goodwill impairment, which could reduce our earnings.
We performed our test for goodwill impairment for fiscal year 2017, and the test concluded that recorded goodwill was not impaired. Our test of goodwill for potential impairment is based on a qualitative assessment by management that takes into consideration macroeconomic conditions, industry and market conditions, cost or margin factors, financial performance and share price. Our evaluation of the fair value of goodwill involves a substantial amount of judgment. If our judgment was incorrect, or if events or circumstances change, and an impairment of goodwill was deemed to exist, we would be required to write down our goodwill resulting in a charge against operations, which would adversely affect our results of operations, perhaps materially; however, it would have no impact on our liquidity, operations or regulatory capital.
We may experience decreases in the fair value of our mortgage servicing rights, which could reduce our earnings.
Mortgage servicing rights (“MSRs”) are capitalized at estimated fair value when acquired through the origination of loans that are subsequently sold with servicing rights retained. At September 30, 2017, our MSRs totaled $1.8 million. MSRs are amortized to servicing income on loans sold over the period of estimated net servicing income. The estimated fair value of MSRs at the date of the sale of loans is determined based on the discounted present value of expected future cash flows using key assumptions for servicing income and costs and prepayment rates on the underlying loans. On a quarterly basis, we evaluate the fair value of MSRs for impairment by comparing actual cash flows and estimated cash flows from the servicing assets to those estimated at the time servicing assets were originated. Our methodology for estimating the fair value of MSRs is highly sensitive to changes in assumptions, such as prepayment speeds. The effect of changes in market interest rates on estimated rates of loan prepayments represents the predominant risk characteristic underlying the MSRs portfolio. For example, a decrease in mortgage interest rates typically increases the prepayment speeds of MSRs and therefore decreases the fair value of the MSRs. Future
decreases in mortgage interest rates could decrease the fair value of our MSRs below their recorded amount, which would decrease our earnings.
Our framework for managing risks may not be effective in mitigating risk and loss to us.
We have established processes and procedures intended to identify, measure, monitor, report, analyze and control the types of risk to which we are subject. These risks include liquidity risk, credit risk, market risk, interest rate risk, operational risk, legal and compliance risk, and reputational risk, among others. We also maintain a compliance program to identify, measure, assess, and report on our adherence to applicable laws, policies and procedures. While we assess and improve these programs on an ongoing basis, there can be no assurance that our risk management or compliance programs, along with other related controls, will effectively mitigate all risk and limit losses in our business. As with any risk management framework, there are inherent limitations to our risk management strategies as there may exist, or develop in the future, risks that we have not appropriately anticipated or identified. If our risk management framework proves ineffective, we could suffer unexpected losses which could have a material adverse effect on our financial condition and results of operations.
We are subject to certain risks in connection with our use of technology.
Our security measures may not be sufficient to mitigate the risk of a cyber attack. Communications and information systems are essential to the conduct of our business, as we use such systems to manage our customer relationships, our general ledger and virtually all other aspects of our business. Our operations rely on the secure processing, storage, and transmission of confidential and other information in our computer systems and networks. Although we take protective measures and endeavor to modify them as circumstances warrant, the security of our computer systems, software, and networks may be vulnerable to breaches, unauthorized access, misuse, computer viruses, or other malicious code and cyber attacks that could have a security impact. If one or more of these events occur, this could jeopardize our or our customers' confidential and other information processed and stored in, and transmitted through, our computer systems and networks, or otherwise cause interruptions or malfunctions in our operations or the operations of our customers or counterparties. We may be required to expend significant additional resources to modify our protective measures or to investigate and remediate vulnerabilities or other exposures, and we may be subject to litigation and financial losses that are either not insured against or not fully covered through any insurance maintained by us. We could also suffer significant reputational damage.
Security breaches in our internet banking activities could further expose us to possible liability and damage our reputation. Any compromise of our security also could deter customers from using our internet banking services that involve the transmission of confidential information. We rely on standard internet security systems to provide the security and authentication necessary to effect secure transmission of data. These precautions may not protect our systems from compromises or breaches of our security measures and could result in significant legal liability and significant damage to our reputation and our business.
Our security measures may not protect us from system failures or interruptions. While we have established policies and procedures to prevent or limit the impact of systems failures and interruptions, there can be no assurance that such events will not occur or that they will be adequately addressed if they do. In addition, we outsource certain aspects of our data processing and other operational functions to certain third-party providers. If our third-party providers encounter difficulties, or if we have difficulty in communicating with them, our ability to adequately process and account for transactions could be affected, and our business operations could be adversely impacted. Threats to information security also exist in the processing of customer information through various other vendors and their personnel.
The occurrence of any failures or interruptions may require us to identify alternative sources of such services, and we cannot assure you that we could negotiate terms that are as favorable to us or could obtain services with similar functionality as found in our existing systems without the need to expend substantial resources, if at all. Further, the occurrence of any systems failure or interruption could damage our reputation and result in a loss of customers and business, could subject us to additional regulatory scrutiny, or could expose us to legal liability. Any of these occurrences could have a material adverse effect on our financial condition and results of operations.
Our business may be adversely affected by an increasing prevalence of fraud and other financial crimes.
Our loans to businesses and individuals and our deposit relationships and related transactions are subject to exposure to the risk of loss due to fraud and other financial crimes. Nationally, reported incidents of fraud and other financial crimes have increased. We have also experienced losses due to apparent fraud and other financial crimes. While we have policies and procedures designed to prevent such losses, there can be no assurance that such losses will not occur.
We are dependent on key personnel, and the loss of one or more of those key personnel may materially and adversely affect our prospects.
Competition for qualified employees and personnel in the banking industry is intense, and there are a limited number of qualified persons with knowledge of, and experience in, the community banking industry where the Bank conducts its business. The process of recruiting personnel with the combination of skills and attributes required to carry out our strategies is often lengthy. Our success depends to a significant degree upon our ability to attract and retain qualified management, loan origination, finance, administrative, marketing and technical personnel and upon the continued contributions of our management and personnel. In particular, our success has been and continues to be highly dependent upon the abilities of key executives, including our President, and certain other employees. In addition, our success has been and continues to be highly dependent upon the services of our directors, and we may not be able to identify and attract suitable candidates to replace such directors.
Managing reputational risk is important to attracting and maintaining customers, investors and employees.
Threats to our reputation can come from many sources, including adverse sentiment about financial institutions generally, unethical practices, employee misconduct, failure to deliver minimum standards of service or quality, compliance deficiencies and questionable or fraudulent activities of our customers. We have policies and procedures in place to protect our reputation and promote ethical conduct, but these policies and procedures may not be fully effective. Negative publicity regarding our business, employees, or customers, with or without merit, may result in the loss of customers, investors and employees, costly litigation, a decline in revenues and increased governmental regulation.
We rely on other companies to provide key components of our business infrastructure.
Third-party vendors provide key components of our business infrastructure such as internet connections, network access and core application processing. While we have selected these third-party vendors carefully, we do not control their actions. Any problems caused by these third-parties, including as a result of their not providing us their services for any reason or their performing their services poorly, could adversely affect our ability to deliver products and services to our customers or otherwise conduct our business efficiently and effectively. Replacing these third-party vendors could also entail significant delay and expense.
Item 1B.
Item 1B. Unresolved Staff Comments
Not applicable.
Item 2.
Item 2. Properties
At September 30, 2017, the Bank operated 22 full service facilities. The following table sets forth certain information regarding the Bank’s offices, all of which are owned, except for the Tacoma office and the Lacey office at 1751 Circle Lane SE, which are leased.
Management believes that all facilities are appropriately insured and are adequately equipped for carrying on the business of the Bank.
At September 30, 2017, the Bank operated 22 proprietary ATMs that are part of a nationwide cash exchange network.
Item 3.
Item 3. Legal Proceedings
Periodically, there have been various claims and lawsuits involving the Company, such as claims to enforce liens, condemnation proceedings on properties in which the Company holds security interests, claims involving the making and servicing of real property loans and other issues incident to the Company's business. The Company is not a party to any pending legal proceedings that it believes would have a material adverse effect on the financial condition or operations of the Company.
Item 4.
Item 4. Mine Safety Disclosures
Not applicable.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The Company's common stock is traded on the Nasdaq Global Market under the symbol “TSBK.” As of November 30, 2017, there were 7,364,627 shares of common stock issued and approximately 435 shareholders of record. The following table sets forth the high and low sales prices of, and dividends paid on, the Company's common stock for each quarter during the years ended September 30, 2017 and 2016. The high and low price information was provided by the Nasdaq Stock Market.
____________
(1) Includes a special dividend of $0.08 in addition to the regular quarterly dividend.
(2) Includes a special dividend of $0.05 in addition to the regular quarterly dividend.
Dividends
The timing and amount of cash dividends paid on our common stock depends on our earnings, capital requirements, financial condition and other relevant factors and is subject to the discretion of our board of directors. There can be no assurance that we will pay dividends on our common stock in the future.
Dividend payments by the Company are dependent primarily on dividends received by the Company from the Bank. Under federal regulations, the dollar amount of dividends the Bank may pay is dependent upon its capital position and recent net income. Generally, if the Bank satisfies its regulatory capital requirements, it may make dividend payments up to the limits prescribed in the FDIC regulations. However, an institution that has converted to a stock form of ownership may not declare or pay a dividend on, or repurchase any of, its common stock if the effect thereof would cause the regulatory capital of the institution to be reduced below the amount required for the liquidation account which was established in connection with the mutual to stock conversion.
The DFI has the power to require any bank to suspend the payment of any and all dividends. In addition, under Washington law, no bank may declare or pay any dividend in an amount greater than its retained earnings without the prior approval of the DFI. Further, under Washington law, Timberland Bancorp is prohibited if, after making such dividend payment, it would be unable to pay its debts as they become due in the usual course of business, or if its total liabilities, plus the amount that would be needed, in the event Timberland Bancorp were to be dissolved at the time of the dividend payment, to satisfy preferential rights on dissolution of holders of preferred stock ranking senior in right of payment to the capital stock on which the applicable distribution is to be made, exceed our total assets.
In addition to the foregoing regulatory considerations, there are numerous governmental requirements and regulations that affect our business activities. A change in applicable statutes, regulations or regulatory policy may have a material effect on our business and on our ability to pay dividends on our common stock.
Equity Compensation Plan Information
The equity compensation plan information presented under subparagraph (d) in Part III, Item 12. of this Form 10-K is incorporated herein by reference.
Stock Repurchases
The Company is subject to certain restrictions on its ability to repurchase its common stock. The Company is required to give the Federal Reserve prior written notice of any purchase or redemption of its outstanding equity securities if the consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of its consolidated net worth. The Federal Reserve may disapprove 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 condition imposed by, or written agreement with, the Federal Reserve.
The Company has had various stock repurchase programs since January 1998. On July 28, 2015, the Company announced a plan to repurchase 352,681 shares of the Company's common stock. This marked the Company's 17th stock repurchase plan. There were no shares repurchased during the year ended September 30, 2017 and 221,893 shares were available to be repurchased under the current repurchase program.
As of September 30, 2017, the Company has repurchased 130,788 of these shares at an average price of $11.69 per share. Cumulatively, since January 1998 the Company has repurchased 7,914,722 shares at an average price of $9.02 per share.
The following table sets forth the Company's repurchases of its outstanding Common Stock during the fourth quarter of the year ended September 30, 2017.
Five-Year Stock Performance Graph
The following graph compares the cumulative total shareholder return on our common stock with the cumulative total return on the Nasdaq U.S. Companies Index and with the SNL $500 million to $1 Billion Asset Thrift Index, peer group indices. Total return assumes the reinvestment of all dividends and that the value of the Company’s Common Stock and each index was $100 on September 30, 2012.
* Source: S&P Global Market Intelligence
Item 6.
Item 6. Selected Financial Data
The following table sets forth certain information concerning the consolidated financial position and results of operations of the Company and its subsidiary at and for the dates indicated. The consolidated data is derived in part from, and should be read in conjunction with, the Consolidated Financial Statements of the Company and its subsidiary presented herein.
_______________
(1)
Cash dividends to common shareholders divided by net income to common shareholders.
__________________
(1)
Net income divided by average total assets.
(2)
Net income divided by average total equity.
(3)
Difference between weighted average yield on interest-earning assets and weighted average cost of interest-bearing liabilities.
(4)
Net interest income before provision for (recapture of) loan losses as a percentage of average interest-earning assets.
(5)
Non-interest expenses divided by the sum of net interest income and non-interest income.
(6)
Non-performing assets include non-accrual loans, loans past due 90 days or more and still accruing, non-accrual investment securities, OREO and other repossessed assets.
(7)
Loans receivable is before the allowance for loan losses.
(8)
Non-performing loans include non-accrual loans and loans past due 90 days or more and still accruing. TDR loans that are on accrual status are not included.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
Management's Discussion and Analysis of Financial Condition and Results of Operations is intended to assist in understanding the consolidated 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 thereto included in Item 8 of this Annual Report on Form 10-K.
Overview
Timberland Bancorp, Inc., a Washington corporation, is the holding company for Timberland Bank. The Bank opened for business in 1915 and serves consumers and businesses across Grays Harbor, Thurston, Pierce, King, Kitsap and Lewis counties, Washington with a full range of lending and deposit services through its 22 branches (including its main office in Hoquiam). At September 30, 2017, the Company had total assets of $952.02 million and total shareholders’ equity of $111.00 million. The Company’s business activities generally are limited to passive investment activities and oversight of its investment in the Bank. Accordingly, the information set forth in this report relates primarily to the Bank’s operations.
The Bank is a community-oriented bank which has traditionally offered a variety of savings products to its retail customers while concentrating its lending activities on real estate mortgage loans. Lending activities have been focused primarily on the origination of loans secured by real estate, including residential construction loans, one- to four-family residential loans, multi-family loans and commercial real estate loans. The Bank originates adjustable-rate residential mortgage loans that do not qualify for sale in the secondary market. The Bank also originates commercial business loans and other consumer loans.
The profitability of the Company’s operations depends primarily on its net interest income after provision for (recapture of) loan losses. Net interest income is the difference between interest income, which is the income that the Company earns on interest-earning assets, which are primarily loans and investments, and interest expense, the amount the Company pays on its interest-bearing liabilities, which are primarily deposits and borrowings (as needed). Net interest income is affected by changes in the volume and mix of interest-earning assets, interest earned on those assets, the volume and mix of interest-bearing liabilities and interest paid on those interest-bearing liabilities. Management attempts to match the re-pricing characteristics of the interest-earning assets and interest-bearing liabilities to protect net interest income from changes in market interest rates and changes in the shape of the yield curve.
The provision for (recapture of) loan losses is dependent on changes in the loan portfolio and management’s assessment of the collectability of the loan portfolio as well as prevailing economic and market conditions. The allowance for loan losses reflects the amount that the Company believes is adequate to cover probable credit losses inherent in its loan portfolio.
Net income is also affected by non-interest income and non-interest expenses. For the year ended September 30, 2017, non-interest income consisted primarily of service charges on deposit accounts, gain on sales of loans, ATM and debit card interchange transaction fees, an increase in the cash surrender value of BOLI, servicing income on loans sold and other operating income. Non-interest income is also increased by net recoveries on investment securities and reduced by net OTTI losses on investment securities, if any. Non-interest expenses consisted primarily of salaries and employee benefits, premises and equipment, advertising, ATM and debit card interchange transaction fees, postage and courier expenses, state and local taxes, professional fees, FDIC insurance premiums, loan administration and foreclosure expenses, data processing and telecommunication expenses, deposit operation expenses and other non-interest expenses. Non-interest income and non-interest expenses are affected by the growth of the Company's operations and growth in the number of loan and deposit accounts.
Results of operations may be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities.
Operating Strategy
The Company is a bank holding company which operates primarily through its subsidiary, the Bank. The Company's primary objective is to operate the Bank as a well capitalized, profitable, independent, community-oriented financial institution, serving customers in its primary market area of Grays Harbor, Pierce, Thurston, Kitsap, King and Lewis counties. The Company's strategy is to provide innovative products and superior service to small businesses, industry and geographic niches, and individuals located in its primary market area.
The Company's goal is to deliver returns to shareholders by increasing higher-yielding assets (in particular commercial real estate, construction, and commercial business loans), increasing core deposit balances, managing problem assets, efficiently managing expenses, and exploring expansion opportunities. The Company seeks to achieve these results by focusing on the following objectives:
Expand our presence within our existing market areas by capturing opportunities resulting from changes in the competitive environment. We currently conduct our business primarily in western Washington. We have a community bank strategy that emphasizes responsive and personalized service to our customers. As a result of consolidation of banks in our market areas, we believe there is an opportunity for a community and customer focused bank to expand its customer base. By offering timely decision making, delivering appropriate banking products and services, and providing customer access to our senior managers we believe community banks, such as Timberland Bank, can distinguish themselves from larger banks operating in our market areas. We believe we have a significant opportunity to attract additional borrowers and depositors and expand our market presence and market share within our extensive branch footprint.
Portfolio diversification. In recent years, we have limited the origination of speculative construction loans and land loans in favor of loans that possess credit profiles representing less risk to the Bank. We continue originating owner/builder and custom construction loans, multi-family loans, commercial business loans and certain commercial real estate loans which offer higher risk adjusted returns, shorter maturities and more sensitivity to interest rate fluctuations than fixed rate one-to four-family loans. We anticipate capturing more of each customer's banking relationship by cross selling our loan and deposit products and offering additional services to our customers.
Increase core deposits and other retail deposit products. We focus on establishing a total banking relationship with our customers with the intent of internally funding our loan portfolio. We anticipate that the continued focus on customer relationships will increase our level of core deposits. In addition to our retail branches, we maintain technology based products such as business cash management and a business remote deposit product that enables us to compete effectively with banks of all sizes.
Limit exposure to increasing interest rates. For many years, the majority of the loans the Bank has retained in its portfolio have generally possessed periodic interest rate adjustment features or have been relatively short term in nature. Loans originated for portfolio retention have generally included ARM loans, short term construction loans, and to a lesser extent commercial business loans with interest rates tied to a market index such as the Prime Rate. Longer term fixed-rate mortgage loans have generally been originated for sale into the secondary market.
Continue generating revenues through mortgage banking operations. The substantial majority of the fixed-rate residential mortgage loans we originate are sold into the secondary market with servicing retained. This strategy produces gains on the sale of such loans and reduces the interest rate and credit risk associated with fixed-rate residential lending. We continue to originate custom construction and owner builder loans for sale into the secondary market upon the completion of construction.
Maintaining strong asset quality. We believe that strong asset quality is a key to our long-term financial success. The percentage of non-performing loans to loans recevable, net was 0.27% and 0.45% at September 30, 2017 and 2016, respectively. The Company's percentage of non-performing assets to total assets at September 30, 2017 was 0.60% compared to 0.88% at September 30, 2016. Non-performing assets have decreased from $28.0 million at September 30, 2013, to $5.7 million at September 30, 2017. We continue to seek to reduce the level of non-performing assets through collections, write-downs, modifications and sales of OREO. We also take proactive steps to resolve our non-performing loans, including negotiating payment plans, forbearances, loan modifications and loan extensions and accepting short payoffs on delinquent loans when such actions have been deemed appropriate. We have also accepted short payoffs on delinquent loans, particularly when such payoffs result in a smaller loss to us than foreclosure. Although the Company plans to continue to place emphasis on certain lending products, such as commercial real estate loans, construction loans, and commercial business loans, the Company expects to continue to manage its credit exposures through the use of experienced bankers and an overall conservative approach to lending.
Critical Accounting Policies and Estimates
The Company has established various accounting policies that govern the application of GAAP in the preparation of the Company's Consolidated Financial Statements. The Company has identified five policies that as a result of judgments, estimates and assumptions inherent in those policies, are critical to an understanding of the Company's Consolidated Financial Statements. These policies relate to the methodology for the determination of the allowance for loan losses, the valuation of MSRs, the determination of any other than temporary impairment ("OTTI") in the fair value of investment securities, the valuation of goodwill for potential impairment and the valuation of OREO. These policies and the judgments, estimates and assumptions are described in greater detail in the notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K. In particular, Note 1 to the Consolidated Financial Statements, “Summary of Significant Accounting Policies,” generally describes the Company's accounting policies. Management believes that the judgments, estimates and assumptions used in the preparation of the Company's Consolidated Financial Statements are appropriate given the factual circumstances at the time. However, given the sensitivity of the Company's Consolidated Financial Statements to these critical policies, the use of other judgments, estimates and assumptions could result in material differences in the Company's results of operations or financial condition.
Market Risk and Asset and Liability Management
General. Market risk is the risk of loss from adverse changes in market prices and rates. The Bank's market risk arises primarily from interest rate risk inherent in its lending, investment, deposit and borrowing activities. The Bank, like other financial institutions, is subject to interest rate risk to the extent that its interest-earning assets reprice differently than its interest-bearing liabilities. Management actively monitors and manages its interest rate risk exposure. Although the Bank manages other risks, such as credit quality and liquidity risk, in the normal course of business management considers interest rate risk to be its most significant market risk that could potentially have the largest material effect on the Bank's financial condition and results of operations. The Bank does not maintain a trading account for any class of financial instruments nor does it engage in hedging activities. Furthermore, the Bank is not subject to foreign currency exchange rate risk or commodity price risk.
Qualitative Aspects of Market Risk. The Bank's principal financial objective is to achieve long-term profitability while reducing its exposure to fluctuating market interest rates. The Bank has sought to reduce the exposure of its earnings to changes in market interest rates by attempting to manage the difference between asset and liability maturities and interest rates. The principal element in achieving this objective is to increase the interest rate sensitivity of the Bank's interest-earning assets by retaining in its portfolio, short-term loans and loans with interest rates subject to periodic adjustments. The Bank relies on retail deposits as its primary source of funds. As part of its interest rate risk management strategy, the Bank promotes transaction accounts and certificates of deposit with terms of up to five years.
The Bank has adopted a strategy that is designed to substantially match the interest rate sensitivity of assets relative to its liabilities. The primary elements of this strategy involve originating ARM loans for its portfolio, maintaining residential construction loans as a portion of total net loans receivable because of their generally shorter terms and higher yields than other one- to four-family residential mortgage loans, matching asset and liability maturities, investing in short-term securities, and originating fixed-rate loans for retention or sale in the secondary market while retaining the related MSRs.
Sharp increases or decreases in interest rates may adversely affect the Bank's earnings. Management of the Bank monitors the Bank's interest rate sensitivity through the use of a model provided by FIMAC Solutions, LLC (“FIMAC”), a company that specializes in providing interest rate risk and balance sheet management services to the financial services industry. Based on a rate shock analysis prepared by FIMAC based on data at September 30, 2017, an immediate increase in interest rates of 100 basis points would increase the Bank’s projected net interest income by approximately 4.2%, primarily because a larger portion of the Bank's interest rate sensitive assets than interest rate sensitive liabilities would reprice within a one year period. Conversely, an immediate decrease in interest rates of 100 basis points would decrease the Bank's projected net interest income by approximately 7.7%. See “Quantitative Aspects of Market Risk” below for additional information. Management has sought to sustain the match between asset and liability maturities and rates, while maintaining an acceptable interest rate spread. Pursuant to this strategy, the Bank actively originates adjustable-rate loans for retention in its loan portfolio. Fixed-rate mortgage loans with maturities greater than seven years generally are originated for the immediate or future resale in the secondary mortgage market. Although the Bank has sought to originate ARM loans, the ability to originate such loans depends to a great extent on market interest rates and borrowers' preferences. In lower interest rate environments, borrowers often prefer fixed-rate loans.
Consumer, commercial business and construction loans typically have shorter terms and higher yields than permanent residential mortgage loans, and accordingly reduce the Bank’s exposure to fluctuations in interest rates. At September 30, 2017, the consumer, commercial business and construction portfolios amounted to $42.2 million, $44.4 million and $168.5 million, or 5.4%, 5.7% and 21.5% of total loans receivable, respectively.
Quantitative Aspects of Market Risk. The model provided for the Bank by FIMAC estimates the changes in net portfolio value ("NPV") and net interest income in response to a range of assumed changes in market interest rates. The model first estimates the level of the Bank's NPV (market value of assets, less market value of liabilities, plus or minus the market value of any off-balance sheet items) under the current rate environment. In general, market values are estimated by discounting the estimated cash flows of each instrument by appropriate discount rates. The model then recalculates the Bank's NPV under different interest rate scenarios. The change in NPV under the different interest rate scenarios provides a measure of the Bank's exposure to interest rate risk. The following table is provided by FIMAC based on data at September 30, 2017.
___________
(1)
Does not include loan fees.
(2)
Includes BOLI income, which is included in non-interest income in the Consolidated Financial Statements.
(3)
No rates in the model are allowed to go below zero. Given the relatively low level of market interest rates, a calculation for a decrease of greater than 200 basis points has not been prepared.
Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan repayments and deposit decay, and should not be relied upon as indicative of actual results. Furthermore, the computations do not reflect any actions management may undertake in response to changes in interest rates.
In the event of a 100 basis point decrease in interest rates, the Bank would be expected to experience a 9.1% decrease in NPV and a 7.7% decrease in net interest income. In the event of a 100 basis point increase in interest rates, a 6.1% increase in NPV and a 4.2% increase in net interest income would be expected. Based upon the modeling described above, the Bank's asset and liability structure generally results in increases in net interest income and NPV in a rising interest rate scenario and decreases in net interest income and NPV in a declining interest rate scenario.
As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets have features which 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, expected rates of prepayments on loans and early withdrawals from certificates of deposit could possibly deviate significantly from those assumed in calculating the table.
Comparison of Financial Condition at September 30, 2017 and September 30, 2016
The Company's total assets increased by $60.64 million, or 6.8%, to $952.02 million at September 30, 2017 from $891.39 million at September 30, 2016. The increase was primarily attributable to increases in cash and cash equivalents and net loans receivable, which were partially offset by a decrease in certificates of deposit ("CDs") held for investment.
Net loans receivable increased by $27.22 million, or 4.1%, to $690.36 million at September 30, 2017 from $663.15 million at September 30, 2016, primarily as a result of increases in custom and owner/builder construction loans, commercial real estate loans, commercial construction loans and multi-family construction loans. These increases in net loans receivable were partially offset by an increase in the undisbursed portion of construction loans in process.
The Company's total liabilities increased by $46.47 million, or 5.8%, to $841.02 million at September 30, 2017 from $794.55 million at September 30, 2016 primarily due to an increase in total deposits, which was partially offset by the repayment of all FHLB borrowings. Total deposits increased by $76.36 million, or 10.0%, to $837.90 million at September 30, 2017 from $761.53 million at September 30, 2016, primarily as a result of increases in non-interest bearing, savings, money market, and NOW checking account balances. These increases were partially offset by a decrease in CD account balances.
Shareholders' equity increased by $14.17 million, or 14.6%, to $111.00 million at September 30, 2017 from $96.83 million at September 30, 2016. The increase was primarily due to net income for the year ended September 30, 2017 of $14.17 million and $2.50 million received from the exercise of a stock warrant to purchase 370,699 shares of the Company's common stock at an exercise price of $6.73 per share, which was partially offset by dividends paid to shareholders of $3.64 million. As of September 30, 2017, the Company exceeded all regulatory capital requirements required for bank holding company regulatory purposes. For additional details see Note 15 of the Notes to Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data" and "Item 1. Business - Regulation of the Company - Capital Requirements."
A more detailed explanation of the changes in significant balance sheet categories follows:
Cash and Cash Equivalents and CDs Held for Investment: Cash and cash equivalents and CDs held for investment increased by $29.28 million, or 18.1%, to $191.22 million at September 30, 2017 from $161.94 million at September 30, 2016. The increase was due to a $39.25 million increase in total cash and cash equivalents which was partially offset by a $9.97 million decrease in CDs held for investment. The Company continued to maintain high levels of liquidity primarily for asset-liability management purposes.
Investment Securities: Investment securities decreased by $473,000, or 5.3%, to $8.38 million at September 30, 2017 from $8.85 million at September 30, 2016. The decrease was primarily due to scheduled amortization and prepayments. For additional details on investment securities, see "Item 1. Business - Investment Activities" and Note 3 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
FHLB Stock: FHLB stock decreased by $1.10 million, or 49.8%, to $1.11 million at September 30, 2017 from $2.20 million at September 30, 2016, due to stock redemptions by the FHLB. The required investment in FHLB stock decreased primarily due to the decrease in FHLB borrowings.
Other Investments: Other investments increased by $3.00 million at September 30, 2017 from none at September 30, 2016 due to the Company investing in the Solomon Hess SBA Loan Fund LLC. This investment is utilized to help satisfy compliance with the Company's Community Reinvestment Act ("CRA") investment test requirements.
Loans Held for Sale: Loans held for sale remained level at $3.60 million at both September 30, 2017 and September 30, 2016. The Company sells longer-term fixed-rate residential loans and the guaranteed portion of SBA commercial business loans for asset-liability management purposes and to generate non-interest income. The Company sold $81.40 million in loans during the year ended September 30, 2017 compared to $58.90 million for the year ended September 30, 2016.
Loans Receivable, Net of Allowance for Loan Losses: Net loans receivable increased by $27.22 million, or 4.1%, to $690.36 million at September 30, 2017 from $663.15 million at September 30, 2016. The increase was primarily a result of a $24.59 million increase in custom and owner/builder construction loans, a $16.40 million increase in commercial real estate loans, a $10.27 million increase in commercial construction loans, an $8.74 million increase in multi-family construction loans, a $2.61 million increase in commercial business loans, a $2.28 million increase in land loans, and a $1.81 million increase in speculative one- to four-family construction loans. These increases were partially set offset by a $33.78 million increase in the undisbursed portion of construction loans in process, a $3.70 million decrease in multi-family loans, a $1.62 million decrease in consumer loans, and a $413,000 decrease in one- to four-family loans.
Loan originations increased by 27.4% to $340.61 million for the year ended September 30, 2017 from $267.35 million for the year ended September 30, 2016. The increase in loan originations was primarily due to increased demand for construction loans and the hiring of additional loan officers. For additional information on loans, see "Item 1. Business - Lending Activities" and Note 4 to the Consolidated Financial Statements contained in "Item 8, Financial Statements and Supplementary Data."
Premises and Equipment: Premises and equipment increased by $2.26 million, or 14.0%, to $18.42 million at September 30, 2017 from $16.16 million at September 30, 2016. The increase was primarily due to the purchase of the building which had been leased for the Gig Harbor branch for $1.84 million in December 2016 and a remodel of the Bank's Edgewood branch office. These additions were partially offset by normal depreciation. For additional information on premises and equipment,
see "Item 2. Properties" and Note 5 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
OREO and Other Repossessed Assets: OREO and other repossessed assets decreased by $816,000, or 19.8%, to $3.30 million at September 30, 2017 from $4.12 million at September 30, 2016. The decrease was primarily due to the disposition of $1.53 million in OREO properties and other repossessed assets and OREO valuation write-downs of $42,000. These decreases in OREO and other repossessed assets were partially offset by the addition of $751,000 in OREO properties and other repossessed assets. At September 30, 2017, the OREO balance was comprised of 15 individual properties and one other repossessed asset. The properties consisted of 11 land parcels totaling $1.87 million, two single family homes totaling $875,000, two commercial real estate properties totaling $533,000 and one travel trailer with a balance of $28,000. The largest OREO property at September 30, 2017 was an undeveloped land parcel located in Lewis County with a balance of $948,000. For additional information on OREO and other repossessed assets, see "Item 1. Business - Lending Activities - Other Real Estate Owned and Other Repossessed Assets" and Note 6 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
Bank Owned Life Insurance ("BOLI"): BOLI increased by $545,000, or 2.9%, to $19.27 million at September 30, 2017 from $18.72 million at September 30, 2016 due to net BOLI earnings, representing the increase in cash surrender value.
Goodwill: The recorded amount of goodwill of $5.65 million at September 30, 2017 remained unchanged from September 30, 2016. The Company performed its annual review of goodwill during the quarter ended June 30, 2017 and determined that there was no impairment. For additional information on goodwill, see Note 1 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
MSRs: MSRs increased by $252,000, or 16.0%, to $1.83 million at September 30, 2017 from $1.57 million at September 30, 2016, primarily due to the addition of $739,000 in capitalized MSRs for new loans being serviced, which was partially offset by amortization of $487,000. The principal amount of loans serviced for Freddie Mac and the SBA increased by $18.24 million, or 5.4%, to $358.87 million at September 30, 2017 from $340.63 million at September 30, 2016. For additional information on MSRs, see Note 7 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
Deposits: Deposits increased by $76.36 million, or 10.0%, to $837.90 million at September 30, 2017 from $761.53 million at September 30, 2016. The increase was primarily a result of a $33.67 million increase in non-interest-bearing demand account balances, a $17.51 million increase in savings account balances, a $17.01 million increase in money market account balances, and a $16.50 million increase in NOW checking account balances. These increases were partially offset by an $8.33 million decrease in CD account balances. The increase in non-interest bearing demand account and NOW checking account balances was primarily due to increased commercial and consumer checking accounts as the Company continued to emphasize increasing its transaction accounts base. The Company also experienced deposit inflows due to a number of customers transferring funds from other financial institutions during the year ended September 30, 2017. The decrease in CD account balances was primarily due to a managed run off as the Company continued to reduce CDs balances by competing slightly less aggressively on certain CD term interest rates. For additional information on deposits, see "Item 1. Business - Deposit Activities and Other Sources of Funds" and Note 8 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
FHLB Borrowings: There were no FHLB borrowings at September 30, 2017 and $30.00 million at September 30, 2016 as the Company prepaid on April 26, 2017 FHLB borrowings with a weighted average cost of 3.98% and incurred prepayment penalties of $282,000. Prepaying the FHLB borrowings reduced future interest expense by approximately $100,000 per month. For additional information on borrowings, see "Item 1. Business - Deposit Activities and Other Sources of Funds - Borrowings" and Note 9 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
Shareholders' Equity: Total shareholders' equity increased by $14.17 million, or 14.6%, to $111.00 million at September 30, 2017 from $96.83 million at September 30, 2016. The increase was primarily due to net income of $14.17 million for the year ended September 30, 2017 and the exercise of a stock warrant for $2.50 million, which was partially offset by the payment of $3.64 million in dividends to common shareholders. The Company did not repurchase any shares of its common stock during the year ended September 30, 2017. For additional information on shareholders' equity, see the Consolidated Statements of Shareholders' Equity contained in "Item 8. Financial Statements and Supplementary Data."
Comparison of Operating Results for the Years Ended September 30, 2017 and 2016
Net income for the year ended September 30, 2017 increased by $4.01 million, or 39.5%, to $14.17 million from $10.15 million for the year ended September 30, 2016. Net income per diluted common share increased by $0.49, or 34.3%, to $1.92 for
the year ended September 30, 2017 from $1.43 for the year ended September 30, 2016. The increase in net income was primarily due to increases in net interest income, non-interest income, and the recapture of loan losses (which added approximately $0.11 to diluted earnings per share), which was partially offset by an increase in non-interest expense and an increase in the provision for income taxes.
A more detailed explanation of the income statement categories is presented below.
Net Interest Income: Net interest income increased by $4.34 million, or 14.1%, to $35.14 million for the year ended September 30, 2017 from $30.80 million for the year ended September 30, 2016. The increase in net interest income was due to an increase in interest income and a decrease in interest expense.
Total interest and dividend income increased by $3.46 million, or 9.9%, to $38.34 million for the year ended September 30, 2017 from $34.88 million for the year ended September 30, 2016, primarily due to a $69.44 million increase in the average balance of total interest-bearing assets to $864.16 million from $794.72 million and an increase in the average yield on interest-earning assets to 4.44% from 4.39%. Interest income on loans receivable and loans held for sale increased by $2.80 million, to $36.39 million for the year ended September 30, 2017 from $33.58 million for the year ended September 30, 2016, primarily due to an increase in the average balance of net loans receivable and loans held for sale of $48.58 million during the year and an increase in the average yield on loans receivable and loans held for sale to 5.26% from 5.22%. Also contributing to the increase in interest and dividend income (and average yields) was a $255,000 increase in non-accrual interest and prepayment penalties collected during the year ended September 30, 2017. During the year ended September 30, 2017, a total of $1.05 million in non-accrual interest and prepayment penalties was collected compared to a total of $795,000 for the year ended September 30, 2016.
Total interest expense decreased by $875,000 to $3.20 million, or 21.5%, for the year ended September 30, 2017 from $4.07 million for the year ended September 30, 2016, primarily due to a $1.05 million decrease in interest expense on FHLB borrowings, which was partially offset by a $177,000 increase in interest expense on deposits. The decrease in FHLB borrowing expense was primarily due to a $27.86 million decrease in the average balance of borrowings to $17.10 million for the year ended September 30, 2017 from $44.96 million for the year ended September 30, 2016 partially offset by prepayment penalties of $282,000 incurred for paying off the borrowings before their scheduled maturities. During the year ended September 30, 2017, the Company repaid all remaining FHLB borrowings. The increase in interest expense on deposits was primarily due to a $51.75 million increase in average interest-bearing deposits to $610.26 million for the year ended September 30, 2017 from $558.52 million for the year ended September 30, 2016.
As a result of these changes, the net interest margin increased 19 basis points to 4.07% for the year ended September 30, 2017 from 3.88% for the year ended September 30, 2016.
Provision for (Recapture of) Loan Losses: No provision for loan losses was made for the years ended September 30, 2017 and 2016. There was a recapture of loan losses of $1.25 million for the year ended September 30, 2017 mainly due to the Bank's recovery on previously charged-off commercial real estate loans and improvement in other underlying credit quality metrics in the loan portfolio. There were net recoveries of $977,000 for the year ended September 30, 2017 compared to net charge-offs of $98,000 for the year ended September 30, 2016. The net charge-offs (recoveries) to average outstanding loans ratio was (0.14%) for the year ended September 30, 2017 and 0.02% for the year ended September 30, 2016. The level of delinquent loans (loans 30 or more days past due) decreased by $1.06 million, or 30.5%, to $2.41 million at September 30, 2017 from $3.47 million at September 30, 2016 and the level of loans graded substandard decreased by $1.78 million, or 35.4%, to $3.25 million at September 30, 2017 from $5.04 million at September 30, 2016. Non-accrual loans decreased by $962,000, or 33.5%, to $1.91 million at September 30, 2017 from $2.87 million at September 30, 2016.
The Company has established a comprehensive methodology for determining the allowance for loan losses. On a quarterly basis the Company performs an analysis that considers pertinent factors underlying the quality of the loan portfolio. These factors include changes in the amount and composition of the loan portfolio, historic loss experience for various loan segments, changes in economic conditions, delinquency rates, a detailed analysis of impaired loans, and other factors to determine an appropriate level of allowance for loan losses. Impaired loans are subject to an impairment analysis to determine an appropriate reserve or write-down to be applied against each loan. The aggregate principal impairment amount determined at September 30, 2017 was $476,000 compared to $776,000 at September 30, 2016.
Based on the comprehensive methodology, management believes the allowance for loan losses of $9.55 million at September 30, 2017 (1.36% of loans receivable and 499.9% of non-performing loans) was adequate to provide for probable losses based on an evaluation of known and inherent risks in the loan portfolio at that date. While the Company believes it has established its existing allowance for loan losses in accordance with GAAP, there can be no assurance that bank regulators, in reviewing the Company's loan portfolio, will not request the Company 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. Any material increase in the allowance for loan losses would adversely affect the Company's financial condition and results of operations. For additional information, see "Item 1. Business - Lending Activities -- Allowance for Loan Losses."
Non-interest Income: Total non-interest income increased by $1.48 million, or 13.6%, to $12.37 million for the year ended September 30, 2017 from $10.89 million for the year ended September 30, 2016. This increase was primarily due to a $549,000 increase in service charges on deposits, a $376,000 increase in gain on sales of loans, a $201,000 change in net OTTI, a $151,000 increase in servicing income on loans sold, and smaller increases and decreases in several other categories.
The increase in service charges on deposits was primarily due to an increase in the amount of service charges collected on checking accounts owned by businesses associated with the marijuana (or Initiative-502) industry in Washington State. It is permissible in Washington State to handle accounts associated with this industry in compliance with federal regulatory guidelines. The increase in gain on sales of loans was primarily due to increases in the dollar volume of fixed-rate one- to four-family loans and of the guaranteed portion of SBA loans sold during the year. The change in net OTTI was a result of $33,000 net recovery for the year ended September 30, 2017 compared to a net OTTI expense of $168,000 for the year ended September 30, 2016. The increase in servicing income on loans sold was primarily due to an increase in the dollar amount of loans serviced for Freddie Mac and a decrease in the amortization of MSRs.
Non-interest Expense: Total non-interest expense increased by $879,000, or 3.3%, to $27.52 million for the year ended September 30, 2017 from $26.64 million for the year ended September 30, 2016. This increase was primarily due to a $987,000 increase in salaries and employee benefits expense and smaller increases in several other categories. These increases were partially offset by a $640,000 decrease in OREO and other repossessed assets expense, and smaller decreases in several other categories.
The increase in salaries and employee benefits expense was primarily due to annual salary adjustments and the hiring of additional lending and operations personnel. The decrease in OREO and other repossessed assets expense was primarily due to a decrease in the level of valuation write-downs based on updated appraisals received on OREO properties. The efficiency ratio for the year ended September 30, 2017 improved to 57.92% from 63.89% for the year ended September 30, 2016 as the increases in net interest income and non-interest income outpaced the increase in non-interest expense.
Provision for Income Taxes: The provision for income taxes increased by $2.18 million, or 44.4% to $7.08 million for the year ended September 30, 2017 from $4.90 million for the year ended September 30, 2016, primarily due to increased income before income taxes. The Company's effective income tax rate was 33.3% for the year ended September 30, 2017 compared to 32.6% for the year ended September 30, 2016. For additional information on income taxes, see Note 11 of the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
Comparison of Operating Results for the Years Ended September 30, 2016 and 2015
Net income for the year ended September 30, 2016 increased by $1.86 million, or 22.5%, to $10.15 million from $8.29 million for the year ended September 30, 2015. Net income per diluted common share increased by $0.26, or 22.2%, to $1.43 for the year ended September 30, 2016 from $1.17 for the year ended September 30, 2015. The increase in net income was primarily due to increases in net interest income and non-interest income, which was partially offset by a decrease in the recapture of loan losses, an increase in non-interest expense, and an increase in the provision for federal income taxes.
A more detailed explanation of the income statement categories is presented below.
Net Interest Income: Net interest income increased by $3.53 million, or 12.9%, to $30.80 million for the year ended September 30, 2016 from $27.28 million for the year ended September 30, 2015. The increase in net interest income was due to an increase in interest income, which was partially offset by an increase in interest expense.
Total interest and dividend income increased by $3.71 million, or 11.9%, to $34.88 million for the year ended September 30, 2016 from $31.17 million for the year ended September 30, 2015, primarily due to a $76.84 million increase in the average balance of total interest-bearing assets to $794.7 million from $717.9 million. Interest income on loans receivable and loans held for sale increased by $3.18 million, to $33.58 million for the year ended September 30, 2016 from $30.40 million for the year ended September 30, 2015, primarily due to an increase in the average balance of net loans receivable and loans held for sale of $46.95 million during the year. Average loan yields increased thirteen basis points compared to the year ended September 30, 2016, as the percentage of higher yielding nonresidential mortgage loans as a percentage of total mortgage loans increased. Also contributing to the increase in the average loan yield and the increase in interest and dividend income was a $454,000 increase in non-accrual interest and prepayment penalties collected during the year ended September 30, 2016.
Total interest expense increased by $182,000 to $4.07 million, or 4.7%, for the year ended September 30, 2016 from $3.89 million for the year ended September 30, 2015, primarily due to a $138,000 prepayment penalty on a $15.00 million FHLB borrowing (that was repaid before its scheduled maturity date of December 21, 2016) and a $35.58 million increase in average interest-bearing liabilities to $603.48 million for the year ended September 30, 2016 from $567.89 million for the year ended September 30, 2015. Partially offsetting these increases was a decrease in the average rate paid on interest-bearing liabilities to 0.67% for the year ended September 30, 2016 from 0.68% for the year ended September 30, 2015.
The net interest margin increased eight basis points to 3.88% for the year ended September 30, 2016 from 3.80% for the year ended September 30, 2015, as the yield on interest-bearing assets increased to 4.39% for the year ended September 30, 2016 from 4.34% for the year ending September 30, 2015. The net interest margin for the year was also increased by the collection of $454,000 of non-accrual interest and prepayment penalties, which was partially offset by the payment of a $138,000 FHLB borrowing prepayment penalty.
Provision for (Recapture of) Loan Losses: There was no provision for (recapture of) loan losses for the year ended September 30, 2016 compared to a recapture of loan losses of $1.53 million for the year ended September 30, 2015. There were net charge-offs of $98,000 for the year ended September 30, 2016 compared to net recoveries of $1.02 million for the year ended September 30, 2015. The net charge-offs (recoveries) to average outstanding loans ratio was 0.02% for the year ended September 30, 2016 and (0.17)% for the year ended September 30, 2015. The recapture of loan losses for the year ended September 30, 2015 was primarily due to the level of net recoveries and improvements in other underlying credit quality metrics in the loan portfolio. The level of delinquent loans (loans 30 or more days past due) decreased by $3.70 million, or 51.6%, to $3.47 million at September 30, 2016 from $7.17 million at September 30, 2015 and the level of loans graded substandard decreased by $7.68 million, or 60.4%, to $5.04 million at September 30, 2016 from $12.72 million at September 30, 2015. Non-accrual loans decreased by $3.17 million, or 52.4%, to $2.87 million at September 30, 2016 from $6.04 million at September 30, 2015.
Based on the Company's comprehensive methodology for determining the allowance for loan losses, management deemed the allowance for loan losses of $9.83 million at September 30, 2016 (1.46% of loans receivable and 326.7% of non-performing loans) was adequate to provide for probable losses based on an evaluation of known and inherent risks in the loan portfolio at that date.
Non-interest Income: Total non-interest income increased by $1.37 million, or 14.4%, to $10.89 million for the year ended September 30, 2016 from $9.52 million for the year ended September 30, 2015. This increase was primarily due to a $597,000 increase in ATM and debit card interchange transaction fees, a $354,000 increase in service charges on deposits, a $270,000 increase in servicing income on loans sold, a $171,000 increase in gain on sales of loans, and smaller increases in several other categories, which was partially offset by a $155,000 increase in OTTI on investment securities.
The increase in ATM and debit card interchange transaction fees was primarily due to an increase in debit card transactions and the receipt of a one-time $262,000 incentive payment from the Company's debit card issuer for meeting certain sales and retention targets since the conversion to the new card issuer in 2014. The increase in service charges on deposits was primarily due to an increase in the amount of service charges collected on checking accounts owned by businesses associated with the marijuana (or Initiative-502) industry in Washington State. The increase in servicing income on loans sold was primarily due to a decrease in the amortization of MSRs. The increase in gain on sales of loans was primarily due to an increase in the dollar volume of fixed-rate one- to four-family loans and the sale of the guaranteed portion of SBA loans sold during the year. The increase in OTTI expense was primarily due to the recognition of additional credit loss on three private label mortgage-backed securities.
Non-interest Expense: Total non-interest expense increased by $796,000, or 3.1%, to $26.64 million for the year ended September 30, 2016 from $25.84 million for the year ended September 30, 2015. This increase was primarily due to a $721,000 increase in salaries and employee benefits expense, a $303,000 difference in the loss (gain) on sales/dispositions of premises and equipment, a $156,000 increase in ATM and debit card interchange transaction fees expense, and smaller increases in several other categories. These increases were partially offset by a $256,000 decrease in OREO and other repossessed assets expense, a $172,000 decrease in professional fees expense, and smaller decreases in several other categories.
The increase in salaries and employee benefits expense was primarily due to annual salary adjustments and the hiring of additional lending and operations personnel. The difference in the loss (gain) on sales/dispositions of premises and equipment was primarily due to a $299,000 gain on the sale of excess land adjacent to the Company's Lacey branch during the year ended September 30, 2015. The increase in ATM and debit card interchange transaction fees expense was primarily due to increased debit card transaction volume and the recognition of costs associated with the Company's upcoming conversion to EMV chip cards. The decrease in OREO and other repossessed assets expense was primarily due to a decrease in the level of valuation write-downs based on updated appraisals received on OREO properties. The decrease in professional fees was primarily due to the recovery of expenses on several non-accrual loans that were paid off during the year ended September 30, 2016.
Provision for Income Taxes: The provision for income taxes increased by $709,000, or 16.9% to $4.90 million for the year ended September 30, 2016 from $4.19 million for the year ended September 30, 2015, primarily due to increased income before income taxes. The Company's effective income tax rate was 32.6% for the year ended September 30, 2016 compared to 33.6% for the year ended September 30, 2015.
Average Balances, Interest and Average Yields/Cost
The earnings of the Company depend largely on the spread between the yield on interest-earning assets and the cost of interest-bearing liabilities, as well as the relative amount of the Company's interest-earning assets and interest- bearing liability portfolios.
The following table sets forth, for the periods indicated, information regarding average balances of assets and liabilities as well as the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities and average yields and costs. Such yields and costs for the periods indicated are derived by dividing income or expense by the average daily balance of assets or liabilities, respectively, for the periods presented.
_______________________________________________
(1)
Does not include interest on loans on non-accrual status. Includes loans held for sale and interest earned on loans held for sale. Amortized net deferred loan fees, late fees, extension fees and prepayment penalties (year ended September 30, 2017 - $1,328; year ended September 30, 2016 - $1,095; and year ended September 30, 2015 - $798) are included with interest and dividends.
(2)
Average balances include loans and investment securities on non-accrual status.
(3)
Includes FHLB borrowings with original maturities of one year or greater. Includes pre-payment penalties of $282 and $138 for the years ended September 30, 2017 and 2016, respectively.
(4)
Net interest income divided by total average interest earning assets.
Rate/Volume Analysis
The following table sets forth the effects of changing rates and volumes on net interest income on the Company. Information is provided with respect to the (i) effects on interest income attributable to changes in volume (changes in volume multiplied by prior rate), (ii) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume), and (iii) the net change (sum of the prior columns). Changes in both rate and volume have been allocated to rate and volume variances based on the absolute values of each.
______________
(1)
Excludes interest on loans on non-accrual status. Includes loans held for sale and interest earned on loans held for sale.
Liquidity and Capital Resources
The Company's primary sources of funds are customer deposits, proceeds from principal and interest payments on loans, the sale of loans, maturing investment securities and FHLB borrowings. While the maturities and the scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition.
The Bank must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund loan originations and deposit withdrawals, to satisfy other financial commitments and to take advantage of investment opportunities. The Bank generally maintains sufficient cash and short-term investments to meet short-term liquidity needs. At September 30, 2017, the Bank's regulatory liquidity ratio (net cash, and short-term and marketable assets, as a percentage of net deposits and short-term liabilities) was 23.4%. At September 30, 2017, the Bank maintained an uncommitted credit facility with the FHLB that provided for immediately available borrowings up to an aggregate amount equal to 35% of total assets, limited by available collateral. The Bank had $297.7 million available for additional borrowings with the FHLB at September 30, 2017. The Bank also has a LOC of up to $22.0 million with the FHLB for the purpose of collateralizing Washington State public deposits, all of which was available to be drawn upon at September 30, 2017. The LOC amount reduces the Bank's available borrowings under the FHLB advance
agreement. The Bank maintains a short-term borrowing line with the FRB with total credit based on eligible collateral. At September 30, 2017, the Bank had no outstanding balance on this borrowing line, under which $62.8 million was available for future borrowings. The Bank also maintains a $10.0 million overnight borrowing line with PCBB. At September 30, 2017, the Bank did not have an outstanding balance on this borrowing line.
Liquidity management is both a short and long-term responsibility of the Bank's management. The Bank adjusts its investments in liquid assets based upon management's assessment of (i) expected loan demand, (ii) projected loan sales, (iii) expected deposit flows, and (iv) yields available on interest-bearing deposits. Excess liquidity is invested generally in interest-bearing overnight deposits, CDs held for investment and short-term government and agency obligations. If the Bank requires funds beyond its ability to generate them internally, it has additional borrowing capacity with the FHLB, the FRB and PCBB.
The Bank's primary investing activity is the origination of loans. During the years ended September 30, 2017, 2016 and 2015, the Bank originated $340.6 million, $267.4 million and $262.4 million of loans, respectively. At September 30, 2017, the Bank had loan commitments totaling $71.2 million and undisbursed loans in process totaling $82.4 million. The Bank anticipates that it will have sufficient funds available to meet current loan commitments. CDs that are scheduled to mature in less than one year from September 30, 2017 totaled $75.4 million. Historically, the Bank has been able to retain a significant amount of its deposits as they mature.
The Bank’s liquidity is also affected by the volume of loans sold and loan principal payments. During the years ended September 30, 2017, 2016 and 2015, the Bank sold $81.4 million, $58.9 million and $57.5 million in loans and loan participation interests, respectively. During the years ended September 30, 2017, 2016 and 2015, the Bank received $211.3 million, $155.4 million and $148.8 million in principal repayments, respectively.
The Bank’s liquidity has been impacted by increases in deposit levels. During the years ended September 30, 2017, 2016 and 2014, deposits increased by $76.4 million, $82.6 million and $63.8 million, respectively.
Cash and cash equivalents, CDs held for investment and investment securities increased to $199.6 million at September 30, 2017 from $170.8 million at September 30, 2016.
Timberland Bancorp is a separate legal entity from the Bank and must provide for its own liquidity and pay its own operating expenses. Sources of capital and liquidity for Timberland Bancorp include principal and interest payments on the loan receivable from the Employee Stock Ownership Plan ("ESOP"), distributions from the Bank and the issuance of debt or equity securities. At September 30, 2017, Timberland Bancorp (on an unconsolidated basis) had liquid assets of $2.3 million.
Bank holding companies and federally-insured state-chartered banks are required to maintain minimum levels of regulatory capital. At September 30, 2017, Timberland Bancorp and the Bank were in compliance with all applicable capital requirements. For additional details see Note 15 to the Consolidated Financial Statements contained in “Item 8. Financial Statements and Supplementary Data” and “Item 1. Business - Regulation of the Bank - Capital Requirements.”
Contractual obligations. The following table presents, as of September 30, 2017, the Company’s significant fixed and determinable contractual operating lease obligations by payment date. There were no other fixed determinable contractual obligations outstanding at September 30, 2017.
Off-Balance Sheet Activities. The Company is a party to financial instruments with off-balance sheet risk in the normal course of business in order to meet the financial needs of its customers. For information regarding our commitments and off-balance sheet arrangements, see Note 14 of the Notes to Consolidated Financial Statements included in Item 8. "Financial Statements and Supplementary Data" of this Form 10-K.
A summary of the Company's commitments at September 30, 2017 and 2016 is as follows (in thousands):
Effect of Inflation and Changing Prices
The consolidated financial statements and related financial data presented herein have been prepared in accordance with GAAP which require the measurement of financial position and operating results in terms of historical dollars, without considering the change in the relative purchasing power of money over time due to inflation. The primary impact of inflation on the operation 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 impact on a financial institution's performance than do general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.
New Accounting Pronouncements
For a discussion of new accounting pronouncements and their impact on the Company, see Note 1 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data".
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The information contained under “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Market Risk and Asset and Liability Management” of this Form 10-K is incorporated herein by reference.
Item 8.
Item 8. Financial Statements and Supplementary Data
TIMBERLAND BANCORP, INC. AND SUBSIDIARY
Index to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of
Timberland Bancorp, Inc.
We have audited the accompanying consolidated balance sheets of Timberland Bancorp, Inc. and Subsidiary (collectively, "the Company") as of September 30, 2017 and 2016, and the related consolidated statements of income, comprehensive income, shareholders' equity, and cash flows for each of the years in the three-year period ended September 30, 2017. The Company's management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated 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 consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated 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, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Timberland Bancorp, Inc. and Subsidiary as of September 30, 2017 and 2016, and the results of their operations and their cash flows for each of the years in the three-year period ended September 30, 2017, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of September 30, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated December 8, 2017, expressed an unqualified opinion thereon.
/s/ Delap LLP
Lake Oswego, Oregon
December 8, 2017
Consolidated Balance Sheets
(Dollars in Thousands, Except Per Share Amounts)
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
See notes to consolidated financial statements
Consolidated Balance Sheets (continued)
(Dollars in Thousands, Except Per Share Amounts)
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
See notes to consolidated financial statements
Consolidated Statements of Income
(Dollars in Thousands, Except Per Share Amounts)
Timberland Bancorp, Inc. and Subsidiary
Years Ended September 30, 2017, 2016 and 2015
See notes to consolidated financial statements
Consolidated Statements of Income (continued)
(Dollars in Thousands, Except Per Share Amounts)
Timberland Bancorp, Inc. and Subsidiary
Years Ended September 30, 2017, 2016 and 2015
See notes to consolidated financial statements
Consolidated Statements of Comprehensive Income
(Dollars in Thousands)
Timberland Bancorp, Inc. and Subsidiary
Years Ended September 30, 2017, 2016 and 2015
See notes to consolidated financial statements
Consolidated Statements of Shareholders’ Equity
(Dollars in Thousands, Except Per Share Amounts)
Timberland Bancorp, Inc. and Subsidiary
Years Ended September 30, 2017, 2016 and 2015
See notes to consolidated financial statements
Consolidated Statements of Shareholders’ Equity (continued)
(Dollars in Thousands, Except Per Share Amounts)
Timberland Bancorp, Inc. and Subsidiary
Years Ended September 30, 2017, 2016 and 2015
See notes to consolidated financial statements
Consolidated Statements of Cash Flows
(Dollars in Thousands)
Timberland Bancorp, Inc. and Subsidiary
Years Ended September 30, 2017, 2016 and 2015
See notes to consolidated financial statements
Consolidated Statements of Cash Flows (continued)
(Dollars in Thousands)
Timberland Bancorp, Inc. and Subsidiary
Years Ended September 30, 2017, 2016 and 2015
See notes to consolidated financial statements
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
Note 1 - Summary of Significant Accounting Policies
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of Timberland Bancorp, Inc. (“Timberland Bancorp”); its wholly owned subsidiary, Timberland Bank (the “Bank”); and the Bank’s wholly owned subsidiary, Timberland Service Corp. (collectively, the "Company”). All significant intercompany transactions and balances have been eliminated in consolidation.
Nature of Operations
Timberland Bancorp is a bank holding company which operates primarily through its subsidiary, the Bank. The Bank was established in 1915 and, through its 22 branches located in Grays Harbor, Pierce, Thurston, Kitsap, King and Lewis counties in Washington State, attracts deposits from the general public, and uses those funds, along with other borrowings, primarily to provide residential real estate, construction, commercial real estate, commercial business and consumer loans to borrowers primarily in western Washington.
Consolidated Financial Statement Presentation
The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S.") (“GAAP”) and prevailing practices within the banking industry. The preparation of consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities, as of the date of the consolidated balance sheets, and the reported amounts of income and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the determination of the estimated fair value of investment securities, the valuation of deferred tax assets, the valuation of MSRs, the valuation of OREO and the valuation of goodwill for potential impairment.
Certain prior year amounts have been reclassified to conform to the 2017 fiscal year presentation with no change to previously reported net income or shareholders’ equity.
Segment Reporting
The Company has one reportable operating segment which is defined as community banking in western Washington under the operating name “Timberland Bank.”
Cash and Cash Equivalents and Cash Flows
The Company considers amounts included in the consolidated balance sheets’ captions “Cash and due from financial institutions” and “Interest-bearing deposits in banks,” all of which mature within ninety days, to be cash equivalents for purposes of reporting cash flows.
Interest-bearing deposits in banks as of September 30, 2017 and 2016 included deposits with the Federal Reserve Bank of San Francisco ("FRB") of $127,128,000 and $88,420,000, respectively. The Company also maintains balances in correspondent bank accounts which, at times, may exceed the FDIC insurance limit of $250,000 per correspondent bank. Management believes that its risk of loss associated with such balances is minimal due to the financial strength of the FRB and the correspondent banks.
CDs Held for Investment
CDs held for investment include amounts invested with other FDIC-insured financial institutions for a stated interest rate and with a fixed maturity date. Such CDs generally have maturities of 12 to 24 months from the date of purchase by the Company. Early withdrawal penalties may apply; however, the Company intends to hold these CDs to maturity. The Company generally limits its purchases of CDs to a maximum of $250,000 (the FDIC insurance coverage limit) with any single financial institution.
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
Investment Securities
Investment securities are classified upon acquisition as either held to maturity or available for sale. Investment securities that the Company has the positive intent and ability to hold to maturity are classified as held to maturity and reflected at amortized cost. Investment securities classified as available for sale are reflected at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income (loss), net of income tax effects. Premiums and discounts are amortized to earnings using the interest method over the contractual lives of the securities. Gains and losses on sales of investment securities are recognized on the trade date and determined using the specific identification method.
In estimating whether there are any OTTI losses, management considers (1) the length of time and the extent to which the fair value has been less than amortized cost, (2) the financial condition and near term prospects of the issuer, (3) the impact of changes in market interest rates and (4) the intent and ability of the Company to retain its investment for a period of time sufficient to allow for any anticipated recovery in fair value.
Declines in the fair value of individual investment securities available for sale that are deemed to be other than temporary are reflected in earnings when identified. The fair value of the investment security then becomes the new cost basis. For individual investment securities that are held to maturity which the Company does not intend to sell, and it is not more likely than not that the Company will be required to sell before recovery of its amortized cost basis, the other than temporary decline in the fair value of the investment security related to: (1) credit loss is recognized in earnings and (2) market or other factors is recognized in other comprehensive income (loss). Credit loss is recorded if the present value of expected future cash flows is less than the amortized cost. For individual investment securities which the Company intends to sell or more likely than not will not recover all of its amortized cost, the OTTI is recognized in earnings equal to the entire difference between the investment security’s cost basis and its fair value at the consolidated balance sheet date. For individual investment securities for which credit loss has been recognized in earnings, interest accruals and amortization and accretion of premiums and discounts are suspended when the credit loss is recognized. Interest received after accruals have been suspended is recognized on a cash basis.
FHLB Stock
The Bank, as a member of the FHLB, is required to maintain an investment in capital stock of the FHLB in an amount equal to 0.12% of the Bank's total assets plus 4.00% of borrowings from the FHLB. No ready market exists for this stock, and it has no quoted market value. However, redemption of FHLB stock has historically been at par value. The Company's investment in FHLB stock is carried at cost, which approximates fair value.
The Company evaluates its FHLB stock for impairment as needed. The Company's determination of whether this investment is impaired is based on its assessment of the ultimate recoverability of cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of cost is influenced by criteria such as (1) the significance of any decline in net assets of the FHLB as compared with the capital stock amount and the length of time any decline has persisted; (2) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB; (3) the impact of legislative and regulatory changes on institutions and, accordingly, the customer base of the FHLB; and (4) the liquidity position of the FHLB. Based on its evaluation, the Company determined that there was no impairment of FHLB stock at September 30, 2017 and 2016.
Other Investments
The Bank invests in the Solomon Hess SBA Loan Fund LLC - a private investment fund - to help satisfy compliance with the Bank's Community Reinvestment Act ("CRA") investment test requirements. Shares in this fund are not publicly traded and therefore have no readily determinable fair market value. The Bank's investment in the fund is recorded at cost. An investor can have its investment in the fund redeemed for the balance of its capital account at any quarter end with a 60 day notice to the fund.
Loans Held for Sale
Mortgage loans and commercial business loans originated and intended for sale in the secondary market are stated in the aggregate at the lower of cost or estimated fair value. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income. Gains or losses on sales of loans are recognized at the time of sale. The gain or loss is the
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
difference between the net sales proceeds and the recorded value of the loans, including any remaining unamortized deferred loan origination fees.
Loans Receivable
Loans are stated at the amount of unpaid principal, reduced by the undisbursed portion of construction loans in process, net deferred loan origination fees and the allowance for loan losses.
Interest on loans is accrued daily based on the principal amount outstanding. Generally, the accrual of interest on loans is discontinued when, in management’s opinion, the borrower may be unable to make payments as they become due or when they are past due 90 days as to either principal or interest (based on contractual terms), unless the loan is well secured and in the process of collection. In determining whether a borrower may be able to make payments as they become due, management considers circumstances such as the financial strength of the borrower, the estimated collateral value, reasons for the delays in payments, payment record, the amounts past due and the number of days past due. All interest accrued but not collected for loans that are placed on non-accrual status or charged off is reversed against interest income. Subsequent collections on a cash basis are applied proportionately to past due principal and interest, unless collectability of principal is in doubt, in which case all payments are applied to principal. Loans are returned to accrual status when the loan is deemed current, and the collectability of principal and interest is no longer doubtful, or, in the case of one- to four-family loans, when the loan is less than 90 days delinquent. The categories of non-accrual loans and impaired loans overlap, although they are not identical.
The Company charges fees for originating loans. These fees, net of certain loan origination costs, are deferred and amortized to income on the level-yield basis over the loan term. If the loan is repaid prior to maturity, the remaining unamortized deferred loan origination fee is recognized in income at the time of repayment.
Troubled Debt Restructured Loans
A troubled debt restructured loan ("TDR") is a loan for which the Company, for reasons related to a borrower’s financial difficulties, grants a concession to the borrower that the Company would not otherwise consider. Examples of such concessions include, but are not limited to: a reduction in the stated interest rate; an extension of the maturity at an interest rate below current market rates; a reduction in the face amount of the debt; a reduction in the accrued interest; or re-amortizations, extensions, deferrals and renewals. TDRs are considered impaired and are individually evaluated for impairment. TDRs are classified as non-accrual (and considered to be non-performing) unless they have been performing in accordance with modified terms for a period of at least six months.
Allowance for Loan Losses
The allowance for loan losses is maintained at a level sufficient to provide for probable losses inherent in the loan portfolio. The allowance is provided based upon management's comprehensive analysis of the pertinent factors underlying the quality of the loan portfolio. These factors include changes in the amount and composition of the loan portfolio, delinquency levels, actual loan loss experience, current economic conditions, and a detailed analysis of individual loans for which full collectability may not be assured. The detailed analysis includes methods to estimate the fair value of loan collateral and the existence of potential alternative sources of repayment. The allowance consists of specific and general components. The specific component relates to loans that are deemed impaired. For such loans that are classified as impaired, an allowance is established when the discounted cash flows, collateral value less selling costs (if applicable), or observable market price of the impaired loan is lower than the recorded value of that loan. The general component covers non-impaired loans and is based on historical loss experience adjusted for qualitative factors. The Company's historical loss experience is determined by evaluating the average net charge-offs over the most recent economic cycle, but not to exceed six years. Qualitative factors are determined by loan type and allow management to adjust reserve levels to reflect the current general economic environment and portfolio performance trends including recent charge-off trends. Allowances are provided 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, actual loan loss experience, current economic conditions, collateral values, geographic concentrations, seasoning of the loan portfolio, specific industry conditions, the duration of the current business cycle, and regulatory requirements and expectations. The appropriateness of the allowance for loan losses is estimated based upon these factors and trends identified by management at the time the consolidated financial statements are prepared.
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
A loan is considered impaired when it is probable that the Company will be unable to collect all amounts (principal and interest) when due according to the contractual terms of the loan agreement. Smaller balance homogeneous loans, such as residential mortgage loans and consumer loans, may be collectively evaluated for impairment. When a loan has been identified as being impaired, the amount of the impairment is measured by using discounted cash flows, except when, as an alternative, the current estimated fair value of the collateral (reduced by estimated costs to sell, if applicable) or observable market price is used. The valuation of real estate collateral is subjective in nature and may be adjusted in future periods because of changes in economic conditions. Management considers third-party appraisals, as well as independent fair market value assessments from realtors or persons involved in selling real estate, in determining the estimated fair value of particular properties. In addition, as certain of these third-party appraisals and independent fair market value assessments are only updated periodically, changes in the values of specific properties may have occurred subsequent to the most recent appraisals. Accordingly, the amounts of any such potential changes and any related adjustments are generally recorded at the time such information is received. When the measurement of the impaired loan is less than the recorded investment in the loan (including accrued interest and net deferred loan origination fees or costs), impairment is recognized by creating or adjusting an allocation of the allowance for loan losses and uncollected accrued interest is reversed against interest income. If ultimate collection of principal is in doubt, all cash receipts on impaired loans are applied to reduce the principal balance.
A provision for (recapture of) loan losses is charged (credited) to operations and is added to (deducted from) the allowance for loan losses based on a quarterly comprehensive analysis of the loan portfolio. The allowance for loan losses is allocated to certain loan categories based on the relative risk characteristics, asset classifications and actual loss experience of the loan portfolio. While management has allocated the allowance for loan losses to various loan portfolio segments, the allowance is general in nature and is available for the loan portfolio in its entirety.
The ultimate recovery of all loans is susceptible to future market factors beyond the Company’s control. These factors may result in losses or recoveries differing significantly from those provided in the consolidated financial statements. If real estate values decline and as updated appraisals are received on collateral for impaired loans, the Company may need to increase the allowance for loan losses appropriately. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses, and may require the Company to make additions to the allowance based on their judgment about information available to them at the time of their examinations.
Premises and Equipment
Premises and equipment are recorded at cost. Depreciation is computed using the straight-line method over the following estimated useful lives: buildings and improvements - five to 40 years and furniture and equipment - three to seven years. The cost of maintenance and repairs is charged to expense as incurred. Gains and losses on dispositions are reflected in earnings.
Impairment of Long-Lived Assets
Long-lived assets, consisting of premises and equipment, are reviewed for impairment whenever events or changes in circumstances indicate that the recorded amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the recorded amount of an asset to undiscounted future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the recorded amount of the assets exceeds the discounted recovery amount or estimated fair value of the assets. No events or changes in circumstances have occurred during the years ended September 30, 2017 or 2016 that would cause management to evaluate the recoverability of the Company’s long-lived assets.
OREO and Other Repossessed Assets
OREO and other repossessed assets consist of properties or assets acquired through or in lieu of foreclosure, and are recorded initially at the estimated fair value of the properties less estimated costs of disposal, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. When the property is acquired, any excess of the loan balance over the estimated net realizable value is charged to the allowance for loan losses. The valuation of real estate is subjective in nature and may be adjusted in future periods because of changes in economic conditions. Management considers third-party appraisals, as well as independent fair market value assessments from realtors or persons involved in selling real estate, in determining the estimated fair value of particular properties. In addition, as certain of these third-party appraisals and independent fair market value assessments are only updated periodically, changes in the values of specific properties may have occurred subsequent to the most recent appraisals. Accordingly, the amounts of any such potential
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
changes and any related adjustments are generally recorded at the time such information is received. Costs relating to development and improvement of the properties or assets are capitalized, while costs relating to holding the properties or assets are expensed.
BOLI
BOLI policies are recorded at their cash surrender value less applicable cash surrender charges. Income from BOLI is recognized when earned.
Goodwill
Goodwill is initially recorded when the purchase price paid in a business combination exceeds the estimated fair value of the net identified tangible and intangible assets acquired and liabilities assumed. Goodwill is presumed to have an indefinite useful life and is analyzed annually for impairment. The Company performs an annual review during the third quarter of each fiscal year, or more frequently if indicators of potential impairment exist, to determine if the recorded goodwill is impaired. For purposes of goodwill impairment testing, the services offered through the Bank and its subsidiary are managed as one strategic unit and represent the Company's only reporting unit.
The annual goodwill impairment test begins with a qualitative assessment of whether it is "more likely than not" that the reporting unit's fair value is less than its carrying amount. If an entity concludes that it is not "more likely than not" that the fair value of a reporting unit is less than its carrying amount, it need not perform a two-step impairment test. If the Company's qualitative assessment concluded that it is "more likely than not" that the fair value of its reporting unit is less than its carrying amount, it must perform the two-step impairment test to identify potential goodwill impairment and measure the amount of goodwill impairment loss to be recognized, if any. The first step of the goodwill impairment test compares the estimated fair value of the reporting unit with its carrying amount, or the book value, including goodwill. If the estimated fair value of the reporting unit equals or exceeds its book value, goodwill is considered not impaired, and the second step of the impairment test is unnecessary.
The second step, if necessary, measures the amount of goodwill impairment loss to be recognized. The reporting unit must determine fair value for all assets and liabilities, excluding goodwill. The net of the assigned fair value of assets and liabilities is then compared to the book value of the reporting unit, and any excess book value becomes the implied fair value of goodwill. If the carrying amount of the goodwill exceeds the newly calculated implied fair value of goodwill, an impairment loss is recognized in the amount required to write-down the goodwill to the implied fair value.
Management's qualitative assessment takes into consideration macroeconomic conditions, industry and market considerations, cost or margin factors, financial performance and share price. Based on this assessment, the Company determined that it is not "more likely than not" that the Company's fair value is less than its carrying amount and therefore goodwill was determined not to be impaired at May 31, 2017.
A significant amount of judgment is involved in determining if an indicator of goodwill impairment has occurred. Such indicators may include, among others: a significant decline in expected future cash flows; a sustained, significant decline in the Company's stock price and market capitalization; a significant adverse change in legal factors or in the business climate; adverse assessment or action by a regulator; and unanticipated competition. Any change in these indicators could have a significant negative impact on the Company's financial condition, impact the goodwill impairment analysis or cause the Company to perform a goodwill impairment analysis more frequently than once per year.
As of September 30, 2017, management believes that there had been no events or changes in the circumstances since May 31, 2017 that would indicate a potential impairment of goodwill. No assurances can be given, however, that the Company will not record an impairment loss on goodwill in the future.
MSRs
The Company holds rights to service (1) loans that it has originated and sold to the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and (2) the guaranteed portion of U.S. Small Business Administration ("SBA") loans sold in the secondary market. MSRs are capitalized at estimated fair value when acquired through the origination of loans that are subsequently sold with the servicing rights retained. MSRs are amortized to servicing income on loans sold approximately in proportion to and
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
over the period of estimated net servicing income. The value of MSRs at the date of the sale of loans is estimated based on the discounted present value of expected future cash flows using key assumptions for servicing income and costs and expected prepayment rates on the underlying loans. The estimated fair value is periodically evaluated for impairment by comparing actual cash flows and estimated future cash flows from the servicing assets to those estimated at the time the servicing assets were originated. Fair values are estimated using expected future discounted cash flows based on current market rates of interest. For purposes of measuring impairment, the MSRs must be stratified by one or more predominant risk characteristics of the underlying loans. The Company stratifies its capitalized MSRs based on product type and term of the underlying loans. The amount of impairment recognized is the amount, if any, by which the amortized cost of the MSRs exceeds their fair value. Impairment, if deemed temporary, is recognized through a valuation allowance to the extent that fair value is less than the recorded amount.
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 Company, (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 Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Income Taxes
The Company files a consolidated federal and various state income tax returns. The Bank provides for income taxes separately and remits to (receives from) Timberland Bancorp amounts currently due (receivable).
Deferred income taxes result from temporary differences between the tax basis of assets and liabilities, and their reported amounts in the consolidated financial statements. These temporary differences will result in differences between income for tax purposes and income for financial reporting purposes in future years. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Valuation allowances are established to reduce the net recorded amount of deferred tax assets if it is determined to be more likely than not that all or some portion of the potential deferred tax asset will not be realized.
With respect to accounting for uncertainty in incomes taxes, a tax provision is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely to be realized upon examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. The Company recognizes interest and/or penalties related to income tax matters as income tax expense. The Company is no longer subject to U.S. federal income tax examination by tax authorities for years ended on or before September 30, 2013.
ESOP
The Bank sponsors a leveraged ESOP. The debt of the ESOP is payable to Timberland Bancorp, is recorded as other borrowed funds of the Bank, and is eliminated in the consolidated financial statements. The shares of the Company's common stock pledged as collateral for the ESOP's debt are reported as unearned shares issued to the ESOP in the consolidated financial statements. As shares are released from collateral, compensation expense is recorded equal to the average market price of the shares for the period, and the shares become available for net income per common share calculations. Dividends paid on unallocated shares reduce the Company’s cash contributions to the ESOP.
Advertising
Costs for advertising and marketing are expensed as incurred.
Stock-Based Compensation
The Company measures compensation cost for all stock-based awards based on the grant-date fair value of the stock-based awards and recognizes compensation cost over the service period of stock-based awards. The fair value of stock options is determined using the Black-Scholes valuation model. Stock option forfeitures are accounted for as they occur.
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
Net Income Per Common Share
Basic net income per common share is computed by dividing net income to common shareholders by the weighted average number of common shares outstanding during the period, without considering any dilutive items. Diluted net income per common share is computed by dividing net income to common shareholders by the weighted average number of common shares and common stock equivalents for items that are dilutive, net of shares assumed to be repurchased using the treasury stock method at the average share price for Timberland Bancorp's common stock during the period. Common stock equivalents arise from the assumed conversion of outstanding stock options and outstanding warrants to purchase common stock. Shares owned by the Bank’s ESOP that have not been allocated are not considered to be outstanding for the purpose of computing net income per common share.
Related Party Transactions
The Chairman of the Board of the Bank and Timberland Bancorp is a member of the law firm that provides general counsel to the Company. Legal and other fees paid to this law firm for the years ended September 30, 2017, 2016 and 2015 totaled $99,000, $127,000 and $164,000, respectively.
Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers (Topic 606). The core principle of this ASU is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In general, the new guidance requires companies to use more judgment and make more estimates than under current guidance, including identifying performance obligations in the contract and estimating the amount of variable consideration to include in the transaction price related to each separate performance obligation. This ASU is effective for annual periods beginning after December 15, 2017, including interim periods within that reporting period. The Company's primary source of revenue is interest income, which is recognized when earned and is deemed to be in compliance with this ASU. Accordingly, the adoption of ASU No. 2014-09 is not expected to have a material impact on the Company's future consolidated financial statements.
In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The main provisions of this ASU address the valuation and impairment of certain equity investments along with simplified disclosures about the fair value of financial instruments. The amendments in this ASU are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017. Management is in the planning stages of developing processes and procedures to comply with the disclosure requirements of this ASU, which could impact the disclosures the Company makes related to the fair value of its financial instruments; however, the adoption of ASU No. 2016-01 is not expected to have a material impact on the Company's future consolidated financial statements.
In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). This ASU is intended to increase transparency and comparability among organizations by requiring the recognition of lease assets and lease liabilities on the balance sheet and disclosure of key information about leasing arrangements. The principal change required by this ASU relates to lessee accounting, and is that for operating leases, a lessee is required to (1) recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the statement of financial position, (2) recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term on a generally straight-line basis, and (3) classify all cash payments within operating activities in the statement of cash flows. For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities. If a lessee makes this election, it should recognize lease expense for such leases generally on a straight-line basis over the lease term. This ASU also changes disclosure requirements related to leasing activities and requires certain qualitative disclosures along with specific quantitative disclosures. The amendments in this ASU are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018. Early application of the amendments in this ASU is permitted. The effect of adoption will depend on leases at the time of adoption. Once adopted, the Company expects to report higher assets and liabilities as a result of including right-of-use assets and lease liabilities related to certain banking offices and certain equipment under non-cancelable operating lease agreements; however, based on current leases the adoption of ASU No. 2016-02 is not expected to have a material impact on the Company's future consolidated financial statements.
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
In March 2016, the FASB issued ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting. This ASU includes provisions intended to simplify various aspects related to how share-based payments are accounted for and presented in the financial statements. The ASU is effective for annual periods, and interim periods within those annual periods, beginning after December 31, 2016, with early adoption permitted. The Company adopted ASU No. 2016-09 during the fourth quarter ended September 30, 2017. The most significant impact of the amended guidance resulted in recognition of excess tax benefits within provision for income taxes, which resulted in an increase in net income and earnings per share. Previously, excess tax benefits were recorded as a component of shareholders' equity. Adoption of this ASU resulted in a cumulative effect adjustment to common stock and provision for income taxes of $131,000 during the quarter ended September 30, 2017. In addition, the guidance increases average diluted shares, since the Company no longer includes such excess tax benefits in the calculation of diluted shares. Adoption of the ASU did not affect the Company's total equity, book value per share, or regulatory capital ratios.
In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses. This ASU replaces the existing incurred losses methodology with a current expected losses methodology with respect to most financial assets measured at amortized cost and certain other instruments, including trade and other receivables, loans, held to maturity investment securities and off-balance sheet commitments. In addition, this ASU requires credit losses relating to available for sale debt securities to be recorded through an allowance for credit losses rather than as a reduction of the carrying amount. ASU No. 2016-13 also changes the accounting for purchased credit-impaired debt securities and loans. The standard retains many of the current disclosure requirements in GAAP and expands disclosure requirements. ASU No. 2016-13 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Upon adoption, the Company expects a change in the processes and procedures to calculate the allowance for loan losses, including changes in the assumptions and estimates to consider expected credit losses over the life of the loan versus the current accounting practice that utilizes the incurred loss model. In addition, the current policy for other-than-temporary impairment on investment securities available for sale will be replaced with an allowance approach. The Company is reviewing the requirements of ASU No. 2016-13 and expects to begin developing and implementing processes and procedures to ensure it is fully compliant with the amendments at the adoption date. At this time, the Company anticipates the allowance for loan losses will increase as a result of the implementation of this ASU; however, until its evaluation is complete, the magnitude of the increase will be unknown.
In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other: Simplifying the Test for Goodwill Impairment. This ASU simplifies the subsequent measurement of goodwill and eliminates Step 2 from the goodwill impairment test. In computing the implied fair value of goodwill under Step 2, an entity had to perform procedures to determine the fair value of its assets and liabilities (including unrecognized assets and liabilities) at the impairment testing date following the procedure that would be required in determining the fair value of assets acquired and liabilities assumed in a business combination. Under ASU No. 2017-04, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit's fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. Additionally, an entity should consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable. ASU No. 2017-04 will be effective for annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early application of this ASU is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The adoption of ASU No. 2017-04 is not expected to have a material impact on the Company's future consolidated financial statements.
In March 2017, the FASB issued ASU No. 2017-08, Receivables - Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. The ASU shortens the amortization period for certain callable debt securities held at a premium. This ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The adoption of ASU No. 2017-08 is not expected to have a material impact on the Company's future consolidated financial statements.
In May 2017, the FASB issued ASU No. 2017-09, Compensation--Stock Compensation (Topic 718): Scope of Modification Accounting. This ASU was issued to provide clarity as to when to apply modification accounting when there is a change in the terms or conditions of a share-based payment award. According to the ASU, an entity should account for the effects of a modification unless the fair value, vesting conditions, and balance sheet classification of the award are the same after the modification as compared to the original award prior to modification. ASU No. 2017-09 is effective for fiscal years, and interim
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
periods within those fiscal years, beginning after December 15, 2017, with early adoption permitted. The adoption of ASU No. 2017-09 is not expected to have a material impact on the Company's future consolidated financial statements.
Note 2 - Restricted Assets
Federal Reserve regulations require that the Bank maintain certain minimum reserve balances on hand or on deposit with the FRB, based on a percentage of transaction account deposits. The amounts of the reserve requirement balances as of September 30, 2017 and 2016 were $1,658,000 and $1,542,000, respectively.
Note 3 - Investment Securities
Held to maturity and available for sale investment securities were as follows as of September 30, 2017 and 2016 (dollars in thousands):
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
Held to maturity and available for sale investment securities with unrealized losses were as follows as of September 30, 2017 (dollars in thousands):
Held to maturity and available for sale investment securities with unrealized losses were as follows as of September 30, 2016 (dollars in thousands):
The Company has evaluated the investment securities in the above tables and has determined that the decline in their value is temporary. The unrealized losses are primarily due to changes in market interest rates and spreads in the market for mortgage-related products. The fair value of these securities is expected to recover as the securities approach their maturity dates and/or as the pricing spreads narrow on mortgage-related securities. The Company has the ability and the intent to hold the investments until the market value recovers. Furthermore, as of September 30, 2017, management does not have the intent to sell any of the securities classified as available for sale where the estimated fair value is below the recorded value and believes that it is more likely than not that the Company will not have to sell such securities before a recovery of cost (or recorded value if previously written down).
The Company bifurcates OTTI into (1) amounts related to credit losses which are recognized through earnings and (2) amounts related to all other factors which are recognized as a component of other comprehensive income (loss).
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
To determine the component of the gross OTTI related to credit losses, the Company compared the amortized cost basis of the OTTI security to the present value of its revised expected cash flows, discounted using its pre-impairment yield. The revised expected cash flow estimates for individual securities are based primarily on an analysis of default rates, prepayment speeds and third-party analytic reports. Significant judgment by management is required in this analysis that includes, but is not limited to, assumptions regarding the collectability of principal and interest, net of related expenses, on the underlying loans.
The following table presents a summary of the significant inputs utilized to measure management’s estimates of the credit loss component on OTTI securities as of September 30, 2017, 2016 and 2015:
The following table presents the OTTI recoveries (losses) for the years ended September 30, 2017, 2016 and 2015 (dollars in thousands):
________________________
(1)
Represents OTTI related to all other factors.
(2)
Represents OTTI related to credit losses.
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
The following table presents a roll forward of the credit loss component of held to maturity and available for sale debt securities that have been written down for OTTI with the credit loss component recognized in earnings for the years ended September 30, 2017, 2016 and 2015 (dollars in thousands):
During the year ended September 30, 2017, the Company recorded a $171,000 net realized loss (as a result of investment securities being deemed worthless) on twenty-two held to maturity investment securities, all of which had been recognized previously as a credit loss. During the year ended September 30, 2016, the Company recorded a $239,000 net realized loss (as a result of investment securities being deemed worthless) on twenty held to maturity investment securities, all of which had been recognized previously as a credit loss. During the year ended September 30, 2015, the Company recorded a $91,000 net realized loss (as a result of investment securities being deemed worthless) on fifteen held to maturity investment securities, all of which had been recognized previously as a credit loss.
The recorded amount of investment securities pledged as collateral for public fund deposits, federal treasury tax and loan deposits, FHLB collateral and other non-profit organization deposits totaled $6,824,000 and $7,039,000 at September 30, 2017 and 2016, respectively.
The contractual maturities of debt securities at September 30, 2017 are as follows (dollars in thousands). Expected maturities may differ from scheduled maturities due to the prepayment of principal or call provisions.
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
Note 4 - Loans Receivable and Allowance for Loan Losses
Loans receivable by portfolio segment consisted of the following at September 30, 2017 and 2016 (dollars in thousands):
Significant Concentrations of Credit Risk
Most of the Company’s lending activity is with customers located in the state of Washington and involves real estate. At September 30, 2017, the Company had $736,527,000 (including $82,411,000 of undisbursed construction loans in process) in loans secured by real estate, which represented 93.8% of total loans receivable. The real estate loan portfolio is primarily secured by one- to four-family properties, multi-family properties, land, and a variety of commercial real estate property types. At September 30, 2017, there were no concentrations of real estate loans to a specific industry or secured by a specific collateral type that equaled or exceeded 20% of the Company’s total loan portfolio, other than loans secured by one-to four-
family properties. The ultimate collectability of a substantial portion of the loan portfolio is susceptible to changes in economic and market conditions in the region and the impact of those changes on the real estate market. The Company typically originates real estate loans with loan-to-value ratios of no greater than 90%. Collateral and/or guarantees are required for all loans.
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
Certain related parties of the Company, principally Bank directors and officers, are loan customers of the Bank in the ordinary course of business. Such related party loans were performing according to their repayment terms at September 30, 2017 and 2016. Activity in related party loans during the years ended September 30, 2017, 2016 and 2015 was as follows (dollars in thousands):
Loan Segment Risk Characteristics
The Company believes that its loan classes are the same as its loan segments.
One- To Four-Family Residential Lending: The Company originates both fixed-rate and adjustable-rate loans secured by one- to four-family residences. A portion of the fixed-rate one- to four-family loans are sold in the secondary market for asset/liability management purposes and to generate non-interest income. The Company’s lending policies generally limit the maximum loan-to-value on one- to four-family loans to 90% of the lesser of the appraised value or the purchase price. However, the Company usually obtains private mortgage insurance on the portion of the principal amount that exceeds 80% of the appraised value of the property.
Multi-Family Lending: The Company originates loans secured by multi-family dwelling units (more than four units). Multi-family lending generally affords the Company an opportunity to receive interest at rates higher than those generally available from one- to four-family residential lending. However, loans secured by multi-family properties usually are greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater degree of risk than one- to four-family residential mortgage loans. Because payments on loans secured by multi-family properties are often dependent on the successful operation and management of the properties, repayment of such loans may be affected by adverse conditions in the real estate market or economy. The Company attempts to minimize these risks by scrutinizing the financial condition of the borrower, the quality of the collateral and the management of the property securing the loan.
Commercial Mortgage Lending: The Company originates commercial real estate loans secured by properties such as office buildings, retail/wholesale facilities, motels, restaurants, mini-storage facilities and other commercial properties. Commercial real estate lending generally affords the Company an opportunity to receive interest at higher rates than those available from one- to four-family residential lending. However, loans secured by such properties usually are greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater degree of risk than one- to four-family residential mortgage loans. Because payments on loans secured by 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 economy. The Company attempts to mitigate these risks by generally limiting the maximum loan-to-value ratio to 80% and scrutinizing the financial condition of the borrower, the quality of the collateral and the management of the property securing the loan.
Construction Lending: The Company currently originates the following types of construction loans: custom construction loans, owner/builder construction loans, speculative construction loans, commercial real estate construction loans and multi-family construction loans.
Construction lending affords the Company the opportunity to achieve higher interest rates and fees with shorter terms to maturity than does its single-family permanent mortgage lending. Construction lending, however, is generally considered to involve a higher degree of risk than one- to four family residential 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. The nature of these loans is such that they are generally more difficult to evaluate and monitor. If the estimated cost of construction proves to be inaccurate, the Company may be required to advance funds beyond the amount originally committed to complete the project. If the estimate of value upon completion proves to be inaccurate, the Company may be confronted with a project whose value is insufficient to assure full repayment, and the Company may incur a loss. Projects may also be jeopardized by disagreements between borrowers and builders and by the failure of builders to pay subcontractors. Loans to construct homes for which no purchaser has been identified carry more risk because the payoff for the loan depends on the builder’s ability to sell the property prior to the time
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
that the construction loan is due. The Company attempts to mitigate these risks by adhering to its underwriting policies, disbursement procedures and monitoring practices.
Construction Lending - Custom and Owner/Builder: Custom construction loans are made to home builders who, at the time of construction, have a signed contract with a home buyer who has a commitment to purchase the finished home. Owner/builder construction loans are originated to home owners rather than home builders and are typically refinanced into permanent loans at the completion of construction.
Construction Lending - Speculative One- To Four-Family: Speculative one-to four-family construction loans are made to home builders and are termed “speculative” because the home builder does not have, at the time of the loan origination, a signed contract with a home buyer who has a commitment for permanent financing with the Company or another lender for the finished home. The home buyer may be identified either during or after the construction period. The Company is currently originating speculative one-to four-family construction loans on a limited basis.
Construction Lending - Commercial: Commercial construction loans are originated to construct properties such as office buildings, hotels, retail rental space and mini-storage facilities.
Construction Lending - Multi-Family: Multi-family construction loans are originated to construct apartment buildings and condominium projects.
Land Lending: The Company has historically originated loans for the acquisition of land upon which the purchaser can then build or make improvements necessary to build or to sell as improved lots. Currently, the Company is originating new land loans on a limited basis. Loans secured by undeveloped land or improved lots involve greater risks than one- to four-family residential mortgage loans because these loans are more difficult to evaluate. If the estimate of value proves to be inaccurate, in the event of default or foreclosure, the Company may be confronted with a property value which is insufficient to assure full repayment. The Company attempts to minimize this risk by generally limiting the maximum loan-to-value ratio on land loans to 75%.
Consumer Lending - Home Equity and Second Mortgage: The Company originates home equity lines of credit and second mortgage loans. Home equity lines of credit and second mortgage loans have a greater credit risk than one- to four-family residential mortgage loans because they are secured by mortgages subordinated to the existing first mortgage on the property, which may or may not be held by the Company. The Company attempts to mitigate these risks by adhering to its underwriting policies in evaluating the collateral and the credit-worthiness of the borrower.
Consumer Lending - Other: The Company originates other consumer loans, which include automobile loans, boat loans, motorcycle loans, recreational vehicle loans, savings account loans and unsecured loans. Other consumer loans generally have shorter terms to maturity than mortgage loans. Other consumer loans generally involve a greater degree of risk than do residential mortgage loans, particularly in the case of consumer loans that 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 Company attempts to mitigate these risks by adhering to its underwriting policies in evaluating the credit-worthiness of the borrower.
Commercial Business Lending: The Company originates commercial business loans which are generally secured by business equipment, accounts receivable, inventory or other property. The Company also generally obtains personal guarantees from the business owners based on a review of personal financial statements. Commercial business lending generally involves risks that are different from those associated with residential and commercial real estate lending. Real estate lending is generally considered to be collateral based lending with loan amounts based on predetermined loan to collateral values, and liquidation of the underlying real estate collateral is viewed as the primary source of repayment in the event of borrower default. Although commercial business loans are often collateralized by equipment, inventory, accounts receivable or other business assets, the liquidation of collateral in the event of a borrower default is often an insufficient source of repayment, because accounts receivable may be uncollectible and inventories and equipment may be obsolete or of limited use. Accordingly, the repayment of a commercial business loan depends primarily on the credit-worthiness of the borrower (and any guarantors), while the liquidation of collateral is a secondary and potentially insufficient source of repayment. The Company attempts to mitigate
these risks by adhering to its underwriting policies in evaluating the management of the business and the credit-worthiness of the borrowers and the guarantors.
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
Allowance for Loan Losses
The following table sets forth information for the year ended September 30, 2017 regarding activity in the allowance for loan losses by portfolio segment (dollars in thousands):
The following table sets forth information for the year ended September 30, 2016 regarding activity in the allowance for loan losses by portfolio segment (dollars in thousands):
The following table sets forth information for the year ended September 30, 2015 regarding activity in the allowance for loan losses by portfolio segment (dollars in thousands):
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
The following table presents information on the loans evaluated individually and collectively for impairment in the allowance for loan losses by portfolio segment at September 30, 2017 (dollars in thousands):
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
The following table presents information on the loans evaluated individually and collectively for impairment in the allowance for loan losses by portfolio segment at September 30, 2016 (dollars in thousands):
The following table presents an analysis of loans by aging category and portfolio segment at September 30, 2017 (dollars in thousands):
__________________
(1)
Includes non-accrual loans past due 90 days or more and other loans classified as non-accrual.
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
The following table presents an analysis of loans by aging category and portfolio segment at September 30, 2016 (dollars in thousands):
___________________
(1) Includes non-accrual loans past due 90 days or more and other loans classified as non-accrual.
Credit Quality Indicators
The Company uses credit risk grades which reflect the Company’s assessment of a loan’s risk or loss potential. The Company categorizes loans into risk grade categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors such as the estimated fair value of the collateral. The Company uses the following definitions for credit risk ratings as part of the on-going monitoring of the credit quality of its loan portfolio:
Pass: Pass loans are defined as those loans that meet acceptable quality underwriting standards.
Watch: Watch loans are defined as those loans that still exhibit acceptable quality but have some concerns that justify greater attention. If these concerns are not corrected, a potential for further adverse categorization exists. These concerns could relate to a specific condition peculiar to the borrower, its industry segment or the general economic environment.
Special Mention: Special mention loans are defined as those loans deemed by management to have some potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in the deterioration of the payment prospects of the loan.
Substandard: Substandard loans are defined as those loans that are inadequately protected by the current net worth and paying capacity of the obligor, or of the collateral pledged. Loans classified as substandard have a well-defined weakness or weaknesses that jeopardize the repayment of the debt. If the weakness or weaknesses are not corrected, there is the distinct possibility that some loss will be sustained.
Loss: Loans in this classification are considered uncollectible and of such little value that continuance as an asset is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this loan even though partial recovery may be realized in the future. At September 30, 2017 and 2016, there were no loans classified as loss.
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
The following table presents an analysis of loans by credit quality indicators and portfolio segment, at September 30, 2017 (dollars in thousands).
The following table presents an analysis of loans by credit quality indicators and portfolio segment, at September 30, 2016 (dollars in thousands):
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
The following table is a summary of information related to impaired loans by portfolio segment as of and for the year ended September 30, 2017 (dollars in thousands):
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
The following table is a summary of information related to impaired loans by portfolio segment as of and for the year ended September 30, 2016 (dollars in thousands):
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
The following table is a summary of information related to impaired loans by portfolio segment as of and for the year ended September 30, 2015 (dollars in thousands):
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
TDRs are considered impaired loans and are individually evaluated for impairment. TDRs can be classified as either accrual or non-accrual. The Company had $3,595,000 in TDRs included in impaired loans at September 30, 2017 and had no commitments to lend additional funds on these loans. The Company had $8,160,000 in TDRs included in impaired loans at September 30, 2016 and had no commitments to lend additional funds on these loans. The allowance for loan losses allocated to TDRs at September 30, 2017 and 2016 was $10,000 and $465,000, respectively.
The following tables set forth information with respect to the Company’s TDRs by interest accrual status as of September 30, 2017 and 2016 (dollars in thousands):
There were no new TDRs during the years ended September 30, 2017 and 2016. The following table sets forth information with respect to the Company’s TDRs, by portfolio segment, during the year ended September 30, 2015 (dollars in thousands):
________________
(1) Modification was a result of a reduction in the stated interest rate.
There were no TDRs for which there was a payment default within the first 12 months of modification during the years ended September 30, 2017, 2016 or 2015.
Note 5 - Premises and Equipment
Premises and equipment consisted of the following at September 30, 2017 and 2016 (dollars in thousands):
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
The Company leases certain premises under operating lease agreements. Certain leases contain renewal options from five to ten years and escalation clauses. Total rental expense was $275,000, $287,000 and $280,000 for the years ended September 30, 2017, 2016 and 2015, respectively, which is included in premises and equipment expense in the accompanying consolidated statements of income.
Minimum net rental commitments under non-cancellable leases having an original or remaining term of more than one year for fiscal years ending subsequent to September 30, 2017 are as follows (dollars in thousands):
Note 6 - OREO and Other Repossessed Assets
The following table presents the activity related to OREO and other repossessed assets for the years ended September 30, 2017 and 2016 (dollars in thousands):
At September 30, 2017, OREO and other repossessed assets consisted of 15 OREO properties and one other repossessed asset in Washington, with balances ranging from $13,000 to $948,000. At September 30, 2016, OREO consisted of 22 OREO properties and one other repossessed asset in Washington, with balances ranging from $6,000 to $957,000. The Company recorded net gains on sales of OREO and other repossessed assets of $54,000, $47,000, and $110,000 for the years ended September 30, 2017, 2016 and 2015, respectively. Gains and losses on sales of OREO and other repossessed assets are recorded in the OREO and other repossessed assets, net category in non-interest expense in the accompanying consolidated statements of income.
At September 30, 2017, the recorded amount of foreclosed residential real estate properties held in OREO as a result of obtaining physical possession was $875,000 and the amount of one- to four-family properties in the process of foreclosure totaled $100,000.
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
Note 7 - MSRs
The Company services loans for Freddie Mac and - beginning in 2016 - for secondary market purchasers of the guaranteed portion of SBA loans; such loans are not included in the accompanying consolidated balance sheets. The principal amount of loans serviced for Freddie Mac at September 30, 2017, 2016 and 2015 was $358,173,000, $340,308,000 and $331,494,000, respectively. The guaranteed principal amount of SBA loans serviced for others at September 30, 2017 and 2016 was $697,000 and $319,000, respectively.
The following is an analysis of the changes in MSRs for the years ended September 30, 2017, 2016 and 2015 (dollars in thousands):
At September 30, 2017, 2016 and 2015, the estimated fair value of MSRs totaled $3,556,000, $2,865,000 and $3,095,000, respectively. The Freddie Mac MSRs' fair values at September 30, 2017, 2016 and 2015 were estimated using discounted cash flow analyses with average discount rates of 9.52%, 9.52% and 9.52%, respectively, and average prepayment speed factors of 159, 209 and 174, respectively. At September 30, 2017 and 2016, the SBA MSRs were insignificant. At September 30, 2017, 2016 and 2015, there were no valuation allowances on MSRs.
Note 8 - Deposits
Deposits consisted of the following at September 30, 2017 and 2016 (dollars in thousands):
Individual certificates of deposit in amounts of $250,000 or greater totaled $15,601,000 and $16,439,000 at September 30, 2017 and 2016, respectively. The Company had brokered deposits totaling $11,322,000 and $10,113,000 at September 30, 2017 and 2016, respectively.
Scheduled maturities of certificates of deposit for future years ending September 30 are as follows (dollars in thousands):
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
Interest expense on deposits by account type was as follows for the years ended September 30, 2017, 2016 and 2015 (dollars in thousands):
Note 9 - FHLB Borrowings and Other Borrowings
The Bank has long- and short-term borrowing lines with the FHLB with total credit on the lines equal to 35% of the Bank’s total assets, limited by available collateral. Borrowings are considered short-term when the original maturity is less than one year. The Bank had no long-term FHLB borrowings outstanding at September 30, 2017 and $30,000,000 outstanding at September 30, 2016. During the year ended September 30, 2017, the Company incurred a $282,000 prepayment penalty on two $15,000,000 FHLB borrowings that were repaid before their scheduled maturity dates. Under the Advances, Pledge and Security Agreement entered into with the FHLB ("FHLB Borrowing Agreement"), virtually all of the Bank’s assets, not otherwise encumbered, are pledged as collateral for borrowings.
The Bank also has a letter of credit ("LOC") with the FHLB for the purpose of collateralizing Washington State public deposits. The LOC amount reduces the Bank's available borrowings under the FHLB Borrowing Agreement. The LOC had a limit of $22,000,000 as of September 30, 2017, all of which was available to draw upon.
The Bank also maintains a short-term borrowing line with the FRB with total credit based on eligible collateral. At September 30, 2017 the Bank had a borrowing capacity on this line of $62,774,000. The Bank had no outstanding borrowings on this line at September 30, 2017 and 2016.
The Bank has a short-term $10,000,000 overnight borrowing line with Pacific Coast Bankers' Bank. The borrowing line may be reduced or withdrawn at any time. The Bank had no outstanding borrowings on this line at September 30, 2017 and 2016.
The Bank had no short-term borrowings outstanding during the years ended September 30, 2017, 2016 and 2015.
Note 10 - Other Liabilities and Accrued Expenses
Other liabilities and accrued expenses were comprised of the following at September 30, 2017 and 2016 (dollars in thousands):
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
Note 11 - Income Taxes
The components of the provision for income taxes for the years ended September 30, 2017, 2016 and 2015 were as follows (dollars in thousands):
At September 30, 2017 the Company had income taxes receivable of $559,000, which is included in other assets in the accompanying 2017 consolidated balance sheet. At September 30, 2016 the Company had income taxes payable of $197,000, which is included in other liabilities in the accompanying 2016 consolidated balance sheet.
The components of the Company’s deferred tax assets and liabilities at September 30, 2017 and 2016 were as follows (dollars in thousands):
The provision for income taxes for the years ended September 30, 2017, 2016 and 2015 differs from that computed at the federal statutory corporate tax rate as follows (dollars in thousands):
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
No valuation allowance for net deferred tax assets was recorded as of September 30, 2017 and 2016, as management believes that it is more likely than not that all of the net deferred tax assets will be realized based on management's expectations of future taxable income and/or because they were supported by recoverable taxes paid in prior years.
Note 12 - Employee Stock Ownership and 401(k) Plan
The Timberland Bank Employee Stock Ownership and 401(k) Plan (“KSOP”) is comprised of two components, the ESOP and the 401(k) Plan. The KSOP benefits employees with at least one year of service who are 21 years of age or older. The Bank may fund the ESOP with contributions of cash or stock, and may fund the 401(k) Plan with contributions of cash. Employee vesting occurs over six years.
ESOP
In January 1998, the ESOP borrowed $7,930,000 from the Company to purchase 1,058,000 shares of common stock of the Company. The loan is being repaid primarily from the Bank’s contributions to the ESOP and is scheduled to be fully repaid by March 31, 2019. The interest rate on the loan is 8.5%. Interest expense on the ESOP debt was $96,000, $136,000 and
$173,000 for the years ended September 30, 2017, 2016 and 2015, respectively. The balance of the loan at September 30, 2017 was $821,000.
The amount of the Bank's annual contribution is discretionary, except that it must be sufficient to enable the ESOP to service its debt. All dividends received by the ESOP are used to pay debt service. Dividends of $293,000, $243,000 and $170,000 were used to service the debt during the years ended September 30, 2017, 2016 and 2015, respectively. As the Plan makes each payment of principal and interest, an appropriate percentage of stock is released and allocated annually to eligible employee accounts, in accordance with applicable regulations. As of September 30, 2017, 515,430 ESOP shares, which were previously released for allocation to participants, had been distributed to participants.
Shares held by the ESOP as of September 30, 2017, 2016 and 2015 were classified as follows:
The approximate fair market value of the ESOP’s unallocated shares at September 30, 2017, 2016 and 2015 was $1,658,000, $1,389,000 and $1,344,000, respectively. Compensation expense recognized under the ESOP for the years ended September 30, 2017, 2016 and 2015 was $495,000, $233,000, and $203,000, respectively.
401(k) Plan
Eligible employees may contribute a portion of their wages to the 401(k) Plan up to the maximum established under the Internal Revenue Code. Contributions by the Bank are at the discretion of the Board except for a safe harbor contribution of 3% of eligible employees' wages, which is mandatory according to the plan document. Bank contributions totaled $358,000, $333,000 and $313,000 for the years ended September 30, 2017, 2016 and 2015, respectively.
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
Note 13 - Stock Compensation Plans
Under the Company’s 2003 Stock Option Plan, the Company was able to grant options for up to 300,000 shares of common stock to employees, officers, directors and directors emeriti. Under the Company's 2014 Equity Incentive Plan, the Company is able to grant options and awards of restricted stock (with or without performance measures) for up to 352,366 shares of common stock to employees, officers, directors and directors emeriti. Shares issued may be purchased in the open market or may be issued from authorized and unissued shares. The exercise price of each option equals the fair market value of the Company’s common stock on the date of grant. Generally, options and restricted stock vest in 20% annual installments on each of the five anniversaries from the date of the grant, and options generally have a maximum contractual term of ten years. At September 30, 2017, there were 113,616 shares of common stock available which may be awarded as options or restricted stock pursuant to future grants under the 2014 Equity Incentive Plan.
At both September 30, 2017 and 2016 there were no unvested restricted stock awards. There were no restricted stock grants awarded during the years ended September 30, 2017, 2016 and 2015.
Stock option activity for the years ended September 30, 2017, 2016 and 2015 is summarized as follows:
The aggregate intrinsic value of options exercised during the years ended September 30, 2017 and 2016 was $659,000 and $124,000, respectively.
The Company uses the Black-Scholes option pricing model to estimate the fair value of stock-based awards with the weighted average assumptions noted in the following table. The risk-free interest rate is based on the rate of a U.S. Treasury security with a similar term as the expected life of the stock option at the particular grant date. The expected life is based on historical data, vesting terms and estimated exercise dates. The expected dividend yield is based on the most recent quarterly dividend on an annualized basis in effect at the time the options were granted, adjusted, if appropriate, for management's expectations regarding future dividends. The expected volatility is based on historical volatility of the Company’s stock price. There were 128,000 options granted during the year ended September 30, 2015 with an aggregate grant date fair value of $241,000. There were 55,750 options granted during the year ended September 30, 2016 with an aggregate grant date fair value of $81,000. There were 58,250 options granted during the year ended September 30, 2017 with an aggregate grant date fair value of $224,000.
The weighted average assumptions for options granted during the years ended September 30, 2017, 2016 and 2015 were as follows:
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
There were 69,800 options that vested during the year ended September 30, 2017 with a total fair value of $145,000. There were 65,100 options that vested during the year ended September 30, 2016 with a total fair value of $144,000. There were 42,900 options that vested during the year ended September 30, 2015 with a total fair value of $100,000.
At September 30, 2017 there were 231,850 unvested options with an aggregate grant date fair value of $569,000, all of which the Company assumes will vest. The unvested options had an aggregate intrinsic value of $3,562,000 at September 30, 2017. At September 30, 2016 there were 250,450 unvested options with an aggregate grant date fair value of $506,000.
Additional information regarding options outstanding at September 30, 2017 is as follows:
The aggregate intrinsic value of options outstanding at September 30, 2017, 2016 and 2015 was $6,882,000, $2,212,000, and $738,000, respectively.
As of September 30, 2017, unrecognized compensation cost related to non-vested stock options was $490,000, which is expected to be recognized over a weighted average 2.37 years.
Note 14 - Commitments and Contingencies
The Company is party to 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. These instruments involve, to varying degrees, elements of credit risk not recognized in the consolidated balance sheets. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments as it does for on-balance-sheet instruments.
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. Since commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s credit-worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the party. However, such loan to value ratios will subsequently change, based on increases and decreases in the supporting collateral values. Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate, land and income-producing commercial properties.
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
A summary of the Company’s commitments at September 30, 2017 and 2016 is as follows (dollars in thousands):
The Company maintains a separate reserve for losses related to unfunded loan commitments. Management estimates the amount of probable losses related to unfunded loan commitments by applying the loss factors used in the allowance for loan loss methodology to an estimate of the expected amount of funding and applies this adjusted factor to the unused portion of unfunded loan commitments. The reserve for unfunded loan commitments totaled $214,000 and $157,000 at September 30, 2017 and 2016, respectively. These amounts are included in other liabilities and accrued expenses in the accompanying consolidated balance sheets. Increases (decreases) in the reserve for unfunded loan commitments are recorded in non-interest expense in the accompanying consolidated statements of income.
The Bank has an employee severance compensation plan which expires in 2027 and which provides severance pay benefits to eligible employees in the event of a change in control of Timberland Bancorp or the Bank (as defined in the plan). In general, all employees with two or more years of service will be eligible to participate in the plan. Under the plan, in the event of a change in control of Timberland Bancorp or the Bank, eligible employees who are terminated or who terminate employment (but only upon the occurrence of events specified in the plan) within 12 months of the effective date of a change in control would be entitled to a payment based on years of service or officer rank with the Bank. The maximum payment for any eligible employee would be equal to 18 months of the employee’s current compensation.
The Company has employment agreements with the Chief Executive Officer and the Chief Financial Officer which provide for a severance payment and other benefits if the officers are involuntarily terminated following a change in control of the Company or the Bank. The maximum value of the severance benefits under the employment agreements is 2.99 times the officer's average annual compensation during the five-year period prior to the effective date of the change in control.
Because of the nature of its activities, the Company is subject to various pending and threatened legal actions which arise in the ordinary course of business. In the opinion of management, liabilities arising from these claims, if any, will not have a material effect on the consolidated financial position of the Company.
Note 15 - Regulatory Matters
The Bank, as a state-chartered, federally insured savings bank, is subject to the capital requirements established by the FDIC. Under the FDIC's capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weighting and other factors. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by bank regulators that, if undertaken, could have a direct material effect on the Company's consolidated financial statements.
The minimum requirements are a common equity Tier 1 ("CET1") capital ratio of 4.5%, a Tier 1 capital ratio of 6.0%, a total capital ratio of 8.0% and a leverage ratio of 4.0%. In addition to the minimum regulatory capital ratios, the Bank must maintain a capital conservation buffer consisting of additional CET1 capital above the required minimum levels in order to avoid limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses based on percentages of eligible retained income that could be utilized for such actions. This capital conservation buffer requirement was phased in beginning in January 2016 at 0.625% of risk-weighted assets and will increase each year to an amount equal to 2.5% of risk-weighted assets when fully implemented in January 2019. At September 30, 2017, the conservation buffer was 1.25%.
At September 30, 2017 and 2016 the Bank exceeded all regulatory capital requirements. The Bank was categorized as "well capitalized" at September 30, 2017 and 2016 under the regulations of the FDIC. The following tables compare the Bank’s actual capital amounts at September 30, 2017 and 2016 to its minimum regulatory capital requirements and "Well Capitalized" regulatory capital at those dates (dollars in thousands):
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
Timberland Bancorp 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, and the regulations of the Federal Reserve. For a bank holding company with less than $1.0 billion in assets, the capital guidelines apply on a bank only basis, and the Federal Reserve expects the holding company's subsidiary bank to be well capitalized under the prompt corrective action regulations. If Timberland Bancorp were subject to regulatory guidelines for bank holding companies with $1.0 billion or more in assets at September 30, 2017, Timberland Bancorp would have exceeded all regulatory requirements.
The following table presents the regulatory capital ratios for Timberland Bancorp at September 30, 2017 and 2016 (dollars in thousands):
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
Note 16 - Condensed Financial Information - Parent Company Only
Condensed Balance Sheets - September 30, 2017 and 2016
(dollars in thousands)
Condensed Statements of Income - Years Ended September 30, 2017, 2016 and 2015
(dollars in thousands)
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
Condensed Statements of Cash Flows - Years Ended September 30, 2017, 2016 and 2015
(dollars in thousands)
Note 17 - Net Income Per Common Share
Information regarding the calculation of basic and diluted net income per common share for the years ended September 30, 2017, 2016 and 2015 is as follows (dollars in thousands, except per share amounts):
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
___________________
(1) For the years ended September 30, 2017, 2016 and 2015, average options to purchase 1,117, 42,801 and 155,152 shares of common stock, respectively, were outstanding but not included in the computation of diluted net income per common share because their effect would have been anti-dilutive.
(2) Represented a warrant to purchase 370,899 shares of the Company's common stock at an exercise price of $6.73 per share (subject to anti-dilution adjustments) at any time through December 23, 2018 (the "Warrant"). The Warrant was granted on December 23, 2008 to the U.S. Treasury Department ("Treasury") as part of the Company's participation in the Treasury's Troubled Asset Relief Program. On June 12, 2013, the Treasury sold the Warrant to private investors. On January 31, 2017, the Warrant was exercised and 370,899 shares of the Company's common stock were issued in exchange for $2,496,000.
Note 18 - Accumulated Other Comprehensive Income (Loss)
The changes in accumulated other comprehensive income (loss) ("AOCI") by component during the years ended September 30, 2017, 2016 and 2015 are as follows (dollars in thousands):
___________________
[1] All amounts are net of income taxes.
Note 19 - Fair Value Measurements
GAAP defines fair value and establishes a framework for measuring fair value. Fair value is the price that would be received for an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date. The three levels for categorizing assets and liabilities under GAAP's fair value measurement requirements are as follows:
Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting
entity has the ability to access at the measurement date.
Level 2: Significant observable inputs other than quoted prices included within Level 1, such as quoted prices for similar (as opposed to identical) assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, and inputs other than quoted prices that are observable or
can be corroborated by observable market data.
Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
assumptions market participants would use in pricing an asset or liability based on the best information
available in the circumstances.
The Company's assets measured at fair value on a recurring basis consist of investment securities available for sale. The estimated fair value of MBS are based upon market prices of similar securities or observable inputs (Level 2). The estimated fair value of mutual funds are based upon quoted market prices (Level 1).
The Company had no liabilities measured at fair value on a recurring basis at September 30, 2017 and 2016. The Company's assets measured at estimated fair value on a recurring basis at September 30, 2017 and 2016 are as follows (dollars in thousands):
There were no transfers among Level 1, Level 2 and Level 3 during the years ended September 30, 2017 and 2016.
The Company may be required, from time to time, to measure certain assets and liabilities at fair value on a non-recurring basis in accordance with GAAP. These include assets that are measured at the lower of cost or market value that were recognized at fair value below cost at the end of the period.
The Company uses the following methods and significant assumptions to estimate fair value of such assets on a non-recurring basis:
Impaired Loans: The estimated fair value of impaired loans is calculated using the collateral value method or on a discounted cash flow basis. The specific reserve for collateral dependent impaired loans is based on the estimated fair value of the collateral less estimated costs to sell, if applicable. In some cases, adjustments are made to the appraised values due to various factors including age of the appraisal, age of comparables included in the appraisal and known changes in the market and in the collateral. Such adjustments may be significant and typically result in a Level 3 classification of the inputs for determining fair value. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.
Investment Securities Held to Maturity: The estimated fair value of investment securities held to maturity is based upon the assumptions market participants would use in pricing the investment security. Such assumptions include quoted market prices (Level 1), market prices of similar securities or observable inputs (Level 2) and unobservable inputs such as dealer quotes, discounted cash flows or similar techniques (Level 3).
OREO and Other Repossessed Assets, net: OREO and other repossessed assets are recorded at estimated fair value less estimated costs to sell. Estimated fair value is generally determined by management based on a number of factors, including third-party appraisals of estimated fair value in an orderly sale. Estimated costs to sell are based on standard market factors. The valuation of OREO and other repossessed assets is subject to significant external and internal judgment (Level 3).
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
The following table summarizes the balances of assets measured at estimated fair value on a non-recurring basis at September 30, 2017 (dollars in thousands):
The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis as of September 30, 2017 (dollars in thousands):
The following table summarizes the balances of assets measured at estimated fair value on a non-recurring basis at September 30, 2016 (dollars in thousands):
The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis as of September 30, 2016 (dollars in thousands):
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
GAAP requires disclosure of estimated fair values for financial instruments. Such estimates are subjective in nature, and significant judgment is required regarding the risk characteristics of various financial instruments at a discrete point in time. Therefore, such estimates could vary significantly if assumptions regarding uncertain factors were to change. In addition, as the Company normally intends to hold the majority of its financial instruments until maturity, it does not expect to realize many of the estimated amounts disclosed. The disclosures also do not include estimated fair value amounts for certain items which are not defined as financial instruments but which may have significant value. The Company does not believe that it would be practicable to estimate a representational fair value for these types of items as of September 30, 2017 and 2016. Because GAAP excludes certain items from fair value disclosure requirements, any aggregation of the fair value amounts presented would not represent the underlying value of the Company.
The following methods and assumptions were used by the Company in estimating fair value of its other financial instruments:
Cash and Cash Equivalents and CDs Held for Investment: The estimated fair value of financial instruments that are short-term or re-price frequently and that have little or no risk are considered to have an estimated fair value equal to the recorded value.
Investment Securities: See descriptions above.
FHLB Stock: No ready market exists for this stock, and it has no quoted market value. However, redemption of this stock has historically been at par value. Accordingly, par value is deemed to be a reasonable estimate of fair value.
Other Investments: The Bank invests in the Solomon Hess SBA Loan Fund LLC. Shares in the fund are not publicly traded and therefore have no readily determinable fair market value, therefore they are recorded on the balance sheet at cost. An investor can have its investment in the fund redeemed for the balance of its capital at any quarter end with 60 days notice to the fund.
Loans Held for Sale: The estimated fair value is based on quoted market prices (for one- to four-family loans) and the guaranteed value of SBA loans (made to small businesses under SBA's 7(a) loan programs). Quoted market prices are obtained from Freddie Mac and the FHLB.
Loans Receivable, Net: The fair value of non-impaired loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers for the same remaining maturities. Prepayments are based on the historical experience of the Bank. Fair values for impaired loans are estimated using the methods described above.
Accrued Interest: The recorded amount of accrued interest approximates the estimated fair value.
Deposits: The estimated fair value of deposits with no stated maturity date is deemed to be the amount payable on demand. The estimated fair value of fixed maturity certificates of deposit is computed by discounting future cash flows using the rates currently offered by the Bank for deposits of similar remaining maturities.
FHLB Borrowings: The estimated fair value of FHLB borrowings is computed by discounting the future cash flows of the borrowings at a rate which approximates the current offering rate of the borrowings with a comparable remaining life.
Off-Balance-Sheet Instruments: Since the majority of the Company’s off-balance-sheet instruments consist of variable-rate commitments, the Company has determined that they do not have a distinguishable estimated fair value.
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
The recorded amounts and estimated fair values of financial instruments were as follows as of September 30, 2017 (dollars in thousands):
The recorded amounts and estimated fair values of financial instruments were as follows as of September 30, 2016 (dollars in thousands):
The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the estimated fair value of the Company’s financial instruments will change when interest rate levels change, and that change may either be favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to appropriately manage interest rate risk. However, borrowers with fixed interest rate obligations are less likely to prepay in a rising interest rate environment and more likely to prepay in a falling
Notes to Consolidated Financial Statements_________________________________________________________________
Timberland Bancorp, Inc. and Subsidiary
September 30, 2017 and 2016
interest rate environment. Conversely, depositors who are receiving fixed interest rates are more likely to withdraw funds before maturity in a rising interest rate environment and less likely to do so in a falling interest rate environment. Management monitors interest rates and maturities of assets and liabilities, and attempts to manage interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company’s overall interest rate risk.
Note 20 - Selected Quarterly Financial Data (Unaudited)
The following selected financial data is presented for the quarters ended (dollars in thousands, except per share amounts):
__________________________________________
(1) During the quarters ended March 31, 2017 and June 30, 2017 the Company recorded recaptures of loan losses of $250 and $1,000, respectively, primarily as a result of significant recoveries on loans which had previously been charged off in prior years and improvements in other credit quality metrics.
(2) The net income per common share amounts for the quarters do not add to the total for the fiscal year due to rounding.
__________________________________________
(1) The net income per common share amounts for the quarters do not add to the total for the fiscal year due to rounding.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures: An evaluation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934 (the “Exchange 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 annual report. The Company’s Chief Executive Officer and Chief Financial Officer concluded that as of September 30, 2017 the Company’s disclosure controls and procedures were effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Exchange 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.
(b) Changes in Internal Controls: There have been no changes in our internal control over financial reporting (as defined in 13a-15(f) of the Exchange Act) that occurred during the quarter ended September 30, 2017, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. The Company continued, however, to implement suggestions from its internal auditor and independent auditor on ways to strengthen existing controls. The Company does not expect that its disclosure controls and procedures and internal controls over financial reporting will prevent all errors and fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns in controls or procedures can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any control procedure is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.
Management’s Report on Internal Control Over Financial Reporting
Management of Timberland Bancorp, Inc. (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13(a)-15(f) of the Securities Exchange Act of 1934. The Company's internal control over financial reporting was 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.
To comply with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, the Company designed and implemented a structured and comprehensive assessment process to evaluate its internal control over financial reporting across the enterprise. The assessment of the effectiveness of the Company's internal control over financial reporting was based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
The Company's internal control over financial reporting includes policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) 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.
A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Also, because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. Additionally, in designing disclosure controls and procedures, our management was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that
any design will succeed in achieving its stated goals under all potential future conditions. As a result of these inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Furthermore, projections of any evaluation of effectiveness to future periods are subject to risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
Based on its assessment, management has concluded that the Company's internal control over financial reporting was effective as of September 30, 2017.
The effectiveness of internal control over financial reporting as of September 30, 2017, has been audited by Delap LLP, the independent registered public accounting firm who also audited the Company's consolidated financial statements. Delap LLP's attestation report on the Company's internal control over financial reporting follows.
The management of the Company has assessed the Company's compliance with the Federal laws and regulations pertaining to insider loans and the Federal and, if applicable, State laws and regulations pertaining to dividend restrictions during the fiscal year that ended on September 30, 2017. Management has concluded that the Company complied with the Federal laws and regulations pertaining to insider loans and the Federal and, if applicable, State laws and regulations.
Date: December 8, 2017
/s/ Michael R. Sand
/s/ Dean J. Brydon
Michael R. Sand
Dean J. Brydon
President and Chief Executive Officer
Chief Financial Officer
Report of Independent Registered Public Accounting Firm
We have audited the internal control over financial reporting of Timberland Bancorp, Inc. and Subsidiary (collectively, "the Company") as of September 30, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management's Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.
We conducted our audit 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 effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit the 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 Company maintained, in all material respects, effective internal control over financial reporting as of September 30, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's consolidated balance sheet as of September 30, 2017, and the related consolidated statements of income, comprehensive income, shareholders' equity, and cash flows for the year then ended, and our report dated December 8, 2017, expressed an unqualified opinion on those consolidated financial statements.
/s/ Delap LLP
Lake Oswego, Oregon
December 8, 2017
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
The information required by this item is contained under the section captioned “Proposal I - Election of Directors” in the Company’s Definitive Proxy Statement for the 2017 Annual Meeting of Stockholders (“Proxy Statement”) and is incorporated herein by reference.
For information regarding the executive officers of the Company and the Bank, see “Item 1. Business - Executive Officers of the Registrant.”
Compliance with Section 16(a) of the Exchange Act
The information required by this item is contained under the section captioned “Section 16(a) Beneficial Ownership Reporting Compliance” included in the Company’s Proxy Statement and is incorporated herein by reference.
Audit Committee Matters and Audit Committee Financial Expert
The Company has a separately designated standing Audit Committee, which as of September 30, 2017 was composed of Directors Stoney, Smith and Goldberg. Effective October 24, 2017 Director Davis was also appointed to the Audit Committee. Each member of the Audit Committee is “independent” as defined in the Nasdaq Stock Market listing standards. The Company’s Board of Directors has designated Director Stoney as the Audit Committee financial expert, as defined in the SEC’s Regulation S-K. Directors Stoney, Smith, Goldberg and Davis are independent as that term is used in Item 7(c) of Schedule 14A promulgated under the Exchange Act.
Code of Ethics
The Board of Directors ratified its Code of Ethics for the Company’s officers (including its senior financial officers), directors and employees during the year ended September 30, 2017. The Code of Ethics requires the Company’s officers, directors and employees to maintain the highest standards of professional conduct. The Company’s Code of Ethics was filed as an exhibit to its Annual Report on Form 10-K for the year ended September 30, 2003 and is available on our website at www.timberlandbank.com.
Nomination Procedures
There have been no material changes to the procedures by which stockholders may recommend nominees to the Company’s Board of Directors.
Item 11.
Item 11. Executive Compensation
The information required by this item is contained under the sections captioned “Executive Compensation” and “Directors’ Compensation” included in the Company’s Proxy Statement and is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
(a)Security Ownership of Certain Beneficial Owners.
The information required by this item is contained under the section captioned “Security Ownership of Certain Beneficial Owners and Management” included in the Company’s Proxy Statement and is incorporated herein by reference.
(b) Security Ownership of Management.
The information required by this item is contained under the sections captioned “Security Ownership of Certain Beneficial Owners and Management” and “Proposal I - Election of Directors” included in the Company’s Proxy Statement and is incorporated herein by reference.
(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.
(d) Equity Compensation Plan Information. The following table summarizes share and exercise price information about the Company’s equity compensation plans as of September 30, 2017.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by this item is contained under the sections captioned “Meetings and Committees of the Board of Directors And Corporate Governance Matters - Corporate Governance - Related Party Transactions” and “Meetings and Committees of the Board of Directors and Corporate Governance Matters - Corporate Governance - Director Independence” included in the Company's Proxy Statement and are incorporated herein by reference.
Item 14.
Item 14. Principal Accounting Fees and Services
The information required by this item is contained under the section captioned “Proposal 3-Ratification of Selection of Independent Auditor” included in the Company’s Proxy Statement and is incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) Exhibits
____________
(1)
Filed as an exhibit to the Registrant's Registration Statement on Form S-1 (333-35817) and incorporated by reference.
(2)
Incorporated by reference to the Registrant’s Current Report on Form 8-K filed June 1, 2017.
(3)
Incorporated by reference to the Registrant’s Current Report on Form 8-K filed on December 23, 2008.
(4)
Incorporated by reference to the Registrant's Current Report on Form 8-K filed April 16, 2007.
(5)
Incorporated by reference to the Registrant's 2004 Annual Meeting Proxy Statement dated December 24, 2003.
(6)
Incorporated by reference to Exhibit 99.2 included in the Registrant’s Registration Statement on Form S-8 (333-1161163)
(7)
Incorporated by reference to the Registrant’s Current Report of Form 8-K filed on March 29, 2013.
(8)
Attached as Appendix A to the Registrant's Annual Meeting Proxy Statement filed on December 19, 2014.
(9)
Incorporated by reference to the Registrant's Annual Report on Form 10-K for the year ended September 30, 2003.
Item 16. Form 10-K Summary
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
TIMBERLAND BANCORP, INC.
Date: December 8, 2017
By:
/s/Michael R. Sand
Michael R. Sand
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX
Exhibit No.
Description of Exhibit
Subsidiaries of the Registrant
23.1
Consent of Delap LLP
31.1
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act
31.2
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act
Certification Pursuant to Section 906 of the Sarbanes-Oxley Act
The following materials from Timberland Bancorp, Inc.’s Annual Report on Form 10-K for the year ended September 30, 2017, formatted in Extensible Business Reporting Language (XBRL): (a) Consolidated Balance Sheets; (b) Consolidated Statements of Income; (c) Consolidated Statements of Comprehensive Income; (d) Consolidated Statements of Shareholders’ Equity; (e) Consolidated Statements of Cash Flows; and (f) Notes to Consolidated Financial Statements