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| BANR > SEC Filings for BANR > Form 10-K on 16-Mar-2009 | All Recent SEC Filings |
16-Mar-2009
Annual Report
Management's discussion and analysis of results of operations is intended to assist in understanding our financial condition and results of operations. The information contained in this section should be read in conjunction with the Consolidated Financial Statements and accompanying Notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K.
We are a bank holding company incorporated in the State of Washington and own two subsidiary banks, Banner Bank and, subsequent to May 1, 2007, Islanders Bank. Banner Bank is a Washington-chartered commercial bank that conducts business from its main office in Walla Walla, Washington and, as of December 31, 2008, its 83 branch offices and 10 loan production offices located in Washington, Oregon and Idaho. Islanders Bank is also a Washington-chartered commercial bank and conducts its business from three locations in San Juan County, Washington. As of December 31, 2008, we had total consolidated assets of $4.6 billion, total loans of $3.9 billion, total deposits of $3.8 billion and total stockholders' equity of $433 million.
Banner Bank is a regional bank which offers a wide variety of commercial banking services and financial products to individuals, businesses and public sector entities in its primary market areas. Islanders Bank is a community bank which offers similar banking services to individuals, businesses and public entities located in the San Juan Islands. The Banks' primary business is that of traditional banking institutions, accepting deposits and originating loans in locations surrounding their offices in portions of Washington, Oregon and Idaho. Banner Bank is also an active participant in the secondary market, engaging in mortgage banking operations largely through the origination and sale of one- to four-family residential loans. Lending activities include commercial business and commercial real estate loans, agriculture business loans, construction and land development loans, one- to four-family residential loans and consumer loans. (See Item 1-Business.)
Branch expansion has been a significant element in our strategy to grow loans, deposits and customer relationships. Over the past several years, we have invested significantly in expanding our branch and distributions systems with a primary emphasis on expanding our presence in the four largest areas of commerce in the Northwest: the Puget Sound region of Washington and the greater Boise, Idaho, Portland, Oregon, and Spokane, Washington markets. As a result of our franchise expansion, we have added 18 new branches through acquisitions, opened 23 new branches and relocated eight others since March, 2004. In 2007 alone, we opened ten branches, relocated five others and closed three acquisitions; and in 2008, we opened two additional branches. In large part because of this expansion activity, we have experienced loan growth of $1.8 billion and deposit growth of $1.9 billion over the last four-year period. The acquisitions and new branches have increased our presence within desirable markets and allow us to better serve existing and future customers. This emphasis on growth has resulted in an elevated level of operating expenses; however, we believe that over time these new branches should help improve profitability by providing lower cost core deposits which will allow us to proportionately reduce higher cost borrowings as a source of funds. We have reached our goal in terms of the number of branches we believe are needed to generate deposit growth sufficient to fund our expected loan growth and produce significant fee generating opportunities. As a result, we plan a more moderate pace of branch expansion going forward.
We completed the acquisitions of F&M Bank and San Juan Financial Holding Company effective May 1, 2007, and NCW Community Bank effective October 10, 2007. SJFHC was merged into Banner and its wholly owned subsidiary, Islanders Bank, has continued operations as a subsidiary of Banner. F&M and NCW were merged into Banner Bank upon acquisition and now operate under the Banner Bank name. The financial results for the year ended December 31, 2008 include the assets, liabilities and results of operations for all three of the recently acquired companies. The financial results for the year ended December 31, 2007 include the assets, liabilities and results of operations for the three acquired companies from their respective acquisition dates.
Deteriorating economic conditions and ongoing strains in the financial and housing markets which accelerated throughout 2008 presented an unusually challenging environment for banks and their holding companies, including Banner Corporation. This was particularly evident in our need to provide for credit losses at a significantly higher level than our historical experience. We had a net loss of $128.0 million, or $(7.94) per diluted share available to common shareholders, for the year ended December 31, 2008, compared to net income of $36.9 million, or $2.49 per diluted share, for the year ended December 31, 2007. The provision for loan losses was $62.5 million for the year ended December 31, 2008, an increase of $56.6 million compared to the year ended December 31, 2007. The increase in the provision for loan losses in the current year reflects material increases in delinquencies, non-performing loans and net charge-offs, particularly for loans for the construction of one- to four-family homes and for acquisition and development of land for residential properties. The current year's results were also adversely affected by a $121.1 million write-off of goodwill, as well as by a substantially narrower net interest margin.
The challenging environment and faltering equity markets also caused us to take a hard look at the carrying value of goodwill and to conclude that it was appropriate to record a non-cash write-off of that asset. At least annually, and more often if appropriate, all companies are required to determine the value of goodwill as an asset. We initially recorded a $50.0 million impairment charge during the quarter ended June 30, 2008. We subsequently recorded an additional $71.1 million charge in the quarter ended December 31, 2008, resulting in the complete elimination of goodwill from our balance sheet and a total $121.1 million goodwill write-off for the year ended December 31, 2008. While there is currently a great deal of uncertainty with respect to the market valuation of certain assets, declining stock prices for financial service companies clearly indicate that the value of goodwill for the industry has been severely diminished. As a result of the significant reduction in most banks' stock prices, including BANR's, and the lack of merger transactions in recent months, measuring the value of goodwill has become difficult and imprecise at best; however, we concluded that continuing to record it as an asset would be inappropriate. The write-off of goodwill was a non-cash charge that did not affect our liquidity or operations. Also, since goodwill is excluded from regulatory capital, the impairment charge (which was not deductable for tax purposes) did not have an adverse effect on the regulatory capital ratios of the Company or either of our subsidiary banks, each of which continues to remain "well capitalized" under the regulatory requirements. (See Note 20 of Notes to the Consolidated Financial Statements.)
For the year ended December 31, 2008, fair value adjustments were also significantly affected by a reduction in the fair value of our investment in Federal National Mortgage Association ("Fannie Mae") and Federal Home Loan Mortgage Corporation ("Freddie Mac") equity securities, which were essentially rendered valueless subsequent to the U.S. Treasury's action in September 2008 placing those institutions into conservatorship under the authority of the Federal Housing Finance Agency. As of June 30, 2008, we owned both common and preferred equity securities issued by Fannie Mae and Freddie Mac with a combined book value of $6.9 million. At December 31, 2008, the fair value of these securities had declined to approximately $227,000. The decrease in the value of these securities was included in the $9.2 million ($5.9 million after tax) net gain in fair value adjustments recorded for the year ended December 31, 2008 (see Note 24, Fair Value Accounting and Measurement). We do not anticipate a meaningful recovery with respect to the valuation of the Fannie Mae and Freddie Mac stock in future periods.
Aside from the level of loan loss provision, fair value adjustments and goodwill write-down, our operating results depend primarily on our net interest income, which is the difference between interest income on interest-earning assets, consisting of loans and investment securities, and interest expense on interest-bearing liabilities, composed primarily of customer deposits and repurchase agreements, FHLB advances, FRBSF borrowings and junior subordinated debentures. Net interest income is primarily a function of our interest rate spread, which is the difference between the yield earned on interest-earning assets and the rate paid on interest-bearing liabilities, as well as a function of the average balances of interest-earning assets and interest-bearing liabilities. As more fully explained below, our net interest income before provision for loan losses decreased by $2.1 million for the year ended December 31, 2008 to $147.6 million as compared to $149.6 million for the prior year, primarily as a result of a contraction in our net interest margin as asset yields have declined sharply over the past twelve months in response to the Federal Reserve's action designed to dramatically lower short-term interest rates. Further, increased delinquencies and the slowdown in the sale and construction of new homes over the year have had an adverse impact on our net interest margin, as well as on the amount of our loan loss provision.
Our net income also is affected by the level of our other operating income, including deposit service charges, loan origination and servicing fees, and gains and losses on the sale of loans and securities, as well as our operating expenses and income tax provisions. Other operating income, excluding the fair value adjustments, increased by $3.7 million, or 14%, to $30.7 million for the year ended December 31, 2008 from $27.0 million for the prior year, primarily as a result of increased deposit fees and other service charges reflecting growth in our customer base and related payment processing activities. Revenues (net interest income before the provision for loan losses plus other operating income), excluding fair value adjustments, increased $1.7 million to $178.3 million for the year ended December 31, 2008, compared to $176.6 million for the year ended December 31, 2007. Other operating expenses, excluding the $121.1 million goodwill write-off, also increased by $11.4 million, or 9%, to $138.9 million for the year ended December 31, 2008 from $127.5 million for prior year. The increase from the prior year reflects the effects of new branch openings, including two added in 2008 and ten added at various times during 2007, as well as last year's three acquisitions which, after consolidations, added another16 branches and nearly $800 million in total assets. Most significantly, the increase in expenses reflects additional occupancy expense, increased deposit insurance assessments, expanded payment processing activities, costs associated with problem loan collection activities and charges related to real estate owned, offset in part by reductions in advertising and information/computer data services.
We offer a wide range of loan products to meet the demands of our customers; however, we do not now and have not previously engaged in any sub-prime lending programs. Historically, our lending activities have been primarily directed toward the origination of real estate and commercial loans. Real estate lending activities have been significantly focused on residential construction and first mortgages on owner occupied, one- to four-family residential properties; however, over the past two years our origination of construction and land development loans has declined materially. Our total construction and land development loan originations in 2007 were $835 million, which was approximately 36% lower than in the previous year, and this trend continued as construction and land development loan originations in 2008 totaled just $345 million, approximately 59% lower than the prior year. Our real estate lending activities have also included the origination of multifamily and commercial real estate loans. Our commercial business lending has been directed toward meeting the credit and related deposit needs of various small- to medium-sized business and agri-business borrowers operating in our primary market areas. We have also increased our emphasis on consumer lending, although the portion of the loan portfolio invested in consumer loans is still relatively small. While continuing our commitment to residential lending, including our mortgage banking activities, we expect commercial lending (including commercial real estate, commercial business and agricultural loans) and consumer lending to become increasingly important activities for us. By contrast, we anticipate residential construction and land development lending will continue to be restrained by market conditions for the next two to three years.
Critical Accounting Policies
In the opinion of management, the accompanying consolidated statements of financial condition and related consolidated statements of income, comprehensive income, changes in stockholders' equity and cash flows reflect all adjustments (which include reclassification and normal recurring adjustments) that are necessary for a fair presentation in conformity with Generally Accepted Accounting Principles ("GAAP"). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect amounts reported in the financial statements.
Interest Income: (Notes 1 & 9) Intereston loans and securities is accrued as earned unless management doubts the collectability of the asset or the unpaid interest. Interest accruals on loans are generally discontinued when loans become 90 days past due for payment of interest and the loans are then placed on nonaccrual status. All previously accrued but uncollected interest is deducted from interest income upon transfer to nonaccrual status. For any future payments collected, interest income is recognized only upon management's assessment that there is a strong likelihood that the full amount of a loan will be repaid or recovered. A loan may be put on nonaccrual status sooner than this policy would dictate if, in management's judgment, the loan may be uncollectible. While less common, similar interest reversal and nonaccrual treatment would apply to investment securities if their ultimate collectability became questionable.
Provision and Allowance for Loan Losses: (Notes 1 & 10) The provision for loan losses reflects the amount required to maintain the allowance for losses at an appropriate level based upon management's evaluation of the adequacy of general and specific loss reserves. We maintain an allowance for loan losses consistent in all material respects with the GAAP guidelines outlined in SFAS No. 5, Accounting for Contingencies. We have established systematic methodologies for the determination of the adequacy of our allowance for loan losses. The methodologies are set forth in a formal policy and take into consideration the need for an overall general valuation allowance as well as specific allowances that are tied to individual problem loans. We increase our allowance for loan losses by charging provisions for probable loan losses against our income and value impaired loans consistent with the guidelines in SFAS No. 114, Accounting by Creditors for Impairment of a Loan,and SFAS No. 118, Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosure.
The allowance for losses on loans is maintained at a level sufficient to provide for estimated losses based on evaluating known and inherent risks in the loan portfolio and upon our continuing analysis of the factors underlying the quality of the loan portfolio. These factors include changes in the size and composition of the loan portfolio, delinquency rates, actual loan loss experience, current and anticipated economic conditions, detailed analysis of individual loans for which full collectability may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. Realized losses related to specific assets are applied as a reduction of the carrying value of the assets and charged immediately against the allowance for loan loss reserve. Recoveries on previously charged off loans are credited to the allowance. The reserve is based upon factors and trends identified by us at the time financial statements are prepared. Although we use the best information available, future adjustments to the allowance may be necessary due to economic, operating, regulatory and other conditions beyond our control. The adequacy of general and specific reserves is based on our continuing evaluation of the pertinent factors underlying the quality of the loan portfolio, including changes in the size and composition of the loan portfolio, delinquency rates, actual loan loss experience and current economic conditions, as well as individual review of certain large balance loans. Large groups of smaller-balance homogeneous loans are collectively evaluated for impairment. Loans that are collectively evaluated for impairment include residential real estate and consumer loans and, as appropriate, smaller balance non-homogeneous loans. Larger balance non-homogeneous residential construction and land, commercial real estate, commercial business loans and unsecured loans are individually evaluated for impairment. Loans are considered impaired when, based on current information and events, we determine that it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Factors involved in determining impairment include, but are not limited to, the financial condition of the borrower, the value of the underlying collateral and the current status of the economy. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of collateral if the loan is collateral dependent. Subsequent changes in the value of impaired loans are included within the provision for loan losses in the same manner in which impairment initially was recognized or as a reduction in the provision that would otherwise be reported.
Our methodology for assessing the appropriateness of the allowance consists of several key elements, which include specific allowances, an allocated formula allowance and an unallocated allowance. Losses on specific loans are provided for when the losses are probable and estimable. General loan loss reserves are established to provide for inherent loan portfolio risks not specifically provided for. The level of general reserves is based on analysis of potential exposures existing in our loan portfolio including evaluation of historical trends, current market conditions and other relevant factors identified by us at the time the financial statements are prepared. The formula allowance is calculated by applying loss factors to outstanding loans, excluding those loans that are subject to individual analysis for specific allowances. Loss factors are based on our historical loss experience adjusted for significant factors including the experience of other banking organizations that, in our judgment, affect the collectability of the portfolio as of the evaluation date. The unallocated allowance is based upon our evaluation of various factors that are not directly measured in the determination of the formula and specific allowances. Beginning with the year ended December 31, 2007, we adjusted our loss factors in accordance with updated guidance from our regulators. The adjusted factors resulted in somewhat lower general and specific reserves; however, in the current economic environment, management's judgment with respect to the appropriate level of loss provisioning and allowance resulted in a significantly greater amount of unallocated allowance than in prior periods. This methodology may result in losses or recoveries differing significantly from those provided in the financial statements.
Fair Value Accounting and Measurement: (Notes 1 and 24) We use fair value measurements to record fair value adjustments to certain financial assets and liabilities and to determine fair value disclosures. We include in the Notes to the Financial Consolidated Statements information about the extent to which fair value is used to measure financial assets and liabilities, the valuation methodologies used and the impact on our results of operations and financial condition. Additionally, for financial instruments not recorded at fair value we disclose, where appropriate, our estimate of their fair value.
SFAS No. 157 defines fair value, establishes a consistent framework for measuring fair value and expands disclosure requirements about fair value measurements. SFAS No. 157 defines fair value as the price that would be received to sell the financial asset or paid to transfer the financial liability in an orderly transaction between willing market participants at the measurement date. SFAS No. 157, among other things, requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our market assumptions. These two types of inputs create the following fair value hierarchy:
• Level 1 - Quoted prices for identical instruments in active markets
• Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.
• Level 3 - Instruments whose significant value drivers are unobservable.
In accordance with SFAF 157, it is our policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. However, in certain instances, when market observable inputs are not available, we are required to make judgments about assumptions market participants would use in estimating the fair value of the financial instruments. In addition, changes in market conditions may reduce the availability of quoted prices or other observable inputs, requiring a change in the method, judgments and assumptions used to estimate fair value for specific instruments from that which was used in prior periods. The disruption of certain financial markets and lack of meaningful transaction activity for certain securities in 2008 made estimating fair values more difficult and less reliable than in prior years.
Goodwill and Other Intangible Assets: (Notes 1 and 23) Goodwilland other intangible assets represent the excess of purchase price over the fair value of net assets acquired by the Company. The excess cost over fair value of net assets acquired consists of goodwill and core deposit premiums. We account for goodwill and other intangibles as provide for in SFAS No. 142, Goodwill and Other Intangible Assets. The majority of goodwill and intangibles generally arise from business combinations accounted for under the purchase method. Goodwill and other intangibles deemed to have indefinite lives generated from purchase business combinations are not subject to amortization and are instead tested for impairment no less than annually. The goodwill we have recorded has been assigned to our one reporting segment, banking.
Annually or more often if appropriate, we engage an independent valuation consultant to assist us in determining whether and to what extent our goodwill . . .
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