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BANR > SEC Filings for BANR > Form 10-Q on 6-Nov-2012All Recent SEC Filings

Show all filings for BANNER CORP

Form 10-Q for BANNER CORP


6-Nov-2012

Quarterly Report


ITEM 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations

Executive Overview

We are a bank holding company incorporated in the State of Washington and own two subsidiary banks, Banner Bank and Islanders Bank. Banner Bank is a Washington-chartered commercial bank that conducts business from its main office in Walla Walla, Washington and, as of September 30, 2012, its 87 branch offices and seven 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. Banner Corporation is subject to regulation by the Board of Governors of the Federal Reserve System (the Federal Reserve Board). Banner Bank and Islanders Bank (the Banks) are subject to regulation by the Washington State Department of Financial Institutions, Division of Banks and the Federal Deposit Insurance Corporation (the FDIC). As of September 30, 2012, we had total consolidated assets of $4.3 billion, total loans of $3.2 billion, total deposits of $3.5 billion and total stockholders' equity of $566 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.

Banner Corporation's successful execution of its strategic turnaround plan and operating initiatives continued in the third quarter, as evidenced by our solid profitability for the quarter and nine months ended September 30, 2012. Highlights for the quarter included further improvement in our asset quality, additional customer account growth, significantly increased non-interest-bearing deposit balances and record revenues from core operations. Also notable during the third quarter was our repurchase for $48.5 million in private transactions of 50,584 shares or 41% of our Series A preferred stock, liquidation value $1,000 per share, at an average price of $959 per share. As a result of these repurchase transactions, we realized gains of $2.1 million, which were partially offset by accelerated amortization of a portion of the initial discount recorded at the issuance of the preferred shares. In addition, the accrual of the quarterly dividend for the preferred stock was reduced by the retirement of the repurchased shares.

Our return to consistent profitability was punctuated in the second quarter of 2012 by management's decision to reverse nearly all of the valuation allowance against our deferred tax assets. This decision resulted in a substantial tax benefit in the second quarter, as well as for the first nine months of year; however, for the third quarter of 2012, we did record a $2.4 million provision for income taxes. The decision to reverse the valuation allowance reflects our confidence in the sustainability of our future profitability. Further, as a result of our return to profitability, including the substantial recovery of our deferred tax asset, our improved asset quality and operating trends, strong capital position and our expectation for sustainable profitability for the foreseeable future, we also significantly reduced the credit portion of the discount rate utilized to estimate the fair value of the junior subordinated debentures issued by the Company. As a result, the estimated fair value of our junior subordinated debentures increased by $21.2 million in the second quarter, accounting for most of the $16.9 million net charge before taxes for fair value adjustments for the nine months ended September 30, 2012. Changes in these two significant accounting estimates, while substantial, represent non-cash valuation adjustments that have no effect on our liquidity or our ability to fund our operations. Reflecting changes in general market spreads, our third quarter results included an additional $2.5 million increase in the fair value of the junior subordinated debentures and resulting charge to earnings, which was generally offset by similar adjustments to the fair value estimates for certain investment securities also carried at fair value.

Despite weak economic conditions and ongoing strains in the financial and housing markets which have created an unusually challenging banking environment for an extended period, the Company experienced marked improvement in 2011 which has continued throughout the first nine months of 2012. Reflecting substantially reduced credit costs and significant improvement in our net interest margin, we returned to profitability in 2011 and we have demonstrated further progress and increased profitability in the three quarters ended September 30, 2012. For the quarter ended September 30, 2012, we had net income of $15.6 million which, after providing for the preferred stock dividend, related discount accretion and gains on repurchases of preferred stock, resulted in a net income available to common shareholders of $15.2 million, or $0.79 per diluted share, compared to a net income to common shareholders of $4.1 million, or $0.24 per diluted share, for the quarter ended September 30, 2011. For the nine months ended September 30, 2012, our net income to common shareholders was $45.8 million, or $2.48 per common share, compared to a net loss of $5.5 million, or $(0.33) per common share for the same period a year earlier. Although economic conditions have improved from the depths of the recession resulting in a material decrease in credit costs in recent periods, the pace of recovery


has been modest and uneven and ongoing stress in the economy, reflected in high unemployment, tepid consumer spending, modest loan demand and very low interest rates, will likely continue to create a challenging operating environment going forward. Nonetheless, over the past two years we have significantly improved our risk profile by aggressively managing and reducing our problem assets, which has resulted in lower credit costs and stronger revenues, and which we believe will lead to further improved operating results in future periods.

Our provision for loan losses was $3.0 million for the quarter ended September 30, 2012, compared to $4.0 million in the prior quarter and $5.0 million in the third quarter of the prior year. The decrease from a year earlier reflects significant progress in reducing the levels of 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. From 2008 through 2011, higher than historical provision for loan losses was the most significant factor adversely affecting our operating results; however, the substantial decrease in non-performing assets has resulted in much lower provisioning in 2012. (See Note 7, Loans Receivable and the Allowance for Loan Losses, as well as "Asset Quality" below in this Form 10-Q.)

Aside from the level of loan loss provision, 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 borrowings. 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. Our net interest income before provision for loan losses increased to $42.7 million for the quarter ended September 30, 2012, compared to $41.7 million for the same quarter one year earlier, primarily as a result of expansion of our net interest spread and net interest margin due to a lower cost of funds and a reduction in the adverse impact of non-performing assets. For the nine months ended September 30, 2012, net interest income before provision for loan losses was $126.1 million, an increase of $3.1 million, or 3%, compared to the same period in 2011. The continuing trend to lower funding costs reflects a further decline in interest expense on deposits driven by significant changes in our deposit mix and pricing. This decrease in deposit costs and the reduction in the adverse impact of non-performing assets represent important improvements in our core operating fundamentals. The increase in net interest income occurred despite a modest decline in average earning assets compared to the same quarter a year ago, as we continued to focus on reducing our non-performing loans and make changes in our mix of assets and liabilities designed to reduce our risk profile and produce more sustainable earnings.

Our net income also is affected by the level of our other operating income, including deposit fees and service charges, loan origination and servicing fees, and gains and losses on the sale of loans and securities, as well as our non-interest operating expenses and income tax provisions. In addition, our net income is affected by the net change in the value of certain financial instruments carried at fair value and in certain periods by other-than-temporary impairment (OTTI) charges or recoveries. (See Note 11 of the Selected Notes to the Consolidated Financial Statements.) For the quarter ended September 30, 2012, we recorded a net gain of $473,000 in fair value adjustments, which was largely offset by $409,000 of OTTI charges. In comparison, we recorded a net fair value loss of $1.0 million for the quarter ended September 30, 2011, which was more than offset by a $3.0 million OTTI recovery. For the nine months ended September 30, 2012, we recorded net fair value losses of $16.9 million, largely related to the increased valuation of our junior subordinated debentures, and OTTI charges of $409,000, compared to net fair value gains of $1.2 million and an OTTI recovery of $3.0 million for the same period in 2011.

As a result of strong mortgage banking revenues and increased deposit fees and service charges, other operating income for the quarter ended September 30, 2012 increased to $11.7 million, compared to $10.3 million for the quarter ended September 30, 2011. Our total revenues (net interest income before the provision for loan losses plus other operating income) for the third quarter of 2012 increased $2.3 million, or 4%, to $54.4 million, compared to $52.1 million for the third quarter of 2011. However, our revenues, excluding fair value and OTTI adjustments, which we believe are more indicative of our core operations, increased $4.2 million, or 8%, to $54.3 million for the quarter ended September 30, 2012, compared to $50.1 million for the quarter ended September 30, 2011. This growth in core revenues was the result of meaningful increases in our net interest income and deposit fees and a substantial increase in revenues from mortgage banking activities. For the nine months ended September 30, 2012, revenues, excluding fair value and OTTI adjustments, increased $11.3 million to $157.0 million compared to $145.7 million for the nine months ended September 30, 2011, primarily the result of a $5.7 million increase in mortgage banking fees, a $3.1 million increase in net interest income and a $1.8 million increase in deposit-related fees.

Our other operating expenses decreased to $33.4 million for the quarter ended September 30, 2012, compared to $41.0 million for the quarter ended September 30, 2011, largely as a result of decreased costs related to real estate owned, FDIC deposit insurance costs and professional services, which were partially offset by increased compensation expenses. While significantly lower in 2012 than in 2011, both quarters' expenses reflect significant costs associated with problem loan collection activities including professional services and valuation charges related to real estate owned, which should decline in future periods as a result of the continuing reduction in non-performing assets. During the quarter and nine months ended September 30, 2012, however, costs


related to real estate owned operations were reduced by net gains on the sale of real estate owned, which are not expected to be recurring in future periods. For the nine months ended September 30, 2012, other operating expenses totaled $106.9 million, compared to $119.4 million for the nine months ended September 30, 2011, with the decrease also primarily reflecting decreased REO valuation adjustments and deposit insurance costs. See "Comparison of Results of Operations for the Three and Nine Months Ended September 30, 2012 and 2011" for more detailed information about our financial performance.

As a result of reversing an additional $4.0 million of the valuation allowance for our net deferred tax asset, our provision for income taxes was reduced to $2.4 million, or 13.4% of pre-tax net income, for the quarter ended September 30, 2012. For the nine months ended September 30, 2012, reversing the valuation allowance resulted in a cumulative net tax benefit of $29.4 million. For the quarter and nine months ended September 30, 2011, our tax expense was fully offset by adjustments to the valuation allowance. Excluding the fair value and OTTI adjustments, our pre-tax net income for the quarter and nine months ended September 30, 2012, would have been $18.0 million and $38.1 million, respectively. By contrast, excluding fair value and OTTI adjustments, our pre-tax net income for the quarter ended September 30, 2011, would have been $4.1 million and we would have had a pre-tax net loss of $3.8 million for the nine months ended September 30, 2011. The significant increase in pre-tax net income, excluding the fair value and OTTI adjustments, largely reflects increased revenues from core operations and decreased credit-related costs.

Other operating income, revenues and other earnings information excluding fair value adjustments and OTTI losses are non-GAAP financial measures. Management has presented these and other non-GAAP financial measures in this discussion and analysis because it believes that they provide useful and comparative information to assess trends in our core operations. Where applicable, we have also presented comparable earnings information using GAAP financial measures. Reconciliations of these non-GAAP financial measures are contained in the tables below. See "Comparison of Results of Operations for the Three and Nine Months Ended September 30, 2012 and 2011" for more detailed information about our financial performance.

The following tables set forth reconciliations of non-GAAP financial measures discussed in this report (dollars in thousands):

                                         For the Three Months Ended           For the Nine Months Ended
                                                September 30                         September 30
                                              2012                2011              2012             2011
Total other operating income         $      11,684       $      10,340     $      13,591       $   26,839
Less other-than-temporary impairment
loss (recovery)                                409              (3,000 )             409           (3,000 )
Less change in valuation of
financial instruments carried at
fair value                                    (473 )             1,032            16,901           (1,163 )
Total other operating income,
excluding fair value adjustments and
OTTI                                 $      11,620       $       8,372     $      30,901       $   22,676
Net interest income before provision
for loan losses                      $      42,698       $      41,728     $     126,114       $  122,985
Total other operating income                11,684              10,340            13,591           26,839
Less other-than-temporary impairment
loss (recovery)                                409              (3,000 )             409           (3,000 )
Less change in valuation of
financial instruments carried at
fair value                                    (473 )             1,032            16,901           (1,163 )
Total revenue, excluding fair value
adjustments and OTTI                 $      54,318       $      50,100     $     157,015       $  145,661
Net income                           $      15,620       $       6,030     $      50,194       $      387
Income tax expense (benefit)                 2,407                   -           (29,423 )              -
Income before income taxes                  18,027               6,030            20,771              387
Less other-than-temporary impairment
(recovery) loss                                409              (3,000 )             409           (3,000 )
Less change in valuation of
financial instruments carried at
fair value                                    (473 )             1,032            16,901           (1,163 )
Pre-tax net income (loss), excluding
fair value adjustments and OTTI      $      17,963       $       4,062     $      38,081       $   (3,776 )


The ratio of tangible common stockholders' equity to tangible assets is also a non-GAAP financial measure. We calculate tangible common equity by excluding other intangible assets and preferred equity from stockholders' equity. We calculate tangible assets by excluding the balance of other intangible assets from total assets. We believe that this is consistent with the treatment by our bank regulatory agencies, which exclude goodwill and other intangible assets from the calculation of risk-based capital ratios. In addition, excluding preferred equity, the level of which may vary from company to company, allows investors to more easily compare our capital adequacy to other companies in the industry that also use this measure. Management believes that this non-GAAP financial measure provides information to investors that is useful in understanding the basis of our capital position. However, this non-GAAP financial measure is supplemental and is not a substitute for any analysis based on GAAP. Because not all companies use the same calculation of tangible common equity and tangible assets, this presentation may not be comparable to other similarly titled measures as calculated by other companies (dollars in thousands).

                                               September 30      December 31       September 30
                                                       2012             2011               2011
Stockholders' equity                         $      566,095     $    532,450     $      521,491
Other intangible assets, net                          4,740            6,331              6,887
Tangible equity                                     561,355          526,119            514,604
Preferred equity                                     72,242          120,702            120,276
Tangible common stockholders' equity         $      489,113     $    405,417     $      394,328
Total assets                                 $    4,268,664     $  4,257,312     $    4,291,764
Other intangible assets, net                          4,740            6,331              6,887
Tangible assets                              $    4,263,924     $  4,250,981     $    4,284,877
Tangible common stockholders' equity to
tangible assets                                       11.47 %           9.54 %             9.20 %

We offer a wide range of loan products to meet the demands of our customers. Historically, our lending activities have been primarily directed toward the origination of real estate and commercial loans. Until recent periods, real estate lending activities were significantly focused on residential construction and first mortgages on owner-occupied, one- to four-family residential properties; however, over the past four years our origination of construction and land development loans declined materially and the proportion of the portfolio invested in these types of loans has declined substantially. More recently, we have experienced more demand for one-to-four family construction loans and outstanding balances have increased modestly. Our residential mortgage loan originations also decreased during most of this cycle, although less significantly than the decline in construction and land development lending as exceptionally low interest rates supported demand for loans to refinance existing debt as well as loans to finance home purchases. Refinancing activity has been particularly significant for the first nine months of 2012, leading to a meaningful increase in residential mortgage originations compared to the same period a year earlier. Despite the recent increase in these loan originations, our outstanding balances for residential mortgages have continued to decline, as most of the new originations have been sold in the secondary market while existing residential loans have been repaying at an accelerated pace. Our real estate lending activities also include the origination of multifamily and commercial real estate loans. While reduced from periods prior to the economic slowdown, our level of activity and investment in these types of loans has been relatively stable in recent periods. Our commercial business lending is directed toward meeting the credit and related deposit needs of various small- to medium-sized business and agribusiness borrowers operating in our primary market areas. Reflecting the weak economy, in recent periods demand for these types of commercial business loans has been modest and, aside from seasonal variations, total outstanding balances have not significantly increased or decreased. Our consumer loan activity is primarily directed at meeting demand from our existing deposit customers and, while we have increased our emphasis on consumer lending in recent years, demand for consumer loans also has been modest during this period of economic weakness as we believe many consumers have been focused on reducing their personal debt. At September 30, 2012, our net loan portfolio totaled $3.135 billion compared to $3.213 billion at December 31, 2011.

Deposits, retail repurchase agreements and loan repayments are the major sources of our funds for lending and other investment purposes. We generally attract deposits from within our primary market areas by offering a broad selection of deposit instruments, including demand checking accounts, interest-bearing checking accounts, money market deposit accounts, regular savings accounts, certificates of deposit, cash management services and retirement savings plans. Deposit account terms vary according to the minimum balance required, the time periods the funds must remain on deposit and the interest rate, among other factors. In determining the terms of deposit accounts, we consider current market interest rates, profitability, matching deposit and loan


products, and customer preferences and concerns. We compete with other financial institutions and financial intermediaries in attracting deposits and we generally attract deposits within our primary market areas.

Much of the focus of our strategic initiatives in recent periods has been directed toward attracting additional deposit customer relationships and balances. The long-term success of our deposit gathering activities is reflected not only in the growth of transaction and savings accounts (checking, savings and money market accounts), but also in the interest cost of our deposits and increases in the level of deposit fees, service charges and other payment processing revenues compared to prior periods. During the last two years, our total deposit balances decreased largely as a result of our decision to significantly reduce our exposure to brokered deposits and high cost certificates of deposit. However, over the same period we have had a meaningful increase in transaction and savings accounts as we have remained focused on growing these core deposits. As a result, our cost of deposits has declined significantly and fees and service charges have increased compared to earlier periods. Total deposits at September 30, 2012 were $3.486 billion, compared to $3.476 billion at December 31, 2011 and $3.537 billion at September 30, 2011. While certificates of deposit decreased $226 million compared to a year earlier, including a decrease of $38 million in brokered deposits, transaction and savings account deposits increased by $175 million over the same one-year period and represented 69% of total deposits at September 30, 2012 compared to 63% at September 30, 2011.

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 Selected Notes to the Consolidated Financial Statements contained in Item 1 of this Form 10-Q.

Summary of Critical Accounting Policies

Our significant accounting policies are described in Note 1 of the Notes to the Consolidated Financial Statements for the year ended December 31, 2011 included in the 2011 Form 10-K. Various elements of our accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. In particular, management has identified several accounting policies that, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of our financial statements. These policies relate to (i) the methodology for the recognition of interest income, (ii) determination of the provision and allowance for loan and lease losses, (iii) the valuation of financial assets and liabilities recorded at fair value, including OTTI losses, (iv) the valuation of intangibles, such as core deposit intangibles and mortgage servicing rights, (v) the valuation of real estate held for sale and (vi) the valuation of or recognition of deferred tax assets and liabilities. These policies and judgments, estimates and assumptions are described in greater detail below. Management believes that the judgments, estimates and assumptions used in the preparation of the financial statements are appropriate based on the factual circumstances at the time. However, given the sensitivity of the financial statements to these critical accounting policies, the use of other judgments, estimates and assumptions could result in material differences in our results of operations or financial condition. Further, subsequent changes in economic or market conditions could have a material impact on these estimates and our financial condition and operating results in future periods. There have been no significant changes in our application of accounting policies during the first nine months of 2012; however, in the quarter ended June 30, 2012, we did recognize significant changes in the estimated fair value of certain financial assets and liabilities and substantially reduced the valuation allowance for our deferred tax assets.

Interest Income: (Note 1) Interest on 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 . . .

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