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HMST > SEC Filings for HMST > Form 10-K on 15-Mar-2013All Recent SEC Filings

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Form 10-K for HOMESTREET, INC.


15-Mar-2013

Annual Report


ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the "Selected Consolidated Financial Data" and the Consolidated Financial Statements and the related Notes included in Items 6 and 8 of this Form 10-K. The following discussion contains statements using the words "anticipate," "believe," "could," "estimate," "expect," "intend," "may," "plan," "potential," "should," "will" and "would" and similar expressions (or the negative of these terms) generally identify forward-looking statements. Such statements involve inherent risks and uncertainties, many of which are difficult to predict and are generally beyond the control of the Company and are subject to risks and uncertainties, including, but not limited to, those discussed below and elsewhere in this Form 10-K, particularly in Item 1A "Risk Factors" that could cause actual results to differ significantly from those projected. Although we believe that expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We do not intend to update any of the forward-looking statements after the date of this Form 10-K to conform these statements to actual results or changes in our expectations. Readers are cautioned not to place undue reliance on these forward-looking statements, which apply only as of the date of this Form 10-K.

This report contains forward-looking statements. For a discussion about such statements, including the risks and uncertainties inherent therein, see "Forward-Looking Statements." Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes presented elsewhere in this annual report on Form 10-K.

Management's Overview of 2012 Financial Performance

We are a 91-year-old diversified financial services company headquartered in Seattle, Washington, serving consumers and businesses primarily in the Pacific Northwest and Hawaii. The Company is principally engaged in real estate lending, including mortgage banking activities, and retail and commercial banking operations. Our primary subsidiaries are HomeStreet Bank (the "Bank") and HomeStreet Capital Corporation. HomeStreet Bank is a Washington state-chartered savings bank that provides residential and commercial loans, deposit products and services, non-deposit investment products, and cash management services. HomeStreet Bank's primary loan products include single family residential mortgages, loans secured by commercial real estate, loans for residential and commercial real estate construction, and commercial business loans. HomeStreet Capital Corporation, a Washington corporation, originates, sells and services multifamily mortgage loans under the Fannie Mae Delegated Underwriting and Servicing Program ("DUS"®) (DUS® is a registered trademark of Fannie Mae.) in conjunction with HomeStreet Bank. Doing business as HomeStreet Insurance, we provide insurance products and services for consumers and businesses. We additionally offer single family home loans through our partial ownership in an affiliated business arrangement known as Windermere Mortgage Services Series LLC ("WMS LLC").

We generate revenue through positive "net interest income" and by earning "noninterest income." Net interest income is primarily the difference between our interest income earned on loans and investment securities less the interest we pay on deposits and other borrowings. We earn noninterest income from the origination, sale and servicing of loans and fees earned on deposit services and investment and insurance sales.

At December 31, 2012, we had total assets of $2.63 billion, net loans held for investment of $1.31 billion, deposits of $1.98 billion and shareholders' equity of $263.8 million. At December 31, 2011, we had total assets of $2.26 billion, net loans held for investment of $1.30 billion, deposits of $2.01 billion and shareholders' equity of $86.4 million.

Our reported net income of $82.1 million for the year ended 2012 marked a significant increase in profitability, reflecting our success in growing our mortgage lending business and our commercial and consumer businesses. As discussed below, during 2012 we improved or expanded major components of our business, including recapitalizing the Company; upgrading the Bank's regulatory standing; expanding our mortgage origination capacity and market share; improving the quality of our deposits; bolstering our processing, compliance and risk management capabilities; and achieving significantly improved results of operations.

The Board of Directors twice approved 2-for-1 forward splits of the Company's common stock that were effective on March 6, 2012 and November 5, 2012, respectively. Shares outstanding and per share information have been adjusted to reflect the stock splits.

Financial Performance


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For 2012, we achieved record net income of $82.1 million, or $5.98 per diluted share, compared to $16.1 million, or $2.80 per share, for 2011. Return on average equity was 39.18% for 2012, compared to 23.52% for 2011, while the return on average assets was 3.43% for 2012, compared to 0.70% for 2011.

Our record net income in 2012 resulted from a $152.6 million increase in net revenue compared to 2011. Our strong revenue growth in 2012 mostly reflected the significant growth in mortgage loan origination and sale activities driven by high mortgage production volume and strong secondary market profit margins that persisted throughout 2012. We also continued to expand our mortgage production capacity by increasing our mortgage origination and support personnel by 146% during the year.

Net interest income, on a tax equivalent basis, was $62.6 million in 2012, an increase of $13.8 million, or 28.2%, compared to net interest income of $48.8 million in 2011. Our net interest margin for 2012 improved to 2.89% from 2.36% for 2011. The improvement in our net interest income and net interest margin in large part reflects the execution of our deposit product and pricing strategy, as growth in transaction and savings account balances more than offset maturities of higher yielding certificates of deposit. Additionally, higher average balances of loans held for sale from increased loan production and higher average balances of investment securities from the use of proceeds from our initial public offering increased our average balances of interest earning assets in 2012.

Provision for credit losses was $11.5 million in 2012, compared to $3.3 million in 2011. Asset quality trends improved during the year as nonaccrual loans declined to $29.9 million at December 31, 2012, a decrease of $46.6 million, or 60.9%, from $76.5 million at December 31, 2011. Loan delinquencies also decreased, with total loans past due decreasing to 6.58% of loans held for investment at December 31, 2012, compared to 10.38% at December 31, 2011. Overall, the allowance for credit losses decreased to $27.8 million, or 2.07% of loans held for investment at December 31, 2012, down from $42.8 million, or 3.18% of total loans held for investment at December 31, 2011.

Noninterest income was $237.5 million in 2012, an increase of $140.3 million, or 144%, from $97.2 million in 2011. Our noninterest income is heavily dependent upon our single family mortgage banking activities, which are comprised of mortgage origination and sale activities and mortgage servicing activities. The increase in noninterest income is predominantly due to higher net gain on mortgage loan origination and sale activities, which totaled $210.2 million in 2012 compared to $48.5 million in 2011, an increase of $161.7 million, or 334%, year-over-year. This income was partially offset by a $21.9 million decrease in mortgage servicing income in 2012 compared to prior year, primarily due to mortgage servicing rights ("MSRs") risk management results.

Noninterest expense was $183.1 million in 2012, an increase of $56.6 million, or 44.8%, from $126.5 million in 2011. Noninterest expense increased primarily due to salaries and related costs, which increased $66.3 million in 2012 compared to 2011, primarily higher incentive compensation, including commissions to lending personnel, driven by growth in single family closed loan production volume and increased headcount as we invested in growth and diversification. This increase was partially offset by lower other real estate owned ("OREO") expenses, which was $10.1 million in 2012, a decrease of $20.2 million from OREO expense of $30.3 million in 2011.

Income tax expense was $21.5 million in 2012 compared to an income tax benefit of $214 thousand in 2011. The Company's 2012 tax expense is based on the Company's annual effective income tax rate plus discrete benefits recognized during the year. The Company's effective tax rate for the year of 21% differs from the federal statutory rate of 35% primarily due to a $14.4 million tax benefit related to the reversal of the Company's beginning of year valuation allowance against deferred tax assets during the second quarter of 2012, tax exempt income and state income taxes in Oregon, Hawaii and Idaho.

Asset Quality

Management believes that the Company's allowance for loan losses is at a level appropriate to cover estimated incurred losses inherent within the loans held for investment portfolio. Our credit risk profile has improved since December 31, 2011 as illustrated by the credit trends below.

We recorded an $11.5 million provision for credit losses in 2012 compared to $3.3 million in 2011. Net charge-offs were $26.5 million in 2012 compared to $25.1 million in 2011. The allowance for loan losses (which excludes the allowance for unfunded commitments) decreased to $27.6 million at December 31, 2012, or 2.06% of loans held for investment, compared to $42.7 million, or 3.17% of total loans held for investment, at December 31, 2011. The decrease in the allowance for loan losses since December 31, 2011 primarily reflects reductions in specific reserves from charge-offs related to the resolution of certain nonaccrual loans as they were transferred to OREO. Additionally, the overall credit quality of our loan portfolio improved during 2012 as reflected in decreased nonaccrual loans and total loan delinquencies.


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Nonperforming assets decreased to $53.8 million at December 31, 2012, from $115.1 million at December 31, 2011. Nonaccrual loans declined to $29.9 million at December 31, 2012, compared to $76.5 million at December 31, 2011. Past due loans totaled $88.2 million, or 6.58% of total loans, at December 31, 2012, compared to $139.9 million, or 10.38% of total loans, at December 31, 2011. OREO balances decreased to $23.9 million at December 31, 2012, compared to $38.6 million at December 31, 2011. In April 2012, bankruptcy courts affirmed the Company's settlement of collection litigation related to two nonperforming construction/land development loans with aggregate carrying values of $26.6 million. As a result, we charged off $11.8 million related to these two loans, transferred the estimated net recovery value of $18.8 million to OREO and subsequently sold the properties.

Expansion of Mortgage Banking Operations

During 2012, we expanded our mortgage origination capacity, accelerating our strategic plan to increase mortgage origination volume and market share by hiring 389 mortgage origination and support personnel, a significant portion of whom were previously employed in Washington and Idaho by MetLife Home Loans. This number included MetLife's former Pacific Northwest regional sales manager and its regional builder services manager, as well as regional and branch managers, loan officers and related production support staff. In 2012, we opened 15 new mortgage loan origination offices in Washington, Oregon and Idaho to accommodate the expansion of these operations.

Capital

We improved our Bank regulatory capital ratios during 2012, increasing our Tier 1 leverage and total risk-based capital ratios to 11.78% and 19.31%, compared with 6.04% and 11.15% at December 31, 2011, respectively. This improvement reflects the completion of our initial public offering of common stock as well as our earnings in 2012.

On February 15, 2012, we completed our initial public offering of 8,723,632 shares of common stock for an initial offering price of $11.00 per share (after giving effect to the 2-for-1 forward stock split effective March 6, 2012 and the 2-for-1 forward stock split effective November 5, 2012). The net increase in HomeStreet's capital was $86.4 million, of which $55.0 million was contributed to the Bank on February 24, 2012 with an additional $10.0 million contributed on April 26, 2012.

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with the accounting principles generally accepted in the United States ("U.S. GAAP") requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expense in the financial statements. Various elements of our accounting policies, by their nature, involve the application of highly sensitive and judgmental estimates and assumptions. Some of these policies and estimates relate to matters that are highly complex and contain inherent uncertainties. It is possible that, in some instances, different estimates and assumptions could reasonably have been made and used by management, instead of those we applied, which might have produced different results that could have had a material effect on the financial statements.

We have identified the following accounting policies and estimates that, due to the inherent judgments and assumptions and the potential sensitivity of the financial statements to those judgments and assumptions, are critical to an understanding of our financial statements. We believe that the judgments, estimates and assumptions used in the preparation of the Company's financial statements are appropriate. For a further description of our accounting policies, see Note 1-Summary of Significant Accounting Policies in the financial statement to this Form 10-K.

Allowance for Loan Losses

The allowance for loan losses represents management's estimate of incurred credit losses inherent within our loan portfolio. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for loan losses in those future periods.

We employ a disciplined process and methodology to establish our allowance for loan losses that has two basic components: first, an asset-specific component involving the identification of impaired loans and the measurement of impairment for each individual loan identified; and second, a formula-based component for estimating probable principal losses for all other loans.

An asset-specific allowance for impaired loans is established based on the amount of impairment calculated on those loans and charging off amounts determined to be uncollectable. A loan is considered impaired when it is probable that all contractual


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principal and interest payments due will not be collected substantially in accordance with the terms of the loan agreement. Factors we consider in determining whether a loan is impaired include payment status, collateral value, borrower financial condition, guarantor support and the probability of collecting scheduled principal and interest payments when due.

When a loan is identified as impaired, impairment is measured as the difference between the recorded investment in the loan and the present value of expected future cash flows discounted at the loan's effective interest rate or based on the loan's observable market price. For impaired collateral-dependent loans, impairment is measured as the difference between the recorded investment in the loan and the fair value of the underlying collateral. The fair value of the collateral is adjusted for the estimated cost to sell if repayment or satisfaction of a loan is dependent on the sale (rather than only on the operation) of the collateral. In accordance with our appraisal policy, the fair value of impaired collateral-dependent loans is based upon independent third-party appraisals or on collateral valuations prepared by in-house appraisers, which generally are updated every six months. We require an independent third-party appraisal at least annually for substandard loans and other real estate owned ("OREO"). Once a third-party appraisal is six months old, or if our chief appraiser determines that market conditions, changes to the property, changes in intended use of the property or other factors indicate that an appraisal is no longer reliable, we perform an internal collateral valuation to assess whether a change in collateral value requires an additional adjustment to carrying value. A collateral valuation is a restricted-use report prepared by our internal appraisal staff in accordance with our appraisal policy. Upon the receipt of an updated appraisal or collateral valuation, loan impairments are remeasured and recorded. If the calculated impairment is determined to be permanent, fixed or nonrecoverable, the impairment will be charged off. Loans designated as impaired are generally placed on nonaccrual and remain in that status until all principal and interest payments are current and the prospects for future payments in accordance with the loan agreement are reasonably assured, at which point the loan is returned to accrual status. See "Credit Risk Management - Asset Quality and Nonperforming Assets" discussions within Management's Discussion and Analysis of this Form 10-K.

In estimating the formula-based component of the allowance for loan losses, loans are segregated into homogeneous loan classes. Loans are designated into loan classes based on loans pooled by product types and similar risk characteristics or areas of risk concentration. Credit loss assumptions are estimated using a model that categorizes loan pools based on loan type and asset quality rating ("AQR") or delinquency bucket. This model calculates an expected loss percentage for each loan category by considering the probability of default, based on the migration of loans from performing to loss by AQR or delinquency buckets using one-year analysis periods, and the potential severity of loss, based on the aggregate net lifetime losses incurred per loan class.

The formula-based component of the allowance for loan losses also considers qualitative factors for each loan class, including the following changes in:
• lending policies and procedures;

•         international, national, regional and local economic business
          conditions and developments that affect the collectability of the
          portfolio, including the condition of various markets;

• the nature of the loan portfolio, including the terms of the loans;

•         the experience, ability and depth of the lending management and other
          relevant staff;


•         the volume and severity of past due and adversely classified or graded
          loans and the volume of nonaccrual loans;

• the quality of our loan review and process;

• the value of underlying collateral for collateral-dependent loans;

•         the existence and effect of any concentrations of credit and changes in
          the level of such concentrations; and


•         the effect of external factors such as competition and legal and
          regulatory requirements on the level of estimated credit losses in the
          existing portfolio.

Qualitative factors are expressed in basis points and are adjusted downward or upward based on management's judgment as to the potential loss impact of each qualitative factor to a particular loan pool at the date of the analysis.

Additionally, our credit administration department continually monitors conditions that affect the carrying values of our collateral, including local and regional economic factors as well as asset-specific factors such as tax values, comparable sales and other factors that affect or suggest changes in the actual collateral values. They also monitor and adjust for changes in comparable sales or competing projects, changes in zoning or entitlement status, changes in occupancy rates for income properties and similar factors. If we deem such factors to be significant, we generally perform an internal collateral valuation or will order an independent appraisal sooner than required under our appraisal policy.


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The provision for loan losses recorded through earnings is based on management's assessment of the amount necessary to maintain the allowance for loan losses at a level appropriate to cover probable incurred losses inherent within the loans held for investment portfolio. The amount of provision and the corresponding level of allowance for loan losses are based on our evaluation of the collectability of the loan portfolio based on historical loss experience and other significant qualitative factors.

The allowance for loan losses, as reported in our consolidated statements of financial condition, is adjusted by a provision for loan losses, which is recognized in earnings, and reduced by the charge-off of loan amounts, net of recoveries. For further information on fair value measurements, see Note 5-Loans and Credit Quality in the notes to the financial statements of this Form 10-K.

Fair Value of Financial Instruments, Single Family MSRs and OREO

A portion of our assets are carried at fair value, including mortgage servicing rights, single family loans held for sale, interest rate lock commitments, investment securities available for sale and derivatives used in our hedging programs. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Fair value is based on quoted market prices, when available. In certain cases where a quoted price for an asset or liability is not available, the Company uses valuation models to estimate its fair value. These models incorporate inputs such as forward yield curves, loan prepayment assumptions, expected loss assumptions, market volatilities, and pricing spreads utilizing market-based inputs where readily available. We believe our valuation methods are appropriate and consistent with those that would be used by other market participants. However, imprecision in estimating unobservable inputs and other factors may result in these fair value measurements not reflecting the amount realized in an actual sale or transfer of the asset or liability in a current market exchange.

A three-level valuation hierarchy has been established under ASC 820 for disclosure of fair value measurements. The valuation hierarchy is based on the observability of inputs to the valuation of an asset or liability as of the measurement date. A financial instrument's categorization within the valuation hierarchy is based on the lowest level of input that is significant to the fair value measurement. The levels are defined as follows:

•         Level 1 - Quoted prices (unadjusted) in active markets for identical
          assets or liabilities that the reporting entity can access at the
          measurement date. An active market for the asset or liability is a
          market in which transactions for the asset or liability take place with
          sufficient frequency and volume to provide pricing information on an
          ongoing basis.


•         Level 2 - Inputs other than quoted prices included within Level 1 that
          are observable for the asset or liability, either directly or
          indirectly. This includes quoted prices for similar assets and
          liabilities in active markets and inputs that are observable for the
          asset or liability for substantially the full term of the financial
          instrument.


•         Level 3 - Unobservable inputs for the asset or liability. These inputs
          reflect the Company's assumptions of what market participants would use
          in pricing the asset or liability.

Significant judgment is required to determine whether certain assets and liabilities measured at fair value are included in Level 2 or Level 3. When making this judgment, we consider all available information, including observable market data, indications of market liquidity and orderliness, and our understanding of the valuation techniques and significant inputs used. The classification of Level 2 or Level 3 is based upon the specific facts and circumstances of each instrument or instrument category and judgments are made regarding the significance of the Level 3 inputs to an instrument's fair value measurement in its entirety. If Level 3 inputs are considered significant, the instrument is classified as Level 3.

The following is a summary of the assets and liabilities recorded at fair value on a recurring basis and where the amounts are measured using significant Level 3 inputs. The fair value of the remaining assets and liabilities were measured using valuation methodologies involving market-based or market-derived information, collectively Level 1 and 2 measurements.


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                                                                  At December 31,
                                                      2012                              2011

  (in millions)                           Total Balance       Level 3       Total Balance       Level 3
  Assets carried at fair value           $      1,135.0     $    109.9     $       543.5     $      70.2
  As a percentage of total assets                    43 %            4 %              24 %             3 %
  Liabilities carried at fair value      $         12.1     $        -     $        11.4     $         -
  As a percentage of total liabilities                1 %           NM                 1 %            NM
  NM = not meaningful

As of December 31, 2012, our Level 3 recurring fair value measurements consisted of single family MSRs and interest rate lock commitments.

On a quarterly basis, our Asset/Liability Management Committee ("ALCO") and the Finance Committee of the Bank's Board of Directors review the significant inputs used in Level 3 measurements. Additionally, at least annually ALCO obtains an independent review of the MSR valuation process and procedures, including a review of the model architecture and the valuation assumptions. The Finance Committee of the Board provides oversight and approves the Company's Asset/Liability Management Policy. We obtain an MSR valuation from an independent valuation firm at least quarterly to assist with the validation of the results and the reasonableness of the assumptions used in measuring fair value.

In addition to the recurring fair value measurements shown above, from time to time the Company may have certain nonrecurring fair value measurements. These . . .

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