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FFNW > SEC Filings for FFNW > Form 10-K on 13-Mar-2014All Recent SEC Filings

Show all filings for FIRST FINANCIAL NORTHWEST, INC.

Form 10-K for FIRST FINANCIAL NORTHWEST, INC.


13-Mar-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

This discussion and analysis reviews our consolidated financial statements and other relevant statistical data and is intended to enhance your understanding of our financial condition and results of operations. The information in this section has been derived from the Consolidated Financial Statements and footnotes thereto that appear in Item 8 of this Form 10-K. The information contained in this section should be read in conjunction with these Consolidated Financial Statements and footnotes and the business and financial information provided in this Form 10-K. Unless otherwise indicated, the financial information presented in this section reflects the consolidated financial condition and results of operations of First Financial Northwest and its subsidiaries.

Overview

First Savings Bank is a wholly-owned subsidiary of First Financial Northwest and, as such, comprises substantially all of the activity for First Financial Northwest. First Savings Bank is a community-based savings bank primarily serving King and to a lesser extent, Pierce, Snohomish and Kitsap counties, Washington through our full-service banking office located in Renton, Washington. First Savings Bank's business consists of attracting deposits from the public and utilizing these funds to originate one-to-four family residential, multifamily, commercial real estate, construction/land development, business and consumer loans. Our current business strategy emphasizes one-to-four family residential, multifamily and commercial real estate lending.

Over the last five years, the national residential lending market has experienced severe challenges as home values declined and loan delinquencies and foreclosure rates reached unprecedented levels. During 2013 real estate values in our market areas modestly improved and the unemployment rates likewise modestly improved, although due to the slow recovery from the recent recession, remain at elevated levels. Total loan originations increased as a result of increased loan demand in our market area and our renewed focus on generating loan volume during the year ended December 31, 2013 to $157.0 million as compared to $118.8


million, for the year ended December 31, 2012. During the year ended December 31, 2013, our net loan portfolio increased $12.7 million, or 2.0% from December 31, 2012, primarily due to increases in our commercial real estate and construction/land development loans offsetting the decline in our on-to four-family residential loans. During the past several years we have limited our origination of construction loans because of the higher risks associated with those loans, the economic challenges in our market area and to focus on reducing our non-performing assets. We are now experiencing improved conditions in our primary market area as evidenced by stronger real estate prices, a general lack of new housing inventory in certain areas and stronger employment in the Puget Sound region. As a result, we have selectively increased our origination of construction lending and anticipate that it will become a larger portion of our total portfolio in future periods. We are taking a disciplined approach in our construction/land development lending by concentrating our efforts on smaller projects with lower total unit development per site. We also have generally limited our origination of land development projects to those projects where the borrower has their required portion of the construction funds available to build the proposed homes. Our current speculative construction lending requirements are also higher than prior periods, with loan to cost guidelines of no more than 80% and loan to completed value of no more than 75%, unless sufficient factors exist to mitigate operating outside of these guidelines.

Our primary source of revenue is net interest income. Net interest income is the difference between interest income, and is the income that we earn on our loans and investments, and interest expense that is the interest that we pay on our deposits and borrowings. Changes in levels of interest rates affect our net interest income. First Savings Bank is liability-sensitive, meaning our liabilities reprice at a faster rate than our interest-earning assets, the lower interest rate environment that we are currently experiencing has contributed to an improvement in our net interest rate spread.

An offset to net interest income is the provision for loan losses that represents the periodic charge to operations and is required to adequately provide for probable losses inherent in our loan portfolio. During 2013, we had a recovery in our provision for loan losses of $100,000, as compared to a provision for loan losses of $3.1 million for the year ended December 31, 2012. The decrease in the provision during 2012 was attributable to the decline in the level of nonperforming and classified loans, improved delinquency rates and the decline in the level of charge-offs. We will continue to monitor our loan portfolio and make adjustments to our ALLL as we deem necessary.

Our noninterest expenses consist primarily of salaries and employee benefits, occupancy and equipment, data processing, OREO-related expenses, professional fees, regulatory assessments and other general and administrative expenses. Salaries and employee benefits consist primarily of the salaries and wages paid to our employees, payroll taxes and expenses for retirement and other employee benefits. Occupancy and equipment expenses, the fixed and variable costs of buildings and equipment, consist primarily of real estate taxes, depreciation expenses, maintenance and costs of utilities. OREO-related expenses consist primarily of maintenance and costs of utilities for the OREO inventory, market valuation adjustments, build-out expenses, gains and losses from OREO sales, legal fees, real estate taxes and insurance related to the properties included in the OREO inventory.

Our noninterest expenses decreased $4.4 million during the year ended December 31, 2013 as compared to 2012. The decrease was primarily attributable to a $3.3 million decrease OREO related expenses, market value adjustments and gain on sale and $948,000 decrease in our proxy contest and related expense during the year ended December 31, 2013.

Net income for the year ended December 31, 2013 was $24.5 million or $1.46 per diluted share, as compared to net income of $2.7 million or $0.15 per diluted share for the year ended December 31, 2012. The increase in net income for the year ended December 31, 2013 was primarily the result of a $1.8 million increase in net interest income, the decreases in the provision for loan losses, and noninterest expense, discussed above, and a federal tax benefit of $13.5 million due to the partial reversal of the deferred tax asset valuation allowance.

Business Strategy

Our long-term business strategy is to operate and grow First Savings Bank as a well-capitalized and profitable community bank, offering one-to-four family residential, commercial and multifamily real estate, construction/land development, consumer and business loans along with a diversified array of deposit and other products and services to individuals and businesses in our market areas. We intend to accomplish this strategy by leveraging our established name and franchise, capital strength and loan production capability by:
Capitalizing on our intimate knowledge of our local communities to serve the convenience and needs of customers, delivering a consistent and high-quality level of professional service;

Offering competitive deposit rates and developing customer relationships to expand our core deposits, diversifying the deposit mix by growing lower cost deposits, attracting new customers and expanding our footprint in the geographical area we serve;


Managing our loan portfolio to minimize concentrations and diversify the types of loans within the portfolio;

Managing credit risk to minimize the risk of loss and interest rate risk to optimize our net interest margin; and

Improving profitability through disciplined pricing, expense control and balance sheet management, while continuing to provide excellent customer service.

Critical Accounting Policies

Critical accounting policies are those that involve significant judgments and assumptions by management and that have, or could have, a material impact on our income or the carrying value of our assets. The following are our critical accounting policies.

Allowance for Loan Losses. Management recognizes that loan losses may occur over the life of a loan and that the ALLL must be maintained at a level necessary to absorb specific losses on impaired loans and probable losses inherent in the loan portfolio. Our methodology for analyzing the ALLL consists of two components: general and specific allowances. The general allowance is determined by applying factors to our various groups of loans. Management considers factors such as charge-off history, the prevailing economy, borrower's ability to repay, the regulatory environment, competition, geographic and loan type concentrations, policy and underwriting standards, nature and volume of the loan portfolio, management's experience level, our loan review and grading systems, the value of underlying collateral and the level of problem loans in assessing the ALLL. Management performs an impairment analysis on a loan when it determines it is probable that all contractual amounts of principal and interest will not be paid as scheduled. The analysis usually occurs when a loan has been classified as substandard or placed on nonaccrual status. If the market value less costs to sell ("market value") of the impaired loan is less than the recorded investment in the loan, impairment is recognized by establishing a specific reserve in the ALLL for the loan or by adjusting an existing reserve amount. The amount of the specific reserve or adjustment is computed using current appraisals, listed sales prices and other available information less costs to complete, if any, and costs to sell the property. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available or as future events differ from predictions. In addition, specific reserves may be created upon a loan's restructuring, based on a discounted cash flow analysis comparing the present value of the anticipated repayments under the restructured terms to the outstanding principal balance of the loan.

Our Board Internal Asset Review Committee approves the provision for loan losses on a quarterly basis and the full Board of Directors ratifies the Committee's actions. The allowance is increased by the provision for loan losses and is charged against current period earnings and decreased by the amount of actual loan charge-offs, net of recoveries.

We believe that the ALLL is a critical accounting estimate because it is highly susceptible to change from period-to-period requiring management to make assumptions about probable losses inherent in the loan portfolio. The impact of an unexpected large loss could deplete the allowance and potentially require increased provisions to replenish the allowance, and would negatively affect earnings. For additional information see Item 1A. "Risk Factors - If our allowance for loan losses is not adequate, we may be required to make further increases in our provision for loan losses and to charge-off additional loans in the future that could adversely affect our results of operations," in this Form 10-K.

Valuation of OREO. Real estate properties acquired through foreclosure or by deed-in-lieu of foreclosure are recorded at the lower of cost or fair value less estimated costs to sell. Fair value is generally determined by management based on a number of factors, including third-party appraisals of fair value in an orderly sale. Accordingly, the valuation of OREO is subject to significant external and internal judgment. If the carrying value of the loan at the date a property is transferred into OREO exceeds the fair value less estimated costs to sell, the excess is charged to the ALLL. Management periodically reviews OREO values to determine whether the property continues to be carried at the lower of its recorded book value or fair value, net of estimated costs to sell. Any further decreases in the value of OREO are considered valuation adjustments and are charged to noninterest expense in the Consolidated Income Statements. Expenses from the maintenance and operations and any gains or losses from the sales of OREO are included in noninterest expense.

Deferred Taxes. Deferred tax assets arise from a variety of sources, the most significant being expenses recognized in our financial statements but disallowed in the tax return until the associated cash flow occurs write-downs in the value of assets for financial statement purposes that are not deductible for tax purposes until the asset is sold or deemed worthless.

We record a valuation allowance to reduce our deferred tax assets to the amount that can be recognized in line with the relevant accounting standards. The level of deferred tax asset recognition is influenced by management's assessment of our historic and future profitability profile. At each balance sheet date, existing assessments are reviewed and, if necessary, revised to reflect changed circumstances. In a situation where income is less than projected or recent losses have been incurred, the relevant accounting


standards require convincing evidence that there will be sufficient future tax capacity. For additional information regarding our deferred taxes, see Note 13 of the Notes to Consolidated Financial Statements contained in Item 8.

Other-Than-Temporary Impairments On the Market Value of Investments. Declines in the fair value of any available-for-sale or held-to-maturity investment below their cost that is deemed to be other-than-temporary results in a reduction in the carrying amount of the investment to that of fair value. A charge to earnings and an establishment of a new cost basis for the investment is made. Unrealized investment losses are evaluated at least quarterly to determine whether such declines should be considered other-than-temporary and therefore be subject to immediate loss recognition. Although these evaluations involve significant judgment, an unrealized loss in the fair value of a debt security is generally deemed to be temporary when the fair value of the investment security is below the carrying value primarily due to changes in interest rates and there has not been significant deterioration in the financial condition of the issuer. An unrealized loss in the value of an equity security is generally considered temporary when the fair value of the security is below the carrying value primarily due to current market conditions and not deterioration in the financial condition of the issuer. Other factors that may be considered in determining whether a decline in the value of either a debt or an equity security is other-than-temporary include ratings by recognized rating agencies; the extent and duration of an unrealized loss position; actions of commercial banks or other lenders relative to the continued extension of credit facilities to the issuer of the security; the financial condition, capital strength and near-term prospects of the issuer and recommendations of investment advisers or market analysts. Therefore, deterioration of market conditions could result in impairment losses recognized within the investment portfolio.

Fair Value. FASB ASC 820, Fair Value Measurements and Disclosures, establishes a hierarchical disclosure framework associated with the level of pricing observability utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no pricing observability and a higher degree of judgment utilized in measuring fair value. Pricing observability is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction. See Note 8 of the Notes to Consolidated Financial Statements contained in Item 8 for additional information about the level of pricing transparency associated with financial instruments carried at fair value.
Comparison of Financial Condition at December 31, 2013 and December 31, 2012

Assets. The following table details the changes in the composition of our assets at December 31, 2013 from December 31, 2012.

                                           Balance at           Increase/(Decrease)           Percentage
                                        December 31, 2013      from December 31, 2012     Increase/(Decrease)
                                                               (Dollars in thousands)
Cash on hand and in
banks                                 $             6,074     $                1,785                41.6  %
Interest-bearing
deposits                                           49,501                    (33,951 )             (40.7 )
Investments available-for-sale, at
fair value                                        144,364                     (7,898 )              (5.2 )
Loans receivable,
net                                               663,153                     12,685                 2.0
Premises and equipment, net                        17,291                       (782 )              (4.3 )
FHLB stock, at cost                                 7,017                       (264 )              (3.6 )
Accrued interest receivable                         3,698                        214                 6.1
Deferred tax assets, net                           14,835                     13,835             1,383.5
OREO                                               11,465                     (5,882 )             (33.9 )
Prepaid expenses and other assets                   3,581                     (1,418 )             (28.4 )
Total assets                          $           920,979     $              (21,676 )              (2.3 )%

Interest-bearing deposits, investments available-for-sale and OREO decreased $33.9 million, $7.9 million and $5.9 million, respectively. Funds received were utilized to reduce our customer interest-bearing deposits by $58.2 million as part of our strategy to reduce our total assets, mainly cash and to reduce higher-cost certificates of deposit.


Net loans receivable increased $12.7 million to $663.2 million at December 31, 2013 compared to $650.5 million at December 31, 2012. Loan originations for the year ended December 31, 2013 totaled $157.0 million, an increase of $38.2 million from the year ended December 31, 2012. The increase in our net loan portfolio was primarily the result of loan originations exceeding paydowns due to normal borrower activity, charge-offs and transfers to OREO. Loan originations increased primarily as a result of increased loan demand during 2013 and a renewed emphasis on loan originations by our staff, now that the performance of our loan portfolio has improved. Loan originations included $61.3 in commercial real estate, $50.9 million in one-to-four family residential, $24.5 million in multifamily and $3.9 million in consumer loans. We also originated $15.4 million in construction/land development and $1.1 million in business loans. Loan repayments during 2013 were $132.6 million and loans transferred to OREO totaled $6.5 million.

Our investments available-for-sale decreased $7.9 million, or 5.2% to $144.4 million at December 31, 2013 from $152.3 million at December 31, 2012. During the year ended December 31, 2013, we sold $45.2 million of investments. Gross proceeds from the sales were $45.1 million with net losses of $38,000. During the year ended December 31, 2013, we purchased $69.0 million of investments that included $51.4 million of fixed-rate securities and variable-rate securities and $17.6 million in variable-rate securities. The anticipated yields on the securities purchased during the year range from 0.90% to 3.03% as compared to the low current yields on the securities sold that ranged from 0.18% to 0.48%. These trades were based on management's assessment of the opportunities presented by the yield curve in effect at the time of the transactions, and the belief that the anticipated returns from holding longer term securities justified the additional interest rate risk. The investment portfolio activity during the year ended December 31, 2013, resulted in an increase of the effective duration of the portfolio to 1.64 at December 31, 2013 as compared to 0.91 at December 31, 2012.

Our nonperforming loans decreased to $4.0 million at December 31, 2013 from $22.8 million at December 31, 2012. Nonperforming loans as a percent of our total loan portfolio, net of LIP, was 0.59% and 3.42% at December 31, 2013 and 2012, respectively. Adversely rated loans decreased to $36.6 million at December 31, 2013, from $51.6 million at December 31, 2012. The following table presents a breakdown of our nonperforming assets:

                                       December 31,         Amount of     Percent of
                                                            Increase/      Increase/
                                     2013        2012       (Decrease)    (Decrease)
                                                 (Dollars in thousands)
Nonperforming loans:
  One-to-four family residential   $  2,297    $  6,248    $   (3,951 )      (63.2 )%
  Multifamily                           233       4,711        (4,478 )      (95.1 )
  Commercial real estate              1,198       6,274        (5,076 )      (80.9 )
  Construction/land development         223       4,767        (4,544 )      (95.3 )
  Consumer                               44         759          (715 )      100.0
Total nonperforming loans             3,995      22,759       (18,764 )      (82.4 )
OREO                                 11,465      17,347        (5,882 )      (33.9 )
Total nonperforming assets         $ 15,460    $ 40,106    $  (24,646 )      (61.5 )%

We continued to focus on reducing our nonperforming assets through foreclosures, short-sales and accepting deeds in lieu of foreclosure. Foregone interest during the year ended December 31, 2013 relating to all nonperforming loans totaled $650,000. There was no LIP related to nonperforming loans at December 31, 2013 or 2012. OREO decreased $5.9 million or 33.9% to $11.5 million at December 31, 2013, from $17.3 million at December 31, 2012 as we continue to sell our inventory of foreclosed real estate. We foreclosed or accepted deeds in lieu of foreclosure on $6.5 million of real estate during 2013 and $12.1 million during 2012. We anticipate continued foreclosure activity in 2014, however, at lower levels than in 2013 and 2012. The number of properties that have been transferred into OREO has decreased considerably compared to previous years and the number of properties that we have sold has also declined. During 2013, we transferred 15 properties into OREO, compared to 35 properties during 2012 and 95 properties during 2011. Sales of OREO in 2013 totaled 43 properties, as compared to 89 properties in 2012 and 121 properties in 2011. The decline in both the transfer of properties into OREO and the sale of OREO properties was a result of our efforts to identify the problem loans within our portfolio and take prompt appropriate actions to turn these nonperforming assets into performing assets.

Deposits. During the year ended December 31, 2013, deposits decreased $53.7 million to $612.1 million as compared to $665.8 million at December 31, 2012. The decrease in deposits was primarily the result of our strategy to utilize our excess liquidity, mainly cash, to reduce higher-cost deposits by competing less aggressively on deposit interest rates. We also believe customers who were more interest rate sensitive elected to withdraw their funds to invest in higher yielding investment products,


and contributed to the decline in our deposit balance. We experienced decreases in our certificates of deposit and money market accounts of $53.3 million and $16.5 million, respectively. These decreases were partially offset by increases in our NOW, statement savings and noninterest-bearing accounts of $9.5 million, $2.1 million and $4.5 million, respectively. Public funds increased to $10.8 million (of which $10.6 million were certificates of deposit) at December 31, 2013 from $1.8 million (of which $1.7 million were certificates of deposit) at December 31, 2012. During the year ended December 31, 2013, we experienced decreases in our certificates of deposit and money market accounts of $53.3 million and $16.5 million, respectively. These decreases were partially offset by increases in our NOW, statement savings and noninterest-bearing accounts of $9.5 million, $2.1 million and $4.5 million, respectively. We did not have any brokered deposits at December 31, 2013 and 2012.

Advances. We use advances from the FHLB as an alternative funding source to manage funding costs, reduce interest rate risk and to leverage our balance sheet. Total advances at December 31, 2013 were $119.0 million as compared to $83.1 million at December 31, 2012. During the year ended December 31, 2013, we restructured our FHLB advances by prepaying $33.1 million with a weighted-average interest rate of 2.93% and borrowing a three year $34.0 million fixed-rate FHLB advance at a rate of 0.81%. In addition, during the year ended December 31, 2013, we repaid a $50.0 million maturing FHLB advance with an interest rate of 2.17% and borrowed $40.0 million in FHLB fixed-rate advances at an average rate of 79 basis points.

Stockholders' Equity. Total stockholders' equity decreased $2.8 million, or 1.5% to $184.4 million at December 31, 2013 from $187.1 million at December 31, 2012. While there was a decrease in stockholder's equity due to $28.1 million related to share repurchase and retirement of common stock and a decline of $2.8 million in accumulated other comprehensive income, net of tax representing unrecognized losses on investment securities this was partially offset by net income of $24.5 million and $4.4 million attributable to share-based compensation and issuance of stock related to the exercise of stock options.

Comparison of Operating Results for the Years Ended December 31, 2013 and December 31, 2012

Net Interest Income. Net interest income in 2013 was $31.0 million, a $1.8 million or 6.1% increase from $29.2 million in 2012. The increase was attributable to a $4.7 million decrease in interest expense partially offset by a $2.9 million decrease in interest income. Average interest-earning assets decreased $107.5 million to $841.7 million for the year ended December 31, 2013 from the year ended December 31, 2012 primarily due to decreases in the average balance of our interest-bearing deposits and loan portfolio of $104.1 million and $10.0 million, respectively. Average interest-bearing liabilities decreased $112.4 million to $691.2 million for 2013 compared to $803.6 million in 2012, primarily due to declines in the average balance of our certificates of deposit, money market accounts and FHLB advances that decreased $85.8 million, $15.6 million and $15.3 million, respectively. During the same period, our yield on interest-earning assets increased 21 basis points while our cost of funds decreased 43 basis points. Our interest rate spread for the year ended December . . .

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