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SFBC > SEC Filings for SFBC > Form 10-K on 31-Mar-2014All Recent SEC Filings

Show all filings for SOUND FINANCIAL BANCORP, INC.

Form 10-K for SOUND FINANCIAL BANCORP, INC.


31-Mar-2014

Annual Report


Item 7.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Our principal business consists of attracting retail deposits from the general public and investing those funds, along with borrowed funds, in loans secured by first and second mortgages on one- to four-family residences (including home equity loans and lines of credit), commercial and multifamily, consumer and commercial business loans and construction and land loans. We offer a wide variety of secured and unsecured consumer loan products, including manufactured home loans, automobile loans, boat loans and recreational vehicle loans. We intend to continue emphasizing our residential mortgage, commercial and multifamily and commercial business lending, while continuing to originate home equity and consumer loans. As part of our business, we focus on residential mortgage loan originations, many of which we sell to Fannie Mae. We typically sell these loans with servicing retained to maintain the direct customer relationship and promote our emphasis on strong customer service. We originated $118.8 million and $107.2 million of one- to four-family residential mortgage loans during the years ended December 31, 2013 and 2012, respectively. During these same periods, we sold $111.5 million and $105.2 million, respectively, of one- to four-family residential mortgage loans.

Our operating revenues are derived principally from earnings on interest earning assets, service charges and fees, and gains on the sale of loans. Our primary sources of funds are deposits, Federal Home Loan Bank of Seattle ("FHLB") advances and other borrowings, and payments received on loans and securities. We offer a variety of deposit accounts that provide a wide range of interest rates and terms, generally including savings, money market, term certificate and checking accounts. Our noninterest expenses consist primarily of salaries and employee benefits, expenses for occupancy, data processing, collection and foreclosures expenses and FDIC deposit insurance premiums. Salaries and benefits consist primarily of the salaries and wages paid to our employees, payroll taxes, expenses for retirement and other employee benefits. Occupancy expenses, which are the fixed and variable costs of buildings and equipment, consist primarily of lease payments, property taxes, depreciation charges, maintenance and costs of utilities.

Our strategic plan targets consumers, small and medium size businesses, and professionals in our market area for loan and deposit growth. In pursuit of these goals, and while managing the size of our loan portfolio, we focused on including a significant amount of commercial business and commercial and multifamily loans in our portfolio. A significant portion of these commercial and multifamily and commercial business loans have adjustable rates, higher yields or shorter terms and higher credit risk than traditional fixed-rate mortgages. Our commercial loan portfolio (commercial and multifamily and commercial business loans) increased to $171.2 million or 43.7% of our loan portfolio at December 31, 2013, from $147.8 million or 44.9% of our loan portfolio at December 31, 2012 and from $119.2 million or 39.4% of our loan portfolio at December 31, 2011. In addition to higher balances in commercial lending, we also benefited from additional lending opportunities in our construction and land development portfolio. Our construction and land development portfolio increased to $44.3 million or 11.3% of our loan portfolio as of December 31, 2013 compared to $25.5 million or 7.8% as of December 31, 2012. The impact of additional commercial and multifamily and construction and land loans has had a positive impact on our net interest income and has helped to further diversify our loan portfolio mix. In particular, our emphasis on multifamily housing has increased our commercial and multifamily loan portfolio. At December 31, 2013, our multifamily portfolio was $53.0 million, which represented a 18.0% increase compared to December 31, 2012 when our multifamily portfolio was $45.0 million.

Our provision for loan losses expense was significantly lower in 2013 than during the last three years and reflects an improvement in the decreased levels of delinquencies, nonperforming loans and net charge-offs, particularly for loans secured by residential properties. For most of the previous three years, housing markets remained weak in our primary market area, resulting in elevated levels of delinquencies and nonperforming assets, deterioration in property values, and the need to provide for realized and anticipated losses. However, in 2013 economic conditions improved in our market area, and more specifically improvements in real estate values and unemployment rates, contributed to the decrease in nonperforming assets and loan charge-offs.

Recent Accounting Standards

For a discussion of recent accounting standards, please see Note 2 - Accounting Pronouncements Recently Issued or Adopted in the Notes to Consolidated Financial Statements in Item 8.


Critical Accounting Policies

Certain of our accounting policies are important to an understanding of our financial condition, since they require management to make difficult, complex or subjective judgments, which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Facts and circumstances that could affect these judgments include, but are not limited to, changes in interest rates, changes in the performance of the economy and changes in the financial condition of borrowers. Management believes that its critical accounting policies include determining the allowance for loan losses, accounting for other-than-temporary impairment of securities, accounting for mortgage servicing rights, accounting for other real estate owned, and accounting for deferred income taxes. For additional information on our accounting policies see "Note 1 - Organization and Significant Accounting Principles" in the Notes to Consolidated Financial Statements in Item 8.

Allowance for Loan Loss. The allowance for loan losses is the amount estimated by management as necessary to cover losses inherent in the loan portfolio as of the balance sheet date. The allowance is established through the provision for loan losses, which is charged to income. Determining the amount of the allowance for loan losses necessarily involves a high degree of subjectivity and requires us to make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. Among the material estimates required to establish the allowance are: loss exposure at default; the amount and timing of future cash flows on impacted loans; value of collateral; and determination of historical and current loss factors to be applied to the various elements of the portfolio. All of these estimates are susceptible to significant change. Management reviews the level of the allowance at least quarterly and establishes the provision for loan losses based upon an evaluation of the portfolio, past loss experience, current economic conditions and other factors related to the collectability of the loan portfolio. To strengthen our loan review and classification process, we engage an independent consultant to review our classified loans and a sampling of our non-classified loans on a regular basis. We also enhanced our credit administration policies and procedures to improve our maintenance of updated financial data on commercial borrowers. While we believe the estimates and assumptions used in our determination of the adequacy of the allowance are reasonable, there can be no assurance that such estimates and assumptions will not be proven incorrect in the future, or that the actual amount of future provisions will not exceed the amount of past provisions or that any increased provisions that may be required will not adversely impact our financial condition and results of operations. In addition, the determination of the amount of our allowance for loan losses is subject to review by bank regulators as part of the routine examination process, which may result in the adjustment of reserves based upon their judgment of information available to them at the time of their examination.

Other-than-temporary impairment of securities. Management reviews investment securities on an ongoing basis for the presence of other-than-temporary impairment ("OTTI"), taking into consideration current market conditions; fair value in relationship to cost; extent and nature of the change in fair value; issuer rating changes and trends; whether management intends to sell a security or if it is likely that we will be required to sell the security before recovery of the amortized cost basis of the investment, which may be upon maturity; and other factors. For debt securities, if management intends to sell the security or it is likely that we will be required to sell the security before recovering our cost basis, the entire impairment loss would be recognized in earnings as an OTTI. If management does not intend to sell the security and it is not more likely than not that we will be required to sell the security, but management does not expect to recover the entire amortized cost basis of the security, only the portion of the impairment loss representing credit losses would be recognized in earnings. The credit loss on a security is measured as the difference between the amortized cost basis and the present value of the cash flows expected to be collected. Projected cash flows are discounted by the original or current effective interest rate depending on the nature of the security being measured for potential OTTI. The remaining impairment related to all other factors, i.e., the difference between the present value of the cash flows expected to be collected and fair value, is recognized as a charge to other comprehensive loss. Impairment losses related to all other factors are presented as separate categories within other comprehensive income (loss).

Mortgage Servicing Rights. We record mortgage servicing rights on loans sold to Fannie Mae with servicing retained as well as for acquired servicing rights. We stratify our capitalized mortgage servicing rights based on the type, term and interest rates of the underlying loans. Mortgage servicing rights are carried at fair value. The value is determined through a discounted cash flow analysis, which uses interest rates, prepayment speeds and delinquency rate assumptions as inputs. All of these assumptions require a significant degree of management judgment. If our assumptions prove to be incorrect, the value of our mortgage servicing rights could be negatively impacted. We use a third party to assist us in the preparation of the analysis of the market value each quarter.

Other Real Estate Owned. Other real estate owned ("OREO") represents real estate that we have taken control of in partial or full satisfaction of significantly delinquent loans. At the time of foreclosure, OREO is recorded at the fair value less costs to sell, which becomes the property's new basis. Any write-downs based on the asset's fair value at the date of acquisition are charged to the allowance for loan and lease losses. After foreclosure, management periodically performs valuations such that the real estate is carried at the lower of its new cost basis or fair value, net of estimated costs to sell. Subsequent valuation adjustments are recognized within net (loss) gain on other real estate owned. Revenue and expenses from operations and subsequent adjustments to the carrying amount of the property are included in other non-interest expense in the consolidated statements of income. In some instances, we may make loans to facilitate the sales of other real estate owned. Management reviews all sales for which it is the lending institution for compliance with sales treatment under provisions established by ASC Topic 360, "Accounting for Sales of Real Estate". Any gains related to sales of OREO are deferred until the buyer has a sufficient initial and continuing investment in the property.


Income Taxes. Income taxes are reflected in our financial statements to show the tax effects of the operations and transactions reported in the financial statements and consist of taxes currently payable plus deferred taxes. ASC Topic 740, "Accounting for Income Taxes," requires the asset and liability approach for financial accounting and reporting for deferred income taxes. Deferred tax assets and liabilities result from differences between the financial statement carrying amounts and the tax bases of assets and liabilities. They are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled and are determined using the assets and liability method of accounting. The deferred income provision represents the difference between net deferred tax asset/liability at the beginning and end of the reported period. In formulating our deferred tax asset, we are required to estimate our income and taxes in the jurisdiction in which we operate. This process involves estimating our actual current tax exposure for the reported period together with assessing temporary differences resulting from differing treatment of items, such as depreciation and the provision for loan losses, for tax and financial reporting purposes. Valuation allowances are established to reduce the net carrying amount of deferred tax assets if it is determined to be more likely than not all or some portion of the potential deferred tax asset will not be realized.

Business and Operating Strategies and Goals

Our goal is to deliver returns to shareholders by increasing higher-yielding assets (in particular commercial and multifamily and commercial business loans), increasing core deposit balances, reducing expenses, managing problem assets and exploring expansion opportunities. We seek to achieve these results by focusing on the following objectives:

Focusing on Asset Quality. Our goal is to maintain or improve upon our level of nonperforming assets by managing credit risk on the current loan portfolio and new originations. We are focused on actively monitoring and managing all segments of our loan portfolio in order to proactively identify and mitigate risk. At December 31, 2013, nonperforming assets totaled $3.1 million, which represents a 51.7% decline from the $6.4 million in nonperforming assets we held at December 31, 2012. We will continue to devote significant efforts and resources to managing problem assets.

Improving Earnings by Expanding Product Offerings. We intend to prudently increase the percentage of our assets consisting of higher-yielding commercial real estate and commercial business loans, which offer higher risk-adjusted returns, shorter maturities and more sensitivity to interest rate fluctuations than one-to four- family mortgage loans while maintaining our focus on residential lending. We also intend to selectively add additional products to further diversify revenue sources and to capture more of each customer's banking relationship by cross selling loan and deposit products and additional services to our customers. We intend to further build relationships with small businesses through new and existing product offerings including merchant services, remote deposit capture, online and mobile cash management, and online tools for wires, ACH and bill payment. We also believe the continuing changes in the secondary market as a result of the uncertainty that is surrounding Fannie Mae and Freddie Mac will result in increased opportunities in the coming years to originate high quality residential loans with more attractive pricing for our loan portfolio. With our long experience and expertise in residential lending we believe we can be effective in capturing the opportunities of these market changes in residential lending.

Emphasizing lower cost core deposits to manage the funding costs of our loan growth. Our strategic focus is to emphasize total relationship banking with our customers to internally fund our loan growth. We are also focused on reducing wholesale funding sources, including FHLB advances, through the continued growth of core customer deposits. We believe that a continued focus on customer relationships will help to increase the level of core deposits and locally-based retail certificates of deposit. We intend to increase demand deposits by growing retail and business banking relationships. New technology and services are generally reviewed for business development and cost saving opportunities. We continue to experience growth in customer use of our online banking services, which allows customers to conduct a full range of services on a real-time basis, including balance inquiries, transfers and electronic bill paying while providing our customers greater flexibility and convenience in conducting their banking. In addition to our retail branches, we maintain state of the art technology-based products, such as business cash management, business remote deposit products and an online personal financial management and consumer remote deposit product which we introduced in the third quarter of 2012 to further enable us to compete effectively with banks of all sizes. Total deposits increased to $348.3 million at December 31, 2013, from $312.1 million at December 31, 2012 and $300.0 million at December 31, 2011. At December 31, 2013, core deposits, which we define as our non-time deposit accounts and time deposit accounts less than $250,000, increased $32.5 million to $302.4 million while FHLB advances increased $21.4 million to $43.2 million from December 31, 2012.

Maintaining Our Customer Service Focus. Exceptional service, local involvement(including volunteering and contributing to the communities where we are located) and timely decision-making are integral parts of our business strategy. We emphasize to our employees the importance of delivering exemplary customer service and seeking opportunities to build further relationships with our customers to enhance our market position and add profitable growth opportunities. The goal is to compete with other financial service providers by relying on the strength of our customer service and relationship banking approach. We believe that one of our strengths is that our employees are also significant shareholders through our employee stock ownership ("ESOP") and 401(k) plans. We also offer an incentive system that is designed to reward well-balanced and high quality growth among our employees.


Expanding our presence within our existing and contiguous market areas and by capturing business opportunities resulting from changes in the competitive environment. We believe that opportunities currently exist within our market area to grow our franchise. We anticipate organic growth as the local economy and loan demand strengthens, through our marketing efforts and as a result of the opportunities being created as a result of the consolidation of financial institutions that is occurring in our market area. In addition, by delivering high quality, customer-focused products and services, we expect to attract additional borrowers and depositors and thus increase our market share and revenue generation. We opened a loan production office in Seattle in March 2013 and plan to add at least one branch in 2014. We will continue to be disciplined as it pertains to future expansion, acquisitions and de novo branching focusing on the markets in Western Washington, which we know and understand.

Comparison of Financial Condition at December 31, 2013 and December 31, 2012

General. Total assets increased by $61.6 million, or 16.2%, to $442.6 million at December 31, 2013 from $381.0 million at December 31, 2012. This increase was primarily the result of a $64.3 million, or 19.9%, increase in our net loan portfolio, a $3.8 million, or 53.3%, increase in bank-owned life insurance and a $2.6 million, or 20.5%, increase in cash and cash equivalents offset partially by a $7.5 million, or 32.7%, decrease in available for sale securities, a $1.6 million, or 92.5%, decrease in loans held for sale and a $1.3 million, or 52.9%, decrease in other real estate owned and repossessed assets. Asset growth was funded by a $36.3 million, or 11.6%, increase in deposits, a $21.4 million, or 97.7%, increase in FHLB advances and a $3.0 million, or 7.0%, increase in shareholders' equity.

Cash and Securities. We decreased our on-balance sheet liquidity slightly in 2013 to fund our loan growth. Cash, cash equivalents and our available-for-sale securities decreased by $4.9 million, or 13.7%, to $30.8 million at December 31, 2012. Cash and cash equivalents increased by $2.6 million, or 20.5%, to $15.3 million at December 31, 2013. Available-for-sale securities, which consist primarily of agency mortgage-backed securities, decreased by $7.5 million, or 32.7%, from $22.9 million at December 31, 2012 to $15.4 million at December 31, 2013 as a result of pay downs.

At December 31, 2013, our available-for-sale securities portfolio consisted of $2.4 million of non-agency mortgage-backed securities. These securities present a higher credit risk than either U.S. agency mortgage-backed securities or municipal bonds, of which we had $11.1 million and $1.9 million, respectively, at December 31, 2013. In order to monitor the increased risk, management receives and reviews a credit surveillance report from a third party quarterly, which evaluates these securities based on a number of factors, including its credit scores, loan-to-value ratios, geographic locations, delinquencies and loss histories of the underlying mortgage loans. This analysis is prepared in order to project future losses based on various home price depreciation scenarios over a three-year horizon. Based on these reports, management ascertains the appropriate value for these securities and, in 2013, recorded an other-than-temporary impairment charge of $30,000 on one non-agency security. See "Note 5 - Investments in the Notes to Consolidated Financial Statements" for more information about this recorded impairment. The current market environment significantly limits our ability to mitigate our exposure to value changes in these more risky securities by selling them, and we do not anticipate these conditions to change significantly in 2014. Accordingly, if the market and economic environment impacting the loans supporting these securities deteriorates, we could determine that an other-than-temporary impairment must be recorded on these securities, as well as on any other securities in our portfolio. As a result, our future earnings, equity, regulatory capital and ongoing operations could be adversely affected.

Loans. Our total loan portfolio, excluding loans held for sale, increased $64.6 million, or 19.7%, from $327.6 million at December 31, 2012 to $392.2 million at December 31, 2013. Loans held for sale decreased from $1.7 million at December 31, 2012 to $130,000 at December 31, 2013, reflecting primarily the timing of transactions in late 2013, as compared to late 2012.

The following table reflects the changes in the types of loans in our portfolio at the end of 2013, as compared to the end of 2012 (dollars in thousands):

                                  December 31,
                                                          Amount      Percent
                               2013          2012         Change       Change
One-to-four-family           $ 117,739     $  94,059     $ 23,680         25.2 %
Home equity                     35,155        35,364         (209 )       (0.6 )
Commercial and multifamily     157,516       133,620       23,896         17.9
Construction and land           44,300        25,458       18,842         74.0
Manufactured homes              13,496        16,232       (2,736 )      (16.9 )
Other consumer                  10,284         8,650        1,634         18.9
Commercial business             13,668        14,193         (525 )       (3.7 )
Total loans                  $ 392,158     $ 327,576     $ 64,582         19.7 %


The most significant change in our loan portfolio was a result of increases in one- to four- family mortgage loans which was primarily a result of increases in higher yielding jumbo mortgage and other portfolio one- to four- family mortgage loans. Construction and land loans increased primarily as a result of increased demand for new homes, reflecting the improvement in the housing market in the communities we serve. We work with a small number of well-established single family home builders in our market areas. Management monitors our exposure on construction loans closely and a third party evaluates each project's percentage of completion before any draw is allowed. Commercial and multifamily loans increased primarily as a result of continued efforts to expand and diversify our lending portfolio. Manufactured home loans decreased as a result of a lack of demand for these types of loans by well-qualified borrowers. The loan portfolio remains well-diversified with commercial and multifamily real estate loans accounting for 40.1% of the portfolio, residential real estate loan accounting for 30.0% of the portfolio and home equity, manufactured and other consumer loans accounting for 15.1% of the portfolio. Construction and land loans account for 11.3% of the portfolio and commercial and industrial loans account for the remaining 3.5% of the portfolio.

Mortgage Servicing Rights. At December 31, 2013, we had $3.0 million in mortgage servicing rights recorded at fair value compared to $2.3 million at December 31, 2012. We record mortgage servicing rights on loans sold to Fannie Mae with servicing retained and upon acquisition of a servicing portfolio. We stratify our capitalized mortgage servicing rights based on the type, term and interest rates of the underlying loans. Mortgage servicing rights are carried at fair value. If the fair value of our mortgage servicing rights fluctuates significantly, our financial results could be materially impacted.

Nonperforming Assets. At December 31, 2013, our nonperforming assets totaled $3.1 million, or 0.70% of total assets, compared to $6.4 million, or 1.68% of total assets at December 31, 2012.

The table below sets forth the amounts and categories of nonperforming assets in our loan portfolio at the dates indicated (dollars in thousands):

                                                      Nonperforming Assets at December 31,
                                                                             Amount        Percent
                                               2013             2012         Change         Change
Nonaccrual loans                            $      558       $    3,003     $  (2,445 )        (81.4 )%
Accruing loans 90 days or more delinquent          321               81           240          296.3
Nonperforming restructured loans                 1,040              828           212           25.6
OREO and repossessed assets                      1,178            2,503        (1,325 )        (52.9 )
Total                                       $    3,099       $    6,415     $  (3,316 )        (51.7 )%

Nonperforming loans to total loans decreased to 0.49% of total loans at the end of 2013 from 1.20% at the end of 2012. This decrease reflects a $2.0 million decrease in nonperforming loans. Our largest nonperforming loans at December 31, 2013 were commercial real estate loans of $380,000 and $237,000 which were restructured in 2013.

OREO and repossessed assets decreased 52.9% during 2013 primarily due to improving economic conditions in our market and our continued focus on credit administration. During 2013, we repossessed 13 personal residences, one land development and 10 manufactured homes. We sold 13 personal residences, two commercial properties and 11 manufactured homes at an aggregate loss of . . .

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