ITEM 1 - BUSINESS
Frontier Financial Corporation ("FFC" or "the Corporation") is a Washington corporation which was incorporated in 1983 and is registered as a financial holding company under the Bank Holding Company Act of 1956. As part of a plan of reorganization consummated following the close of business September 30, 1983, FFC acquired all of the stock of Frontier Bank (the "Bank"), issuing its common stock in an exchange for the Bank's common stock on a share-for-share basis. FFC has two subsidiaries: the Bank, which is engaged in a general banking business and in businesses related to banking, and FFP, Inc., a nonbank corporation which leases property to the Bank. As of December 31, 2005, Frontier had total assets of approximately $2.64 billion, net loans receivable of approximately $2.39 billion, total deposits of approximately $2.06 billion and shareowner's equity of approximately $296.1 million.
THE BANK
Frontier Bank is a Washington state-chartered commercial bank that is a nonmember with its headquarters located in Everett, Snohomish County, Washington. It was founded in September 1978 by Robert J. Dickson and local business persons. The Bank is an "insured bank" as defined in the Federal Deposit Insurance Act.
LOCATION OF PRINCIPAL MARKET AREAS
The Bank engages in general banking business in the State of Washington, including the acceptance of demand, time and savings deposits and the making of loans. Headquartered in Everett, Washington, Frontier served its customers from forty-one full service offices in 2005. In Snohomish County, four offices are located in Everett, and one office each is located in Arlington, Edmonds, Lake Stevens, Marysville, Mill Creek, Monroe, Lynnwood, Smokey Point, Snohomish, and Stanwood. Six offices are located in Pierce County in the cities of Buckley, Edgewood-Milton, Orting, Puyallup, Sumner and Tacoma. Frontier has ten branches in King County, one each in Bothell, Duvall, Kent, Kirkland, Lake City (Seattle), Redmond, Renton, Seattle, Totem Lake (Kirkland) and Woodinville. In addition, the following eleven branches are located in Clallam, Jefferson, Kitsap, Skagit and Whatcom Counties: two branches each in Bellingham and Poulsbo, and one each in Bainbridge Island, Lynden, Mount Vernon, Port Angeles, Port Townsend, Sequim and Silverdale.
In February 2004, the Bank opened a full service banking office downtown Seattle, its only office in downtown Seattle. In April 2004, the Bank opened a real estate lending office in Tacoma, Pierce County, which makes commercial and construction loans. In 2005, the Bank opened a second full service office in Bellingham downtown, a Renton Office in Pierce County and an office in Lynden, Whatcom County. As of February 1, 2006, Frontier completed its merger with NorthStar Financial Corporation and acquired two additional offices in the Ballard and Fremont communities of Seattle for a total of 43 offices.
On January 31, 2006, FFC completed the acquisition of NorthStar Financial Corporation and its subsidiary, NorthStar Bank, a privately held financial institution headquartered in Seattle, Washington, with two additional banking centers in the Ballard and Fremont communities north of downtown Seattle. The shareowners of NorthStar received 1,455,959 share so FFC common stock in exchange for all of the outstanding shares of NorthStar. The transaction was accounted for under the purchase method of accounting. As of September 30, 2005, NorthStar had total assets of $180.5 million, total loans receivable of $149.8 million, total deposits of $147.2 million and shareowners' equity of $14.3 million.
BANKING SERVICES
The Bank provides a full range of consumer banking services including savings accounts, checking accounts, installments and commercial lending, safe deposit facilities, time deposits and other consumer and business related financial services. In addition to consumer-oriented activities, the Bank maintains a strong commercial lending program, servicing individuals and businesses headquartered in the Bank's principal market area.
Frontier's loan portfolio consists of primarily of loans secured by real estate, although emphasis is also placed on commercial and agriculture loans, consumer installment loans and bankcard loans. At December 31, 2005, real estate category loans comprised 85% of the net loan portfolio, while commercial and agriculture loans made up 13% of the portfolio and installment and bankcard loans were 2%. Loans totaled $2.39 billion, and were 116% of deposits. Almost all of these loans were to borrowers within the Bank's principal market areas. See page 23 for loan category amounts for the last five years.
COMMERCIAL AND AGRICULTURE LOANS
This category of loans includes both commercial and agriculture loans used to provide working capital or for specific purposes, such as to finance the purchase of fixed assets, equipment or inventory. Commercial loans include lines of credit and term loans. Lines of credit are extended to businesses based on the financial strength and integrity of the borrower and generally (with some exceptions) are collateralized by short-term assets such as accounts receivable and have a maturity of one year or less. Such lines of credit bear an interest rate that floats with the base rate or another established index. Commercial term loans are typically made to finance the acquisition of fixed assets, refinance short-term debt originally used to purchase fixed assets or, in rare cases, to finance a businesses purchase. Commercial term loans generally mature within one to five years. They may be collateralized by the asset being acquired or other available assets. These term loans will generally bear interest that either floats with the base rate or another established index or is fixed for the term of the loan. Agricultural loans consist of farm related credits used to finance operating expenses. These loans generally have terms of one year and bear interest that either floats with the base or is fixed for the term of the loan. These loans are generally collateralized by farm related assets including land, equipment, crops or livestock.
REAL ESTATE LOANS
Real estate loans represent the largest share of our loan portfolio. These loans are comprised of construction and land development loans, commercial term loans and home mortgages. The construction and land development loan portfolio is comprised of three types:
o Loans for construction of residential and commercial income-producing properties that generally have terms of less than two years and typically bear an interest rate that floats with the base rate. o Loans for construction of single-family spec and owner-occupied properties that generally have terms of one year or less and typically bear an interest rate that floats with the base rate. o Land development used for either residential or commercial purposes. These loans generally have terms of one year or less and typically bear an interest rate that floats with the base rate.
Our real estate commercial term loans finance the purchase and/or ownership of income producing properties. These loans are generally made with an amortization schedule ranging from 15 to 25 years with a lump sum balloon payment due in one to ten years. Interest rates will either be fixed or variable. Fixed rate loans typically reprice within one to five years.
Mortgages loans include various types of loans for which real property is held as collateral. These loans, collateralized by one to four family residences, will typically have maturities between one and five years with amortization schedules ranging from 10 to 20 years. Mortgage loans will be written with both fixed and variable rates.
In addition to home mortgages held in our portfolio, the Bank is active in originating and selling mortgages into the secondary market. The Bank offers a variety of products for refinancing and purchases and is approved to originate FHA and VA loans. The majority of loans originated in 2005 were fixed rate single-family loans. Total loans sold in 2005 were approximately $91.3 million. Servicing is sold with the loan. Funding requirements for these loans is very minimal as few of these loans originated through this operation are retained for investment.
INSTALLMENT LOANS
We provide loans for personal use including: auto loans, boat loans, home improvement loans, revolving lines of credit, VISA credit cards and other loans typically made by banks to individual borrowers. These loans generally have terms ranging from one to five years, with up to 20-year amortizations and are written with both fixed and variable rates.
INVESTMENTS
From time to time, the Bank acquires investment securities when funds acquired through deposit activities exceed loan demand. When excess funds are considered temporary in nature by management, they are typically placed in federal funds sold on an overnight basis to correspondent banks, approved by the Board of Directors. This type of investment is not considered desirable, as the interest rate earned on these funds is minimal in nature. When funds are considered longer term, they are generally invested in securities purchased in the open market. At December 31, 2005, the Bank had investments totaling $103.8 million at amortized cost. U.S. Agency bonds comprised 48% of the portfolio and corporate bonds made up 19% and U.S. Treasury bonds made up 7%. Please see Note 3, page 12 of our 2005 Annual Report for details on the makeup of the portfolio. The Bank has an investment policy that generally permits purchasing securities rated only in one of the four highest rating categories by a nationally recognized credit rating organization. The policy also provides for maturity patterns, diversification of investments and avoidance of concentrations within the portfolio.
DEPOSIT ACTIVITIES
The Bank's primary source of funds has historically been customer deposits. The Bank offers a variety of accounts designed to attract both short-term and long-term deposits from its market area. These accounts include NOW, money market, sweep accounts, savings and certificates of deposit. Interest rates paid on these account vary from time to time and are based on competitive factors and liquidity needs. One of the goals of management is to maintain noninterest-bearing deposits at the highest level possible. These are low cost funds and help to increase the net interest margin. Over the last two years, noninterest-bearing accounts have grown from 17.4% of total deposits at the end of 2003 to 19.2% of total deposits at the end of 2005.
OTHER FUNDING SOURCES/FHLB ADVANCES
The Bank has other funding sources such as FHLB advances, federal funds purchased and repurchase agreements. The major source of funds in this area is advances from the FHLB of Seattle. Although this source of funding can be more costly than deposit activities, large portions of funds are available very quickly for meeting loan commitments. The Bank's line of credit with the FHLB is 24% of qualifying assets and is collateralized by qualifying first mortgage loans, qualifying commercial real estate and government agency securities. The Bank, as of December 31, 2005, had FHLB advances totaling $240.0 million (please refer to page 16 of the Annual Report to Shareowners for detail regarding these advances). These advances were collateralized with $581.4 million in qualifying first mortgages, other certain assets, a blanket filing on our commercial real estate portfolio and the remainder was secured by stock in FHLB. No commercial real estate or government securities were pledged at year-end. The unused portion of this credit line at December 31, 2005 was $341.4 million.
BUSINESS STRATEGY
Frontier is attempting to pursue the following strategies:
o increasing the percentage of its assets consisting of business, construction, and commercial real estate loans with higher risk-adjusted returns, shorter maturities and greater sensitivity to interest rate fluctuations; o increasing deposits by attracting lower cost transaction accounts (such as checking, savings and money market accounts) through an enhanced branch network and online banking; o maintaining cost-effective operations by efficiently offering products and services; o maintaining its capital position at or above the "well-capitalized" (as defined for regulatory purposes) levels; and o exploring prudent means to grow the business internally and/or through acquisitions.
A source of future growth may be through acquisitions, although no assurance can be given that acquisition activity will continue in the future. See "Risk Factors".
FACILITIES
Frontier owns its administrative offices and operations centers in Everett and Sumner, and 24 of its branches, through its wholly-owned bank premises holding corporation subsidiary, FFP, Inc., which leases the properties to the Bank. Owned offices and branches range in size from 1,000 to 42,000 square feet and have a total net book value at December 31, 2005, including leasehold improvements, furniture and fixtures, of $29.8 million.
OTHER FINANCIAL SERVICES
The Bank offers other financial services complementary to banking including an insurance and investment center that markets annuities, life insurance products, and mutual funds to Bank customers and the general public, a trust department that offers a full array of trust services, and a private banking office to provide personal service to high net worth customers.
COMPETITION. The banking industry is highly competitive. The Bank faces strong competition in attracting deposits and in originating loans. The most direct competition for deposits has historically come from other commercial banks, saving institutions and credit unions located in the primary market area. As with all banking organizations, FFC also has competition from nonbanking sources, including mutual funds, corporate and governmental debt securities and other investment alternatives. FFC expects increasing competition from other financial institutions and nonbanking sources in the future. Many of FFC's competitors have more significant financial resources, larger market share and greater name recognition than FFC. The existence of such competitors may make it difficult for FFC to achieve its financial goals.
Competition has further increased as a result of Washington banking laws that permit statewide branching of Washington domiciled financial institutions and acquisitions of Washington-based financial institutions by out-of-state bank holding companies.
Management believes that the principal competitive factors affecting FFC's markets include interest rates paid on deposits and charged on loans, the range of banking products available, and customer service and support. Although management believes that the Bank's products currently compete favorably with respect to these factors, there can be no assurance that FFC can maintain its competitive position against current and potential competitors, especially those with significantly greater financial resources.
The Bank's competition for loans comes principally from other commercial banks, savings institutions, credit unions and mortgage banking companies. The Bank competes for loans principally through the efficiency and quality of the services it provides borrowers, real estate brokers and home builders, and the interest rates and loan fees it charges.
The Bank competes for deposits by offering depositors a wide variety of checking accounts, savings accounts, certificates and other services. The Bank's ability to attract and retain deposits depends on its ability to provide deposit products that satisfy the requirements of customers as to interest rates, liquidity, transaction fees, risk of loss of deposit, convenience and other factors. Deposit relationships are actively solicited through a sales and service system.
Changes in technology, mostly from the growing use of computers and computer-based technology, present competitive challenges to FFC. Large banking institutions typically have the ability to devote significant resources to developing and maintaining technology-based services such as on-line banking and other banking products and services over the Internet, including deposit services and mortgage loans. Some new banking competitors offer all of these services online. Customers who bank by computer or by telephone may not need to go to a branch location in person. FFC's high service philosophy emphasizes face-to-face contact with tellers, loan officers and other employees. FFC believes a personal approach to banking is a competitive advantage, one that will remain popular in the communities that it serves. However, customer preferences may change, and the rapid growth of online banking could, at some point, render the Bank's personal, branch-based approach obsolete. FFC believes that it has reduced this risk by offering on-line banking services to its customers, and by continuing to provide 24-hour banking services. There can be no assurance that these efforts will be successful in preventing the loss of customers to competitors.
EMPLOYEES
At December 31, 2005, the Bank had 663 full time equivalent employees. None of the Bank's employees are covered by a collective bargaining agreement. The Bank considers its relations with employees to be good.
COMPETITION
All phases of the Bank's activities are highly competitive. Management believes that the principal competitive factors affecting the Corporation's markets include interest rates paid on deposits and charged on loans, the range of banking products available, and customer service and support. The Bank competes actively with national and state banks, mutual savings banks, savings and loan associations, finance companies, credit unions, brokerage houses, and other financial institutions operating in its service area. Some of these financial institutions have greater resources than those of the Bank. On December 31, 2005, the consolidated Corporation had total assets of $2.64 billion and deposits of $2.06 billion.
REGULATION AND SUPERVISION
To the extent that the following information describes statutory and regulatory provisions, it is qualified in its entirety by reference to the full text of those provisions. Also, such statutes, regulations and policies are continually under review by Congress and state legislatures and federal and state regulatory agencies. A change in statutes, regulations or regulatory policies applicable to FFC could have a material effect on the business of FFC.
INTRODUCTION
FFC, its banking and nonbanking subsidiaries are subject to extensive regulation by federal and state agencies. The regulation of bank holding companies and their subsidiaries is intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole and not for the protection of security holders.
As discussed in more detail below, this regulatory environment, among other things, may restrict FFC's ability to diversify into certain areas of financial services and pay dividends on its capital stock. It may also require FFC to provide financial support to its banking subsidiary, maintain capital balances in excess of those desired by management and pay higher deposit insurance premiums as a result of the deterioration in the financial condition of depository institutions in general.
HOLDING COMPANY STRUCTURE
FFC is a Washington corporation which was incorporated in 1983 and is registered as a bank holding company under the Bank Holding Company Act of 1956 (the "Bank Holding Company Act"). As part of a plan of reorganization consummated following the close of business on September 30, 1983, FFC acquired all of the stock of Frontier Bank (the "Bank"), issuing its common stock in an exchange for the Bank's common stock on a share-for-share basis. FFC has two subsidiaries: the Bank, which is engaged in a general banking business and in businesses related to banking, and FFP, Inc., a nonbank corporation which leases property to the Bank. Effective October 28, 2000, FFC became a financial holding company.
SOURCE OF STRENGTH DOCTRINE. Under current FRB policy, FFC is expected to act as a source of financial and managerial strength to its subsidiary bank and, under appropriate circumstances, to commit resources to support such subsidiary bank.
Capital loans from FFC to its subsidiary bank are subordinate in right of payment to deposits and certain other indebtedness of the subsidiary bank. In the event of FFC's bankruptcy, any commitment by FFC to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment.
DEPOSITOR PREFERENCE. The Federal Deposit Insurance Act ("FDI Act") provides that, in the event of the "liquidation or other resolution" of an insured depository institution, the claims of depositors of the institution, including the claims of the FDIC as subrogate of insured depositors, and certain claims for administrative expenses of the FDIC as a receiver will have priority over other general unsecured claims against the institution. If an insured depository institution fails, insured and uninsured depositors, along with the FDIC, will have priority in payment ahead of unsecured, nondeposit creditors, including FFC, with respect to any extensions of credit they have made to such insured depository institution.
REGULATORY AGENCIES
BANK HOLDING COMPANY. FFC, as a financial holding company, is subject to regulation under the Bank Holding Company Act and to inspection, examination and supervision by the Board of Governors of the Federal Reserve System (Federal Reserve Board) ("FRB") under the Bank Holding Company Act. As of October 28, 2000, FFC became a financial holding company under the Bank Holding Company Act.
SUBSIDIARY BANK. FFC's subsidiary bank, Frontier Bank, is a Washington state-chartered commercial nonmember bank. Frontier Bank is subject to supervision and examination by applicable federal and state bank agencies, the Federal Deposit Insurance Corporation ("FDIC") and the Division of Banks of the Department of Financial Institutions for the State of Washington (the "Division").
BANK HOLDING COMPANY ACTIVITIES
"FINANCIAL IN NATURE" REQUIREMENT. As a bank holding company that has also elected to become a financial holding company pursuant to the Bank Holding Company Act, FFC may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature or are incidental or complementary to activities that are financial in nature. "Financial in nature" activities include securities underwriting, dealing and market making, sponsoring mutual funds and investment companies, insurance underwriting and agency, merchant banking, and activities that the FRB determines from time to time to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. A bank holding company that is not also a financial holding company is limited to engaging in banking and such other activities as determined by the FRB to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.
FRB approval is not required for FFC to acquire a company (other than a bank holding company, bank or savings association) engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the FRB. Prior FRB approval is required before FFC may acquire the beneficial ownership or control of more than 5% of the voting shares or substantially all of the assets of a bank holding company, bank or savings association.
If the subsidiary bank of FFC receives a rating under the Community Reinvestment Act of 1977 of less than satisfactory, FFC will be prohibited from engaging in new activities or acquiring companies other than bank holding companies, banks or savings associations.
REGULATORY APPROVAL. In determining whether to approve a proposed bank acquisition, federal banking regulators will consider, among other factors, the effect of the acquisition on competition, the public benefits expected to be received from the acquisition, the projected capital ratios and levels on a post-acquisition basis, and the acquiring institution's record of addressing the credit needs of the communities it serves, including the needs of low and moderate income neighborhoods, consistent with the safe and sound operation of the bank, under the Community Reinvestment Act of 1977.
DIVIDEND RESTRICTIONS
FFC is a legal entity separate and distinct from its subsidiary bank. Its principal source of funds to pay dividends on its common stock and debt service on its debt is dividends from its subsidiary bank. The Bank, by statute, cannot declare or pay any dividend in an amount greater than its retained earnings without the approval of the Director of the Division of Banks for the State of Washington.
DEPOSIT INSURANCE ASSESSMENTS
Through the Bank Insurance Fund ("BIF"), the FDIC insures the deposits of FFC's depository institution subsidiaries up to prescribed limits for each depositor. The amount of FDIC assessments paid by each BIF member institution is based on its relative risk of default as measured by regulatory capital ratios and other factors. Specifically, the assessment rate is based on the institution's capitalization risk category and supervisory subgroup category. An institution's capitalization risk category is based on the FDIC's determination of whether the institution is well capitalized, adequately capitalized or less than adequately capitalized. An institution's supervisory subgroup category is based on the FDIC's assessment of the financial condition of the institution and the probability that FDIC intervention or other corrective action will be required. Frontier Bank is currently rated well capitalized under the regulatory framework for prompt corrective action.
The BIF assessment rate currently ranges from zero to 27 cents per $100 of domestic deposits. The FDIC may increase or decrease the assessment rate schedule on a semi-annual basis. An increase in the BIF assessment rate could have a material adverse effect on FFC's earnings, depending on the amount of the increase. The FDIC is authorized to terminate a depository institution's deposit insurance upon a finding by the FDIC that the institution's financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the institution's regulatory agency.
All FDIC-insured depository institutions must pay an annual assessment to provide funds for the payment of interest on bonds issued by the Financing Corporation, a federal corporation chartered under the authority of the Federal Housing Finance Board. The bonds, commonly referred to as FICO bonds, were issued to capitalize the Federal Savings and Loan Insurance Corporation. The FDIC established the FICO assessment rates effective for the first quarter of 2002 at approximately $.0154 per $100 annually for BIF-assessable deposits. The FICO assessments are adjusted quarterly to reflect changes in the assessment bases of the FDIC's insurance funds and do not vary depending on a depository institution's capitalization or supervisory evaluations.
FDIC-insured depository institutions pay an assessment rate equal to the rate assessed on deposits insured by the Savings Association Insurance Fund ("SAIF").
SECURITIES REGISTRATION AND REPORTING
FFC common stock is registered with the SEC under Section 12(g) of the Securities Exchange Act of 1934 and thus is subject to the periodic reporting and proxy solicitation requirements and the insider-trading restrictions of that Act. The periodic reports, proxy statements and other information filed by FFC under that Act can be inspected and copied at or obtained from the SEC's Public Reference Room at 450 Fifth Street NW, Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. FFC is an electronic filer with the SEC, and the FFC filings may be obtained at the SEC website (http://www.sec.gov). In addition, the securities issued by FFC are subject to the registration requirements of the Securities Act of 1933 and applicable state securities laws unless exemptions are available.
NASD
FFC common stock is traded on the Nasdaq market under the symbol FTBK. The National Association of Securities Dealers ("NASD") is the self-regulatory organization of the Nasdaq market. FFC is subject to the rules of the NASD.
The NASD may implement rules from time to time that are required by the SEC. The NASD implemented rules under the Sarbanes-Oxley Act of 2002 regarding certain required disclosures to shareowners, and independence requirements for directors. In order for FFC common stock to continue to be traded on the Nasdaq market, FFC is required to comply with these listing rules, as amended from time to time.
FISCAL AND MONETARY POLICIES
FFC's business and earnings are affected significantly by the fiscal and monetary policies of the federal government and its agencies. FFC is particularly affected by the policies of the FRB, which regulates the supply of money and credit in the United States. Among the instruments of monetary policy available to the Federal Reserve are (a) conducting open market operations in United States government securities, (b) changing the discount rates of borrowings of depository institutions, (c) imposing or changing reserve requirements against depository institutions' deposits, and (d) imposing or changing reserve requirements against certain borrowing by banks and their affiliates. These methods are used in varying degrees and combinations to directly affect the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits. For that reason alone, the policies of the FRB have a material effect on the earnings of FFC.
DISCLOSURE CONTROLS AND PROCEDURES
The Sarbanes-Oxley Act of 2002 and related rulemaking by the SEC, which effected sweeping corporate disclosure and financial reporting reform, generally require public companies to focus more attention on their disclosure controls and procedures. As a result, public companies such as FFC now must have disclosure controls and procedures in place and make certain disclosures about them in their periodic SEC reports (I.E., Forms 10-K and 10-Q) and their chief executive and chief financial officer must certify in these filings that they are responsible for developing and evaluating disclosure controls and procedures and disclose the results of an evaluation conducted by them within the 75-day period preceding the filing of the relevant report, among other things.
FUTURE LEGISLATION
Various legislation, including proposals to substantially change the financial institution regulatory system and to expand or contract the powers of banking institutions and bank holding companies, are from time to time introduced in the Congress. This legislation may change banking statutes and the operating environment of FFC and its subsidiaries in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. FFC cannot predict whether any of this potential legislation will be enacted, and if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of FFC or any of its subsidiaries.
THE BANK
GENERAL. Applicable federal and state statutes and regulations governing a bank's operations relate, among other matters, to capital requirements, required reserves against deposits, investments, loans, legal lending limits, certain interest rates payable, mergers and acquisitions, borrowings, issuance of securities, payment of dividends (see "Restrictions on Capital Distributions" below), establishment of branches, and dealings with affiliated persons. The FDIC has authority to prohibit banks under their supervision from engaging in what they consider to be an unsafe and unsound practice in conducting their business.
FFC's subsidiary bank, Frontier Bank, is a Washington state-chartered commercial bank that is a nonmember bank. Frontier Bank is subject to supervision and examination by applicable federal and state banking agencies, the FDIC and the Division. The Bank is also subject to regulation and examination by the FDIC which insures the deposits of the Bank to the maximum extent permitted by law and by requirements established by the FRB. The federal laws that apply to the Bank regulate, among other things, the scope of its business, investments, reserves against deposits, the timing of the availability of deposited funds and the nature and amount of and collateral for loans. The laws and regulations governing the Bank generally have been promulgated to protect depositors and not to protect shareowners of such institutions or their holding companies.
The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") requires federal banking regulators to adopt regulations or guidelines in a number of areas to ensure bank safety and soundness including: internal controls, credit underwriting, asset growth, management compensation, ratios of classified assets to capital, and earnings. FDICIA also contains provisions which are intended to change independent auditing requirements; restrict the activities of "undercapitalized banks" to borrow from the FRB's discount window; and require regulators to perform annual on-site bank examinations and set standards for real estate lending.
LOANS TO ONE BORROWER. The Bank is subject to limitations on the aggregate amount of loans that it can make to any one borrower, including related entities. Applicable regulations generally limit loans-to-one borrower to 20 percent of capital. As of December 31, 2005, the Bank was in compliance with applicable loans-to-one borrower requirements.
FDIC INSURANCE. Generally, customer deposit accounts in banks are insured by the FDIC for up to a maximum amount of $100,000. The FDIC has adopted a risk-based insurance assessment system under which depository institutions contribute funds to the Bank Insurance Fund ("BIF"), based on their risk.
On September 30, 1996, the Deposit Insurance Fund Act of 1996 ("Funds Act") was enacted. The Funds Act provides, among other things, for the recapitalization of the SAIF through a special assessment on all depository institutions that hold SAIF insured deposits. The one-time assessment was designed to place the SAIF at its 1.25 reserve ratio goal.
The Funds Act, for the three-year period beginning in 1997, subjects BIF insured deposits to a Financing Corporation ("FICO") premium assessment on domestic deposits at one-fifth the premium rate (approximately 1.3 basis points) imposed on SAIF insured deposits (approximately 6.5 basis points).
Beginning in the year 2000, BIF insured institutions were required to pay the FICO obligations on a pro-rata basis with all thrift institutions; annual assessments are expected to equal approximately 2.4 basis points until 2017, to be phased out completely by 2019. Until further action by the FDIC, BIF premiums will be maintained at their current level.
Banking regulations are empowered under the Funds Act to prohibit insured institutions and their holding companies from facilitating or encouraging the shifting of deposits from the SAIF to the BIF in order to avoid higher assessment rates. It is expected that Congress will continue to address comprehensive legislation on the merger of the funds and elimination of the thrift charter.
The FDIC may terminate the deposit insurance of any insured depository institution if it determined after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law. The insurance may be terminated permanently, if the institution has no tangible capital. If deposit insurance is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, will continue to be insured for a period of six months to two years, as determined by the FDIC.
CAPITAL ADEQUACY REQUIREMENTS. The FRB and the FDIC (collectively, the "Agencies") have adopted risk-based capital guidelines for banks and bank holding companies that are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies and account for off-balance sheet items. The guidelines are minimums, and the federal regulators have noted that banks and bank holding companies contemplating significant expansion programs should not allow expansion to diminish their capital ratios and should maintain ratios in excess of the minimums. Failure to achieve and maintain adequate capital levels may give rise to supervisory action through the issuance of a capital directive to ensure the maintenance of required capital levels.
The current guidelines require all federally regulated banks to maintain a minimum risk-based total ratio equal to 8 percent, of which at least 4 percent must be Tier 1 capital. Tier 1 capital includes common shareowners' equity, qualifying perpetual preferred stock, and minority interest in equity accounts of consolidated subsidiaries, but excludes goodwill and most other intangibles, gains or losses on available for sale securities and the allowance for losses on loans. Total capital includes the excess of any preferred stock not included in Tier 1 capital, mandatory convertible securities, hybrid capital instruments, subordinated debts and intermediate term preferred stock and the allowance for losses on loans up to 1.25 percent of risk-weighted assets. The Bank has not received notice indicating that it will be subject to higher capital requirements.
PROMPT CORRECTIVE ACTION. Regulations adopted by the Agencies as required by FDICIA impose even more stringent capital requirements. The regulators require the FDIC and other Federal Banking Agencies to take certain "prompt corrective action" when a bank fails to meet certain capital requirements. The regulations establish and define five capital levels: (1) "well-capitalized", (2) "adequately capitalized", (3) "undercapitalized", (4) "significantly undercapitalized", and (5) "critically undercapitalized." To qualify as "well capitalized" an institution must maintain at least 10 percent total risk-based capital, 6 percent Tier 1 risk-based capital, and a leverage ratio of no less than 5 percent. Increasingly severe restrictions are imposed on the payment of dividends and management fees, asset growth and other aspects of the operations of institutions that fall below the category of being "adequately capitalized" (which requires at least 8 percent total risk-based capital, 4 percent Tier 1 risk-based capital, and a leverage ratio of at least 4 percent). Undercapitalized institutions are required to develop and implement capital plans acceptable to the appropriate federal regulatory agency. Such plans must require that any company that controls the undercapitalized institution must provide certain guarantees that the institution will comply with the plan until it is adequately capitalized. As of December 31, 2005, the Bank was well capitalized and maintained a risk-based total capital ratio of 11.39 percent, a risk-based Tier 1 capital ratio of 10.14 percent, and a leverage ratio of 10.07 percent.
RESTRICTIONS ON CAPITAL DISTRIBUTIONS. Dividends paid to FFC by the Bank are a material source of FFC's cash flow. Various federal and state statutory provisions limit the amount of dividends the Bank is permitted to pay to FFC without regulatory approval.
FRB policy further limits the circumstances under which bank holding companies may declare dividends. For example, a bank holding company should not continue its existing rate of cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality, and overall financial condition.
If, in the opinion of the applicable federal banking agency, a depository institution under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which depending on the financial condition of the institution, could include the payment of dividends), the agency may require, after notice and hearing, that such institution cease and desist from such practice. In addition, the FRB and the FDIC have issued policy statements which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings.
According to Washington law, the Bank may not declare or pay a cash dividend in an amount greater than its retained earnings, without the approval of the Director of the Division of Financial Institutions.
INTERSTATE BANKING AND BRANCHING. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 ("Interstate Act") generally permits nationwide interstate banking and branching by relaxing federal law restrictions on interstate banking and providing general authorization for interstate branching. Subject to certain state laws, such as age and contingency laws, the Interstate Act allows adequately capitalized and adequately managed bank holding companies to purchase the assets of out-of-state banks. Additionally, since June 1, 1997, the Interstate Act permits interstate bank mergers subject to these state laws, unless the home state of either merging bank has "opted-out" of these provisions by enacting "opt-out" legislation. The Interstate Act does allow states to impose certain conditions on interstate bank mergers within their borders; for example, states may require that the in-state merging bank exist for up to five years before the interstate merger. Under the Interstate Act, states may also "opt-in" to de novo branching, allowing out-of-state banks to establish de novo branches within the state.
In 1996, Washington enacted "opting-in" legislation authorizing interstate mergers pursuant to the Interstate Act. Accordingly, as of June 6, 1996, an out-of-state bank holding company may now acquire more than 5 percent of the voting shares of a Washington-based bank, regardless of reciprocity, provided such bank or its predecessor has been doing business for at least five years prior to the acquisition. Further, an out-of-state bank may engage in banking in Washington if the requirement of Washington's interstate banking statute are met, and either: (1) was lawfully engaged in banking in Washington on June 6, 1996, (2) resulted from an interstate combination pursuant to Washington law, (3) resulted from a relocation of a head office of a state bank or a main office of a national bank pursuant to federal law, or (4) resulted from the establishment of a savings bank branch in compliance with applicable Washington law. Additionally, the Director of the Division of Financial Institutions may approve interstate combinations if the basis for such approval does not discriminate against out-of-state banks, out-of-state holding companies, or their subsidiaries.
The agencies recently adopted regulations, under which banks are prohibited from using their interstate branches primarily for deposit production. The Agencies have accordingly implemented a loan-to-deposit ratio screen to ensure compliance with this prohibition.
REGULATORY IMPROVEMENT. In 1994, Congress enacted the Community Development and Regulatory Improvement Act ("Regulatory Improvement Act"), with the intent of, among other things, reducing the regulatory burden on financial institutions. This Act is intended to streamline certain regulatory procedures and relax certain regulatory compliance requirements. In addition, the Regulatory Improvement Act specifically directs each federal banking agency to review and streamline its regulations and written supervisory policies.
EFFECT OF GOVERNMENTAL POLICIES. The Bank is affected not only by general economic conditions, but also by the monetary and fiscal policies of the United States Government and various agencies, particularly the Federal Reserve System. In its role of implementing its monetary policy, the Federal Reserve Board has the power to regulate the national supply of bank credit through such methods as open market operations in the United States Government securities markets, control of the discount rate on member bank borrowings, and establishment of reserve requirements against bank deposits. These means are used in varying combinations and have an influence over the growth of bank loans, investments, and deposits. They may also affect interest rates charged on loans or paid on deposits. The nature and timing of future changes in monetary policies and their impact on the Bank are not predictable. As a consequence of extensive regulation of commercial banking activities in the United States, the Bank's business is particularly susceptible to being affected by Federal legislation and regulations which may have the effect of increasing the cost of doing business or limiting permissible activities.
CUSTOMER PRIVACY REGULATION. The Gramm-Leach-Bliley Act restricts financial institutions from disclosing nonpublic consumer information to nonaffiliated third parties. As a result, the Bank is required to disclose its written privacy policy to its consumers and must restrict dissemination of consumer information as required by law.
ANTI-MONEY LAUNDERING REGULATION. The Bank Secrecy Act of 1970 requires banks to maintain internal systems to prevent banks from being utilized to facilitate the flow of illegal or illicit money. The USA Patriot Act of 2001 was enacted in response to terrorist activities in 2001 and significantly expanded the restrictions on so-called "money laundering" schemes and terrorist financing activities. These statutes and related regulations have required the Bank to implement additional operating systems and controls, to expand record-keeping and positive customer identification policies, and to develop additional reporting systems to ensure compliance and to assist the Federal government in detecting money laundering schemes and terrorist financing activities. Failure to comply could result in legal consequences and/or penalties to the Bank.
Bank regulatory authorities have been placing a special emphasis upon banks' compliance with the Bank Secrecy Act (BSA) and the USA Patriot Act as a part of the effort to thwart terrorism and other criminal activity in this country. In June 2005, the Federal Financial Institutions Examination Council published a new Bank Secrecy Act/Anti-Money Laundering Examination Manual which provides guidelines for examination of compliance with the Bank Secrecy Act and the USA Patriot Act.
In substantial part in response to that examination, the Bank has developed a plan to expand and enhance the Bank's Bank Secrecy Act/Anti-Money Laundering compliance program. Bank management, at the direction of the Bank's Board of Directors, has evaluated and is in the process of modifying its controls and procedures to better identify customers and transactions that should be evaluated and reported under the BSA.
Bank management expects that the Federal Reserve Bank will continue to review the Bank's plans relative to Bank Secrecy Act/Anti-Money Laundering compliance and following that review will determine any regulatory action concerning the Bank's Bank Secrecy Act/Anti-Money Laundering program that may be unnecessary. Such action may include an agreement with the Federal Reserve Bank to correct the weaknesses by implementing the steps described in the plan or other
corrective action deemed necessary by the regulatory authorities. Bank management is committed to enhancing the Bank's compliance with Bank Secrecy Act/Anti-Money Laundering statutes and regulations and believes that the plan as developed and implemented will be in full compliance with applicable requirements. Other than the ongoing costs of compliance with Bank Secrecy Act/Anti-Money Laundering requirements, the Bank does not expect to incur other costs.
EQUITY COMPENSATION PLANS
The following table sets forth information regarding outstanding options and shares reserved for issuance under the Corporation's plans:
(A) Consists of FFC Incentive Stock Option Plan.
(B) Consists of FFC 1999 Employee Stock Award Plan and 2001 Stock Award Plan.
FFP, INC.
On April 4, 1988, the Corporation formed a new subsidiary corporation called FFP, Inc. The purpose of this corporation is to purchase and lease improved real property to the Bank. For further details, please see page 32 of this Form 10-K Report, "Properties." It is intended that future purchases of real property will be made by FFP, Inc. At this time, it is not anticipated that FFP, Inc. will engage in any other type of business.
RECENT STOCK PURCHASE
In December 2004, the Corporation purchased 4.95% of the common stock of Skagit State Bank, located in Burlington, Washington, which is approximately 44 miles north of Everett in Skagit County. Subsequent to this investment, the Corporation applied to the Board of Governors of the Federal Reserve System to purchase up to 20% of Skagit State. Approval was received in February 2005 and the Corporation has made additional purchases for a total ownership of 11.3% as of December 31, 2005. In January 2006, the Corporation purchased 5,022 shares for $653 thousand, bringing total ownership to 12.02%.
SHARE REPURCHASE PROGRAM
In January 2001, the Board announced the adoption of a stock repurchase program authorizing the Corporation to repurchase up to 5% of its outstanding stock in the open market. On October 17, 2001and 2002, and September 16, 2004, the Board of Directors authorized three increases of 5% of the outstanding common stock under the plan. The plan expires in September 2006. The Corporation last repurchased 361,800 shares in 2003. There were 1,398,405 shares remaining under the current plan at December 31, 2005.
TREATMENT OF GOODWILL
The Corporation has goodwill which was recorded in connection with acquisitions over the years. Prior to January 1, 2002, the Corporation amortized goodwill over 20 years. Upon the implementation of Statement of Financial Standards No. 142 (SFAS No. 142), GOODWILL AND OTHER INTANGIBLE ASSETS, on January 1, 2002, the Company ceased amortization of goodwill. SFAS 142 requires the Corporation to test the goodwill for impairment at least annually. The Corporation tested its goodwill and found no impairment during 2005. The Corporation uses the fair market value approach to determine if there has been any impairment.
AVAILABLE INFORMATION
FFC maintains an Internet website at www.frontierbank.com. FFC makes available free of charge through its website its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to these reports, generally within 24 hours after FFC files these reports with the SEC. FFC's Code of Ethics for Senior Financial Officers is also available on the website. From FFC's home page at www.frontierbank.com, go to "Resource Centers" and click on "Investor Relations" to access these reports and other documents. The Code of Ethics for Senior Financial Officers is also available in print upon written request addressed to Investor Relations, Frontier Financial Corporation, 332 S.W. Everett Mall Way, P.O. Box 2215, Everett, WA 98213.
FORWARD-LOOKING STATEMENTS
The Annual Report on Form 10-K contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, the Corporation may make certain statements in future SEC filings, in press releases, and in oral and written statements made with the Corporation's approval that are not statements of historical fact and may constitute forward-looking statements. Forward-looking statements may relate to, without limitation the Corporation's financial condition, results of operations, plans, objectives, future performance or business.
Forward-looking statements are identified by the fact that they do not relate only to historical or current facts. Sentences containing words such as "may", "will", "expect", "anticipate", "believe", "estimate", "should", "projected", or similar words may constitute forward-looking statements, but are not the only means to identify these statements. The Corporation may have used these statements to describe expectations and estimates in various areas, including, but not limited to: changes in the economy of the markets in which it operates; interest rate movements; future acquisition and growth strategies; system conversions and integration activities; the impact of competitive products, services and pricing; and legislative, regulatory and accounting changes affecting the banking and financial service industry.
Forward-looking statements are subject to risks and uncertainties that may cause actual future results to differ materially from estimated or projected results. Factors that could cause this difference--many of which are beyond the Corporation's control--include the following, without limitation: interest rate trends may differ more than expected; loan delinquency rates may be significantly higher than expected; the general state of the economy in Washington state and the United States as a whole could be worse than expected; competitive pressures among financial institutions could increase significantly; and changes in laws and regulations could adversely affect the Corporation.
ITEM 1A.
ITEM 1A. RISK FACTORS
An investment in our common shares is subject to risks inherent to our business. The material risks and uncertainties that management believes affect us are described below. Before making an investment decision, one should carefully consider the risks and uncertainties described below together, with all of the other information, included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones we face. Although we have significant risk management policies, procedures and verification processes in place, additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair our business operations. This report is qualified in its entirety by these risk factors.
If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of our common shares could decline, perhaps significantly, and you could lose all or part of your investment. Investments in shares of bank stock are not government guaranteed.
RISKS RELATED TO OUR BUSINESS
WE ARE SUBJECT TO INTEREST RATE RISK
Our earnings and cash flows are largely dependent upon our net interest income. Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond our control, including but not limited to general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Reserve Board. Changes in monetary policy, including changes in interest rates, could influence not only the amount of interest we receive on loans and securities and the amount of interest we pay on deposits and borrowings, but such changes could also affect our ability to originate loans and obtain deposits as well as the fair value of our financial assets and liabilities. If the interest we pay on deposits and other borrowings increases at a faster rate than the interest we receive on loans and other investments, our net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest we receive on loans and other investments fall more quickly than the interest we pay on deposits and other borrowings.
Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on our results of operations, any substantial, unexpected and/or prolonged change in market interest rates could have a material adverse effect on our financial condition and results of operations.
WE ARE SUBJECT TO CREDIT RISK
There are inherent risks associated with our lending and trading activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in the markets where we operate and the customers we serve. Increases in interest rates and/or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans. We also are subject to various laws and regulations that affect our lending activities. Failure to comply with applicable laws and regulations could subject us to regulatory enforcement action that could result in the assessment against us of civil money or other penalties.
As of December 31, 2005, approximately 85% of our loan portfolio consisted primarily of loans secured by real estate, including real estate commercial, construction, land development and mortgage. These types of loans are generally viewed as potentially having more risk of default than residential real estate loans or consumer loans. Although we closely monitor and manage risk concentrations and utilize various portfolio management practices, our loan portfolio contains a number of real estate loans with relatively large balances. The deterioration of one or a few of these loans could cause a significant increase in nonperforming loans, and an increase in overall nonperforming loans could result in a net loss of earnings, an increase in the provision for probable loan losses and an increase in loan charge-offs, all of which could have a material adverse effect on our financial condition and results of operations. Additional information regarding credit risk is included in Management's Discussion and Analysis of Financial Condition and Results of Operations on page 41 and 42 of Frontier Financial Corporation's 2005 Annual report to Shareowners.
VARIOUS FACTORS MAY CAUSE OUR ALLOWANCE FOR PROBABLE LOAN LOSSES TO INCREASE
We maintain an allowance for probable loan losses, which is a reserve established through a provision for probable loan losses charged to expense, which represents management's estimate of probable losses within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The level of the allowance reflects management's continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present and future economic, political and regulatory conditions; and unexpected losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for probable loan losses inherently involves a degree of subjectivity and requires that we make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of
additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for probable loan losses. In addition, bank regulatory agencies and our independent auditors periodically review our allowance for loan losses and may require an increase in the provision for probable loan losses or the recognition of further loan charge-offs, based on judgments that can differ somewhat from those of our own management. In addition, if charge-offs in future periods exceed the allowance for probable loan losses, we will need additional provisions to increase the allowance for probable loan losses, which should they become necessary, would result in a decrease in net income and capital, and may have a material adverse effect on our financial condition and results of operations. Additional information regarding the allowance for loan losses is included in the section Reserve and Provision for Loan Losses on pages 31 and 32 of the Management's Discussion and Analysis of Financial Condition and Results of Operations section of Frontier Financial Corporation's 2005 Annual Report to Shareowners.
WE ARE SUBJECT TO LIQUIDITY RISK
Market conditions or other events could negatively affect the level or cost of liquidity, affecting our ongoing ability to accommodate liability maturities and deposit withdrawals, meet contractual obligations, and fund asset growth and new business transactions at a reasonable cost, in a timely manner and without adverse consequences. Management has implemented strategies to maintain sufficient and diverse sources of funding to accommodate planned as well as unanticipated changes in assets and liabilities under both normal and adverse conditions. However, substantial, unexpected and/or prolonged changes in the level or cost of liquidity could have a material adverse effect on our financial condition and results of operations. Additional information regarding liquidity risk is included in the section captioned "Liquidity" beginning on page 38 of the Management's Discussion and Analysis of Financial Condition and Results of Operations section of Frontier Financial Corporation's 2005 Annual Report to Shareowners.
WE ARE SUBJECT TO OPERATIONAL RISK
We, like all businesses, are subject to operational risk, which represents the risk of loss resulting from human error, inadequate or failed internal processes and systems, and external events. Operational risk also encompasses compliance (legal) risk, which is the risk of loss from violations of, or noncompliance with, laws, rules, and regulations, prescribed practices or ethical standards. Although we seek to mitigate operational risk through a system of internal controls, losses resulting from operational risk could take the form of explicit charges, increased operational costs, harm to our reputation or forgone opportunities, any and all of which could have a material adverse effect on our financial condition and results of operations.
OUR PROFITABILITY DEPENDS SIGNIFICANTLY ON ECONOMIC CONDITIONS IN THE GEOGRAPHIC REGIONS IN WHICH WE OPERATE
Our success depends on the general economic conditions of the markets in which we operate. The regional economic conditions in the areas have an impact on the demand for our products and services as well as the ability of our customers to repay loans, the value of the collateral securing loans and the stability of our deposit funding sources. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities markets or other factors could also impact these regional economies and, in turn, have a material adverse effect on our financial condition and results of operations.
WE OPERATE IN A HIGHLY COMPETITIVE INDUSTRY AND MARKET AREAS
We face substantial competition in all areas of our operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include national and super-regional banks as well as smaller community banks within the various markets in which we operate. However, we also face competition from many other types of financial institutions, including without limitation: savings associations, credit unions, mortgage banking companies, finance companies, mutual funds, insurance companies, investment management firms, investment banking firms, broker-dealers and other local, regional and national financial services firms. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Also, technology has lowered barriers to entry and made it possible for nonbanks to offer products and services traditionally provided by banks.
Our ability to compete successfully depends on a number of factors, including, among other things:
o Our ability to develop and execute strategic plans and initiatives.
o Our ability to develop, maintain and build upon long-term customer relationships based on quality service, high ethical standards and safe, sound assets.
o Our ability to expand our market position.
o The scope, relevance and pricing of the products and services we offer to meet customer needs and demands.
o The rate at which we introduce new products and services relative to our competitors.
o Industry and general economic trends.
o Our ability to attract and retain qualified employees.
o Our ability to respond to and resolve unexpected legal, regulatory or other compliance issues.
Failure to perform in any of these areas could significantly weaken our competitive position, which could adversely affect our growth and profitability and have a material adverse effect on our financial condition and results of operations.
WE ARE SUBJECT TO EXTENSIVE GOVERNMENT REGULATION AND SUPERVISION
We are subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors' funds, federal deposit insurance funds and the banking system as a whole, not shareowners. These regulations affect our lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies; changes in the interpretation or implementation of statutes, regulations or policies; and/or changes to regulatory requirements or expectations, could affect us in substantial and unpredictable ways. Such changes could subject us to additional costs, limit the types of financial services and products that we may offer and/or increase the ability of nonbanks to offer competing financial services and products, among other things. Failure to appropriately comply with laws, regulations or policies (including internal policies and procedures designed to prevent such violations) could result in sanctions by regulatory agencies, civil money penalties and/or reputational damage, which could have a material adverse effect on our business, financial condition and results of operations. Additional information regarding regulation and supervision is included in the section captioned "Regulation and Supervision" in Item 1, Business, beginning on page 5 of this report.
OUR CONTROLS AND PROCEDURES MAY FAIL OR BE CIRCUMVENTED
Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, financial condition and results of operations.
WE RELY ON DIVIDENDS FROM OUR SUBSIDIARIES FOR MOST OF OUR REVENUE
Frontier Financial Corporation is a legal entity separate and distinct from its subsidiaries. It receives substantially all of its revenue from dividends from its subsidiaries. These dividends are the principal source of funds to pay dividends on our common shares. Various laws and regulations limit the amount of dividends that Frontier Bank may pay to Frontier Financial Corporation. In the event Frontier Bank is unable to pay dividends to Frontier Financial Corporation, we may not be able pay dividends on our common shares. The inability to receive dividends from Frontier Bank could have a material adverse effect on our business, financial condition and results of operations. Additional information regarding dividend restrictions is included in the section captioned "Regulation and Supervision" in Item 1, Business, on pages 6 - -7 of this report.
POTENTIAL ACQUISITIONS MAY DISRUPT OUR BUSINESS AND DILUTE SHAREOWNER VALUE
Acquiring other banks or financial institutions or financial service companies involves various risks commonly associated with acquisitions, including, among other things:
o Potential exposure to unknown or contingent liabilities of the acquired company.
o Exposure to potential asset quality issues of the acquired company.
o Difficulty and expense of integrating the operations and personnel of the acquired company.
o Potential disruption to our business.
o Potential diversion of our management's time and attention.
o The possible loss of key employees and customers of the acquired company.
o Difficulty in estimating the value (including goodwill) of the acquired company.
o Difficulty in estimating the fair value of acquired assets, liabilities and derivatives of the acquired company.
o Potential changes in banking or tax laws or regulations that may affect the acquired company.
We regularly evaluate merger and acquisition opportunities and conduct due diligence activities related to possible transactions with other financial institutions. As a result, merger or acquisition discussions and, in some cases, negotiations may take place and future mergers or acquisitions involving cash, debt or equity securities may occur at any time. Acquisitions typically involve the payment of a premium over book and market values, and, therefore, some dilution of our tangible book value and net income per common share may occur in connection with any future transaction. Furthermore, failure to realize the expected revenue increases, cost savings, increases in geographic or product presence or market share, and/or other projected benefits from an acquisition could have a material adverse effect on our financial condition and results of operations.
WE MAY NOT BE ABLE TO ATTRACT AND RETAIN SKILLED PEOPLE
Our success depends, in large part, on our ability to attract and retain key people. Competition for the best people in most activities in which we are engaged can be intense and we may not be able to hire or retain the people we want and/or need. The unexpected loss of services of one or more of our key personnel could occur, and such events may have a material adverse impact on our business because of the difficulty of promptly finding qualified replacement personnel and the loss of the employee's skills, knowledge of our market, years of industry experience.
OUR INFORMATION SYSTEMS MAY EXPERIENCE AN INTERRUPTION OR BREACH IN SECURITY
We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the possible failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
WE CONTINUALLY ENCOUNTER TECHNOLOGICAL CHANGE
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Our largest competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on our business and, in turn, our financial condition and results of operations.
WE ARE SUBJECT TO CLAIMS AND LITIGATION
From time to time, customers and/or vendors may make claims and take legal action against us. Whether these claims and legal action are founded or unfounded, if such claims and legal actions are not resolved in our favor they may result in significant financial liability and/or adversely affect how the market perceives us and our products and services as well as impact customer demand for those products and services. Any financial liability or reputation damage could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.
OUR EARNINGS MAY BE AFFECTED BY CHANGES IN ACCOUNTING PRINCIPLES AND IN TAX LAWS
Changes in U.S. generally accepted accounting principles could have a significant adverse effect on Frontier Financial Corporation's reported financial results. Although these changes may not have an economic impact on our business, they could affect our ability to attain targeted levels for certain performance or regulatory measures.
We, like all businesses, are subject to tax laws, rules and regulations. Changes to tax laws, rules and regulations, including changes in the interpretation or implementation of tax laws, rules and regulations by the Internal Revenue Service or other governmental bodies, could affect us in substantial and unpredictable ways. Such changes could subject us to additional costs, among other things. Failure to appropriately comply with tax laws, rules and regulations could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on our business, financial condition and results of operations.
SEVERE WEATHER, NATURAL DISASTERS, ACTS OF WAR OR TERRORISM AND OTHER EXTERNAL EVENTS COULD SIGNIFICANTLY IMPACT OUR BUSINESS
Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on our ability to conduct business. Such events could affect the stability of our deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue, interrupt our information systems, and/or cause us to incur additional expenses. For example, during 2005, hurricanes Katrina and Rita caused extensive flooding and destruction along the coastal areas of the Gulf of Mexico which severely impacted the operations of many financial institutions. While we were not adversely affected by the impact of these specific disasters, other severe weather or natural disasters, acts of war or terrorism or other adverse external events may occur in the future that would have an effect on our business. Although management has established disaster recovery plans and procedures, the occurrence of any such event could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.
RISKS ASSOCIATED WITH OUR COMMON SHARES
OUR SHARE PRICE CAN BE VOLATILE
Share price volatility may make it more difficult to resell our common stock when desired or at prices deemed statisfactory. Our share price can fluctuate significantly in response to a variety of factors including, among other things:
o Actual or anticipated variations in quarterly results of operations.
o Recommendations by securities analysts.
o Operating and stock price performance of other companies that investors deem comparable to our business.
o News reports relating to trends, concerns and other issues in or affecting the financial services industry.
o Perceptions of us and/or our competitors in the marketplace.
o New technology used, or services offered, by our competitors, or ourselves.
o Significant acquisitions or business combinations, strategic partnerships, joint ventures or capital commitments entered into by us or our competitors.
o Failure to integrate acquisitions or realize anticipated benefits from acquisitions.
o Changes in government regulations.
o Geopolitical conditions such as acts or threats of terrorism or military conflicts.
General market fluctuations, industry factors and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes or credit loss trends, could also cause our share price to increase or decrease regardless of operating results.
AN INVESTMENT IN OUR COMMON SHARES IS NOT INSURED OR AN INSURED DEPOSIT
Our common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described in this "Risk Factors" section and elsewhere in this report and is subject to many of the same market forces that affect the price of common stock in any company. As a result, acquisition of our common shares may result in a loss of some or all of an investment in our shares.
OUR ARTICLES OF INCORPORATION, REGULATIONS AND SHAREOWNERS RIGHTS PLAN AS WELL AS CERTAIN BANKING LAWS MAY HAVE AN ANTI-TAKEOVER EFFECT
Provisions of our articles of incorporation and regulations, federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire us, even if doing so would be perceived to be beneficial to our shareowners. The combination of these provisions may inhibit a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of our common shares.
RISKS ASSOCIATED WITH OUR INDUSTRY
THE EARNINGS OF FINANCIAL SERVICES COMPANIES ARE SIGNIFICANTLY AFFECTED BY GENERAL BUSINESS AND ECONOMIC CONDITIONS
Our operations and profitability are impacted by general business and economic conditions in the United States and abroad. These conditions include short-term and long-term interest rates, inflation, money supply, political issues, legislative and regulatory changes, fluctuations in both debt and equity capital markets, broad trends in industry and finance, and the strength of the U.S. economy and the local economies in which we operate, all of which are beyond our control. A deterioration in economic conditions could result in an increase in loan delinquencies and nonperforming assets, decreases in loan collateral values and a decrease in demand for our products and services, among other things, any of which could have a material adverse impact on our financial condition and results of operations.
FINANCIAL SERVICES COMPANIES DEPEND ON THE ACCURACY AND COMPLETENESS OF INFORMATION ABOUT CUSTOMERS AND COUNTERPARTIES
In deciding whether to extend credit or enter into other transactions, we may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports and other financial information. We may also rely on representations of those customers, counterparties or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports or other financial information could have a material adverse impact on our business and, in turn, our financial condition and results of operations.
CONSUMERS MAY DECIDE NOT TO USE BANKS TO COMPLETE THEIR FINANCIAL TRANSACTIONS
Technology and other changes are allowing parties to complete financial transactions through alternative methods that historically have involved banks. For example, consumers can now maintain funds in brokerage accounts or mutual funds that would have historically been held as bank deposits. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as "disintermediation," could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from the use of those deposits. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
There are no unresolved SEC staff comments.
STATISTICAL DISCLOSURE INDEX
The schedules listed below set forth the statistical information relating to Frontier Financial Corporation and subsidiaries (unless otherwise stated) in accordance with Guide 3. This information should be read in conjunction with the consolidated financial statements. Annual Form 10-K Report I. Distribution of Assets, Liabilities PAGE PAGE and Shareowners' Equity; Interest --------- --------- Rates and Interest Differential:
A. Consolidated Average Balance Sheets/Interest Income and Expense/Rates 44 B. Changes in Net Interest Income and Expense due to Rate and Volume 45
II. Investment Portfolio A. Analysis of Investment Securities at Year-end 22 12-13 B. Maturity Distribution of Investment Securities 22 13
III. Loan Portfolio
A. Types of Loans 23 14 B. Loan Maturities and Sensitivity to Changes in Interest Rates 23 14, 33, 35 - 37, 39 C. Risk Elements 24-25 D. Concentrations of Credit 30
IV. Summary of Loan Loss Experience A. Analysis 28 B. Allocation of Allowance for Possible Loan Losses 29
V. Deposits
Average Interest and Noninterest Bearing Deposit Balances 44
VI. Return on Equity and Assets
Significant Financial Ratios 34
VII. Short-term Borrowings 32
Analysis of Investment Securities
The aggregate amortized cost of investment securities at December 31 are as follows:
2005 2004 2003 Amortized Amortized Amortized (In Thousands) Cost Cost Cost ----------------- ----------------- ----------------- U.S. Treasuries $7,232 $15,704 $251 U.S. Agencies 49,621 49,738 67,903 Municipal Bonds 4,231 6,051 10,705 Corporate Bonds 19,326 44,214 77,029 Equities 23,400 32,518 26,653 ----------------- ----------------- ----------------- $103,810 $148,225 $182,541 ================= ================= =================
Maturity Distribution of Investment Securities
The following table sets forth the maturities of investment securities at December 31, 2005. Taxable equivalent values are used in calculating weighted average yields assuming a tax rate of 35%.
As of December 31, 2005 and 2004, the Corporation held FHLB bonds that had a book value of $34.0 million and a market value of $33.2 million and $33.8 million, respectively.
Types of Loans
Major classifications of loans, net of deferred loan fees, at December 31 are as follows:
Loan Maturities and Sensitivity to Changes in Interest Rates
The following table shows the contractual maturity amounts and maturity analysis of loans outstanding as of December 31, 2005. Also, the amounts are classified as to fixed and variable rate sensitivity for amounts due after one year.
Expected maturities will differ from contractual maturities because borrowers may have the right to prepay loans with or without prepayment penalties. It is also not uncommon to rollover loans at the maturity period, provided that the rate and terms of the loan conform to the current policy.
LOAN ADMINISTRATION
The credit approval process at the Bank provides for the prompt and thorough underwriting and approval or decline of loan requests. The method used is a step process based on assigned lending limits. Approval process includes authority assigned to individual officers and an internal loan committee. Lending authority is also assigned to the Bank's Directors' Loan Committee to approve the Bank's largest credit relationships up to the legal lending limit of the Bank.
Credit Review personnel conduct continuous reviews to ensure the loan portfolio remains in compliance with our lending policies and safe and sound practices. They provide ongoing reporting to management regarding credit weakness and policy exceptions and economic and portfolio trends. Quarterly reports are prepared for submission to Senior Management, and the Director's Audit Committee, which details the levels of exceptions and follow-up corrective actions.
Certain problem loans are placed on a nonaccrual basis in conformance with defined policy. The Loan Committee and other administrative personnel regularly review information reports on adversely classified and delinquent loans. Comparative summaries of delinquent loans are also provided on a regular basis to senior management and to the Board of Directors.
Management performs and in dept analysis of the loan loss reserve four times a year and closely monitors the adequacy of the loan loss reserve. The allowance is maintained at a level deemed sufficient to meet estimated potential losses.
The reviews, examinations and actions described above are in addition to the periodic examinations by federal and state regulatory agencies, as well as the Bank's internal audit department and the Bank's outside public accounting firm.
RISK ELEMENTS - IMPAIRED ASSETS
NONACCRUING/IMPAIRED LOANS
Loans are placed on nonaccrual status when, in the opinion of management, the collection of additional interest is doubtful or when the loan becomes 90 or more days past due. When a loan is placed on nonaccrual status, all interest previously accrued, but not collected, is reversed and charged against interest income. Income on nonaccrual loans is then recognized only to the extent cash is received and where the future collection of principal is probable. Accruals are resumed only when the loan is brought current, and when, in the opinion of management, the borrower has demonstrated the ability to resume payments of principal and interest. Interest income on restructured loans is recognized pursuant to the terms of the new loan agreement. Interest income on other impaired loans is monitored and based upon the terms of the underlying loan agreement. However, the recorded net investment in impaired loans, including accrued interest, is limited to the present value of the expected cash flows of the impaired loan or the observable fair market value of the loan or the fair market value of the loan's collateral.
A loan is considered impaired when management determines it is probable that all contractual amounts of principal and interest will not be paid as scheduled in the loan agreement. These loans include all loans in nonaccrual, loans restructured, and other loans that management considers to be impaired.
This assessment for impairment occurs when and while such loans are on nonaccrual, or the loan has been restructured. When a loan with unique risk characteristics has been identified as being impaired, the amount of impairment will be measured by the Corporation. If the current value of the impaired loan is less than the recorded investment in the loan an impairment is recognized by creating or adjusting an existing allocation of the allowance for loan losses.
RESTRUCTURED LOANS
In cases where a borrower experiences financial difficulties and the Corporation makes certain concessionary modifications to the contractual terms, the loan is classified as a restructured (accruing) loan. Loans restructured at a rate equal to or greater than that of a new loan with comparable risk at the time of the contract is modified may be excluded from the impairment assessment and may cease to be considered impaired.
DELINQUENT AND PROBLEM LOANS
Delinquent and problem loans are a part of any lending enterprise. When a borrower fails to make payments, the Bank implements collection activities commencing with simple past due notices. This then progresses to phone calls and letters, followed by legal activity when and if necessary. At one month past due, the loan is tracked and reported as delinquent.
It is the Bank's practice to discontinue accruing interest on all loans that are delinquent 90 days or more regardless of risk of loss, collateral, etc. Some problem loans which are less than 90 days delinquent are also placed into nonaccrual status if the success of collecting additional interest is in doubt and some loans will remain in nonaccrual even after improved performance until a consistent timely payment pattern is exhibited and/or timely performance is considered to be reliable.
LEVELS OF, AND TRENDS IN, DELINQUENCIES AND NONACCRUALS
Nonperforming loans and other real estate decreased in 2005 to $4.9 million, from $14.1 million in 2004. Management monitors delinquencies monthly and reports are reviewed by the Board of Directors. Delinquencies for the commercial, personal, real estate and credit lines categories are charted separately. The current level of nonperforming assets represents a 65% decrease by dollar amount from the previous year.
The dollar amount of loans past due 90 days or more nonaccruing and other real estate owned as a percentage of total loans was .21%, .71%, and .61%, at year-end 2005, 2004, and 2003, respectively. These loans have a variety of situations, some of which may lead to foreclosure or involve a bankruptcy case and while some of these loans are in active legal collection processes, others are under active repayment plans and may continue payment as the borrower's financial situation improves.
Loans delinquent due 90 days or more or other nonaccruing, restructured and other real estate owned (OREO) on which the accrual of interest has been discontinued as of December 31st are as follows:
There are certain amounts of interest collected on nonaccrual loans that is included in income, and amounts that have not been accrued which are indicated in the following table:
(In Thousands) At December 31, 2005 2004 2003 2002 2001 - --------------- ---- ---- ---- ---- ----
Additional interest income which would have been recorded during the period under original terms of loans above $67 $925 $443 $1,400 $958
Interest collected and included in net income for the period $327 $350 $429 $774 $1,600
Commitments for additional funds related to loans above -0- -0- -0- -0- -0-
LOAN CHARGE OFF'S
It is the Bank's policy to aggressively review questionable loans for charge-off. The Bank adheres to all regulatory, accounting, and legal requirements in writing off loans.
OTHER REAL ESTATE OWNED (OREO)
OREO is carried at the lesser of book value or market value. The costs related to completion, repair, maintenance, or other costs of such properties, are generally expensed with any gains or shortfalls from the ultimate sale of OREO being shown as other income or expense.
The Bank had no OREO to report at year-end December 31, 2005 and 2004.
Certain other loans, currently in nonaccrual, are in the process of foreclosure and there is a likelihood these foreclosures will be completed and the loans will then become OREO. This is viewed as an ordinary part of the collection process and efforts are constantly underway to reduce and minimize such nonperforming assets.
The table below shows the carrying value of OREO at December 31st of the past five years:
(In Thousands) 2005 2004 2003 2002 2001 - -------------- ---- ---- ---- ---- ----
Other real estate owned - - $4,162 $6,532 $769
ALLOWANCE FOR LOAN LOSSES - QUALITATIVE FACTORS
The allowance for loan losses was $37.1 million, or 1.55% of loans at December 31, 2005. This compares to $32.7 million, or 1.65% at December 31, 2004, and $29.6 million, or 1.67% at December 31, 2003. Net charge-off's as a percentage of average loans was a net recovery of (.01%) in 2005, net charge-off's of .02% in 2004 and .17% in 2003. An improving economy, and positive credit performance trends, is reflected in year-end 2005 reserves of 1.55% and net recovery of $147 thousand. An uncertain economic environment and increasing delinquencies supported the higher loan loss reserve percentages for year-end 2003 and 2002.
The allowance for loan losses is the amount, which, in the opinion of management, provides adequate protection in the event of loan losses. This analysis is performed quarterly and reviewed by senior management to determine the adequacy of the reserve. The analysis takes into consideration current economic trends both on a national and local level. It includes careful consideration of delinquency rates and trends for all loan categories including commercial, personal and real estate related loans by geographic location.
Management and the Board review policies and procedures at least annually, and changes are made to reflect the current operating environment integrated with regulatory requirements. Partly out of these policies has evolved an internal credit risk review process. During this process the quality grade of loans are reviewed and loans are assigned a dollar value of the loan loss reserve by degree of risk. This analysis is performed quarterly and reviewed by senior management who makes the determination if the risk is reasonable, and if the reserve is adequate.
Another consideration is the volume and terms of loans. Management reviews the growth and terms of loans so that the allowance can be adjusted for current and anticipated future losses.
QUANTITATIVE FACTORS
The allowance for loan losses is the amount which, in the opinion of management, is necessary to absorb loan losses. Management's evaluation of the adequacy of the allowance is based on the market area served, local and national economic conditions, the growth and composition of the loan portfolio and the related risk characteristics, by continual review by management of the quality of the portfolio.
The Corporation has an active ongoing credit review function. When a loan has degradation in quality its internal rating is downgraded. An assessment of these loans is performed to determine whether it is appropriate to establish a specific allocation reserve or write down as directed by FAS 114, ACCOUNTING BY CREDITORS FOR IMPAIRMENT OF A LOAN. If appropriate, such allocation reserve or write down is made. For the remainder of these loans that which no specific allocation reserve or write down is necessary a background reserve is established. The background reserves are also reviewed quarterly to determine if the background reserve percentages are appropriate.
All other loans which have not been identified with degradation in quality have background reserves based upon our experience and information concerning actual industry losses by loan types.
Every quarter certain qualitative facts are evaluated to determine if certain adjustments are indicated for any of the background reserves established. This is accomplished through an internal narrative and the tracking of statistics including but not limited to unemployment rates, historical charge offs, job growth, effects of changing interest rates, housing starts, trends in volume and terms of loans, levels of, and trends in, delinquencies and nonaccruals, and other real estate owned trends.
Loan concentrations, quality, terms and basic underlying assumptions remained substantially unchanged during the period. The actual loan loss reserve as a percentage of total loans has declined over the last two years, mainly due to loan portfolio quality performance improvement.
SUMMARY OF LOAN LOSS EXPERIENCE
The following table provides an analysis of the allowance for loan losses and the net losses by loan type for the last five years and December 31:
ALLOCATION OF ALLOWANCE FOR LOAN LOSSES
Based on certain characteristics of the portfolio, potential losses can be anticipated for major loan categories. In the following table, the allowance for loan losses at year-end, for the last five years, has been allocated among major loan categories based primarily on their historical net charge-off experience, along with consideration of factors such as quality, volume, anticipated economic conditions and other business considerations.
Historical net charge-offs are not necessarily accurate indicators of future losses since net charge-offs vary from period to period due to economic conditions and other factors that cannot be accurately predicted. Thus, an evaluation based on historical loss experience within individual loan categories is only one of many factors considered by management in evaluating the adequacy of the overall allocation.
In addition, regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may require the Bank to change the allowance based upon their judgment at the time of their examination. It is the Bank's policy to be in compliance with all accounting and regulatory standards related to loan loss reserves and all accounting policies promulgated by GAAP.
Loan concentrations, quality, terms and basic underlying assumptions remained substantially unchanged during the period. The actual loan loss reserve as a percentage of total loans has declined over the last five years, mainly due to loan portfolio quality and performance improvements.
EFFECTS OF CHANGING INTEREST RATES
A review of the past 12 months shows that the tax equivalent net interest margin began the year 2005 at 5.32% (quarter ended December 31, 2004). The margin then declined to 5.12% for the first quarter but increased to 5.40% in the second quarter, increased in the third quarter to 5.56% and 5.80% for the fourth quarter. In 2005, the Corporation increased its key lending index 25 basis points in February, March, May, June, August, September, November and December. The improvement in the net interest margin was attributed to these rates changes. In 2004, the Corporation increased its key lending index 25 basis points in August, September, November and December. However, the improvement in the net interest margin was more attributed to continued decline in the cost of funds during the first three quarters of 2004. The Corporation dropped its key lending index 25 basis points in the third quarter 2003. The impact of these movements contributed to the narrowing of the margin in all but the fourth quarter 2003 and the second, third, and fourth quarters of 2004.
CONCENTRATIONS OF CREDIT
The most significant portion of the loan portfolio consists of real estate construction and land development loans. Loans within this category grew by $358.9 million or 59%. Continued demand for housing and favorable interest rated continued to fuel this growth. Real estate construction loans are generally composed of commitments to customers within our market area for construction purposes. Loans within this category are used for construction projects that range from residential and commercial land development to residential and commercial building projects. They are generally secured by first trust deeds with well-defined repayment sources following project completion. Maturities are set to match the time required for project completion, which typically run from 12 to 18 months depending on complexity. While the Bank has significant balances within this lending category, management believes that its lending policies and underwriting standards are sufficient to minimize risk even during these uncertain economic times. Management closely monitors the effects of current and expected market conditions and other factors that may influence the repayment of these loans.
The following chart indicates the amount of those loans, net of deferred fees, and as a percent of total loans for the period:
TRENDS IN VOLUME AND TERMS OF LOANS
Average loans for the year 2005 were $2.20 billion, representing an increase of $312.8 million, or 16.6% over the average balance for 2004. Average loans for the year 2004 were $1.89 billion, representing an increase of $196.5 million, or 11.6% over the average balance for 2003. In 2005, growth substantially increased over prior years increases mainly due to favorable market conditions and additional lending staff. Terms of loans have remained competitive and within policy guidelines.
CONCLUSION OF QUALITATIVE FACTORS
The allowance for loan losses is the amount, which, in the opinion of management, is necessary to absorb inherent loan losses regardless of source. Management's evaluation of the adequacy of the allowance is based on the market area served, local economic conditions, the growth and mix of the portfolio and their related risk characteristics. Based solely upon recent actual historical loan loss rates, the loan loss reserve may appear to be somewhat larger than might be necessary; however our analysis included important subjective factors that cause us to believe the reserve is adequate, but not unduly conservative.
OFF BALANCE SHEET ARRANGEMENTS
In the ordinary course of business, Frontier has entered into off-balance sheet financial instruments consisting of commitments for the extension of credit, credit card commitments, letter of credit commitments, home equity lines and standby letters of credit. These instruments are recorded in the financial statements only when they are funded or related fees are incurred or received. The following table summarizes the amount of commitments as of December 31, 2005:
(IN THOUSANDS) - -------------- Standby letters of credit $29,979 Credit card arrangements 31,917 Commitments to fund loans secured by real estate 810,736
Commitments to extend credit and letters of credit are written for one year, or have a call in one year. The fair value of these commitments is not material since they are for a short period of time and subject to customary credit terms. A fee is charged for all commitments to lend. Due to the Bank's underwriting policies, there have been no losses associated with these commitments.
DEPOSITS
For the average amount of deposits and rates paid on such deposits for years ended December 31, 2005, 2004, and 2003 please refer to page 44 of 2005 Annual Report to Shareowners.
Maturities of time certificates of deposit $100,000 and over at year-end 2005 are shown below:
(IN THOUSANDS) - -------------- 3 months or less $87,288 Over 3 months through 6 months 60,737 6 months through 12 months 211,453 Over 12 months 112,248 ---------- $471,726 ==========
The following table represents the noninterest and interest-bearing deposit accounts that will mature or reprice in one year or less as compared to the past year:
Although 72% of our time deposit portfolio will mature within the next year, we feel that cash flows are sufficient to support operations for the foreseeable future. Over the past year, we have had the ability to retain and grow each category of our deposit accounts. If liquidity was needed going forward, sources would consist of maturing securities, increased customer deposits or loan maturities. If need be, lines of credit are available or we could issue additional capital stock. Cash flows from operations also contribute significantly to liquidity needs.
BORROWINGS
SHORT-TERM BORROWINGS
For information regarding average balances and yields, please refer to page 44 of 2005 Annual Report to Shareowners.
ITEM 2
ITEM 2 - PROPERTIES
At December 31, 2005, the Bank had 44 offices, including the main office, all of which are located in the State of Washington. These offices are located in Arlington, Bainbridge Island, Bellingham, Bellingham Downtown, Bothell, Buckley, Duvall, Edmonds, Everett (4), Kent, Kirkland, Lake City, Lake Stevens, Lynden, Lynnwood, Marysville, Puyallup, Mill Creek, Milton, Monroe, Mount Vernon, Orting, Port Angeles, Port Hadlock, Port Townsend, Poulsbo (2), Redmond, Renton, Seattle (2), Sequim, Silverdale, Smokey Point, Snohomish, Stanwood, Sumner, Tacoma, Totem Lake and Woodinville. All of its branches are located on properties owned by FFP, Inc., a real estate holding subsidiary, except for the offices located in Bellingham Downtown (lease expires August 2009), Edmonds (lease expires July 2009), one office in Everett (lease expires October 2014), Lake Stevens (lease expires May 2011), Lynden (lease expires April 2010), Mill Creek (lease expires November 2010), Puyallup (building is owned, land lease expires 2009), Mount Vernon (building owned, land lease expires March 2023), Bainbridge Island (lease expires July 2012) Poulsbo (lease expires on October 2006 on one of the two branches there), Port Angeles (lease expires January 2019), Renton (lease expires April 2007), Seattle Metro (lease expires October 2013), Tacoma (lease expires September 2011), Totem Lake (lease expires June 2010) and Milton lease expires March 2007). FFP, Inc. also owns the building and land in South Everett and Sumner where Frontier Bank data processing and operations departments are located.
ITEM 3
ITEM 3 - LEGAL PROCEEDINGS
The Corporation is involved in ordinary routine litigation arising in the normal course of business. In the opinion of management, liabilities (if any) arising from such claims will not have a material effect on the business, results of operations or financial condition of the Corporation.
ITEM 4
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SHAREOWNERS
No matters were submitted to shareowners during the fourth quarter of 2005.
PART II
ITEM 5
ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREOWNER MATTERS
(a) Frontier Financial Corporation's common stock is traded on the Nasdaq market under the symbol FTBK. The table below indicates the high/low trading range of Frontier stock over the last eight quarters:
HIGH LOW ---- ---
1st quarter 2004 $23.46 $21.41 2nd quarter 2004 23.33 20.67 3rd quarter 2004 24.91 21.50 4th quarter 2004 27.67 23.10
1st quarter 2005 $26.67 $24.33 2nd quarter 2005 26.07 23.49 3rd quarter 2005 30.26 25.32 4th quarter 2005 33.49 26.00
(b) Frontier Financial Corporation has only one class of stock outstanding, which is common stock. At February 28, 2006 there were 30,002,122 shares outstanding.
(c) The table below indicates the cash dividends paid on each share of its common stock over the last two years:
DIVIDEND DECLARED RECORD DATE PAYMENT DATE ----------------- ----------- ------------ $.123 January 7, 2004 January 20, 2004 .127 April 12, 2004 April 26, 2004 .13 July 12, 2004 July 26, 2004 .133 October 12, 2004 October 25, 2004
.137 January 10, 2005 January 25, 2005 .14 April 11, 2005 April 25, 2005 .16 July 11, 2005 July 25, 2005 .165 October 11, 2005 October 24, 2005
(d) During the quarter ended December 31, 2005, there were no issuer repurchases of its equity securities.
ITEM 6
ITEM 6 - SELECTED FINANCIAL DATA
ITEM 7
ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Please see 2005 Annual Report to Shareowners, page 28 through 45.
ITEM 7A
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Please see 2005 Annual Report to Shareowners, pages 33-36 Please see this Form 10-K, pages 26-29.
ITEM 8
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Annual Form Report to 10-K Shareowners Page Page ---- ---- Report of Independent Registered Public Accounting Firm 1
Consolidated Balance Sheet at December 31, 2005 and 2004 2
Consolidated Statement of Income for the years Ended December 31, 2005, 2004 and 2003 3
Consolidated Statement of Shareowners' Equity 4
Consolidated Statement of Cash Flows for the Years ended December 31, 2005, 2004 and 2003 5
Condensed Balance Sheet (Parent Only) at December 31, 2005 and 2004 25
Condensed Statement of Income (Parent Only) for the Years Ended December 31, 2005, 2004 and 2003 25
Condensed Statement of Cash Flows (Parent Only) for Years Ended December 31, 2005, 2004 and 2003 26
Notes to Consolidated Financial Statements 6 - 27
ITEM 9
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A
ITEM 9A - CONTROLS AND PROCEDURES
The Corporation's management, including the Corporation's Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of its disclosure controls and procedures as of December 31, 2005. Based on this evaluation, the Chief Executive Officer and the Chief Financial Officer each concludes that as of December 31, 2005, the Corporation maintained effective disclosure controls and procedures in all material respects, including those to ensure that information required to be disclosed in reports filed or submitted with the SEC is recorded, processed, and reported within the time periods specified by the SEC, and is accumulated and communicated to management, including the Chief Executive Officer and the Chief Financial Officer, as appropriate to allow for timely decisions regarding required disclosure.
There has been no change in the Corporation's internal control over financial reporting in the period covered by this report that have materially affected, or are reasonably likely to affect, the Corporation's internal control over financial reporting.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of Frontier Financial Corporation and its subsidiaries ("the Corporation") is responsible for establishing and maintaining adequate internal control over financial reporting, and for performing an assessment of the effectiveness of internal control over financial reporting as of December 31, 2005. The Corporation's internal control over financial reporting is a process designed under the supervision of the Corporation's management, including the Chief Executive Officer and Chief Financial Officer, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.
The Corporation's system of internal control over financial reporting includes policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets of the Corporation; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States, and that receipts and expenditures of the Corporation are being made only in accordance with authorizations of Management and Directors of the Corporation; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Corporation's assets that could have a material effect on the financial statements.
Management recognizes that there are inherent limitations in the effectiveness of any system of internal control, and accordingly, even effective internal control can provide only reasonable assurance with respect to financial statements preparation and fair presentation. Further, because of changes in condition, the effectiveness of internal control may vary over time.
Under the supervision and with the participation of the Corporation's management, including the Corporation's Chief Executive Officer and Chief Financial Officer, the Corporation performed an assessment of the effectiveness of the Corporation's internal control over financial reporting as of December 31, 2004 based upon criteria in INTERNAL CONTROL - INTEGRATED FRAMEWORK issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). Based on this assessment, Management determined that the Corporation's internal control over financial reporting was effective as of December 31, 2005.
The Corporation's independent registered public accounting firm, Moss Adams LLP who audits the Corporation's consolidated financial statements, have issued an attestation report on Management's assessment and on the effectiveness of the Corporation's internal control over financial reporting.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING
See Report of Independent Registered Public Accounting Firm in Annual Report to Shareowners on page 1.
ITEM 9B
ITEM 9B - OTHER INFORMATION
Not applicable.
PART III
ITEM 10
ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF FRONTIER FINANCIAL CORPORATION
Biographical and business experience information about the directors and director nominees of FFC included in Frontier Financial Corporation's Proxy Statement for the Annual Meeting of Shareowners to be held on April 19, 2006 (the Proxy Statement) under the caption "Election of Directors" and the information incorporated by reference pursuant to Item 13 below are hereby incorporated herein by reference. Information on FFC's executive officers is also included in the Proxy Statement.
Information regarding FFC's Audit Committee included under the caption "Directors' Meetings, Committees and Compensation" of the Proxy Statement is hereby incorporated herein by reference.
Information regarding late filings under Section 16(a) of the Securities Exchange Act of 1934 included in the Proxy Statement under the caption "Section 16(a) Beneficial Ownership Reporting Compliance" is hereby incorporated herein by reference.
FFC's Code of Ethics for Senior Executive Officers ("Code of Ethics") is available at www.frontierbank.com, as discussed in "Available Information" above. FFC intends to disclose any amendments or waivers with respect to its Code of Ethics on its website at www.frontierbank.com.
ITEM 11
ITEM 11 - EXECUTIVE COMPENSATION
Information regarding compensation of directors and executive officers included under the caption "Compensation of Executives" of the Proxy Statement is hereby incorporated herein by reference. However, the information provided in the Proxy Statement under the headings "Report of the Compensation Committee of the Board of Directors on Executive Compensation" and "Five Year Performance Comparison" shall not be deemed to be "soliciting material" or to be "filed" with the Securities and Exchange Commission, subject to Regulation 14A or 14C, other than as provided in Item 402 of Regulation S-K, or subject to liabilities of Section 18 of the Securities Exchange Act of 1934.
ITEM 12
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREOWNER MATTERS
The information set forth under the caption "Share Ownership Information" in the Proxy Statement is hereby incorporated herein by reference.
ITEM 13
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information set forth in the Proxy Statement under the caption "Related Party Transactions and Business Relationships" is hereby incorporated herein by reference.
ITEM 14
ITEM 14 - PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information set forth in the Proxy Statement under the caption "Independent Auditors" is hereby incorporated herein by reference.
PART IV
ITEM 15
ITEM 15 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of the report:
1. Financial Statements
Financial statements required by Item 8 of this report are incorporated by reference, from the 2005 Annual Report to Shareowners.
3. Exhibits
(3)(a) Articles of Incorporation are incorporated herein by reference to Appendix A to the registrant's definitive Proxy Statement on Schedule 14A filed on March 20, 1998 (File No. 000-15540).
(3)(b) By-Laws are incorporated herein by reference to Exhibit 3(ii) to Form 10Q filed on October 29, 2003.
(10)(a) Amended and Restated Frontier Financial Corporation Incentive Stock Option Plan incorporated by reference to Exhibit 99.1 to Registration Statement on Form S-8, filed March 27, 1998 (File No. 333-48805).
(10)(b) Frontier Financial Corporation 1999 Employee Stock Award Plan is incorporated herein by reference to Exhibit 99.1 to Registration Statement on Form S-8, filed March 2, 1999 (File No. 333-73217).
(10)(c) Frontier Financial Corporation 2001 Stock Award Plan, is incorporated herein by reference to Exhibit 99.1 to Registration Statement on Form S-8, filed January 26, 2001, (File No. 333-54362).
(10)(d) Frontier Financial Corporation Employee Stock Option Plan and Interbancorp, Inc. Director Stock Option Plan, is incorporated herein by reference to Exhibit 10.1 to Registration Statement on Form S-8, filed January 26, 2001 (File No. 333-37242).
(10)(e) Interbancorp, Inc. Employee Stock Option Plan and Interbancorp, Inc. Director Stock Option Plan, is incorporated herein by reference to Exhibit 10.1 to Registration Statement on Form S-8, filed February 13, 2001 (File No. 333-50882).
(11) Statement Regarding Computation of Earnings Per Share.
(13) Annual Report to Shareowners for the year ended December 31, 2005, is incorporated herein by reference to the Annual Report on Schedule 14A, filed March 14, 2006.
(21) Subsidiaries of Registrant are incorporated by reference to Part I, pages 1 - 32 of this report.
(23.1) Consent of Moss Adams LLP, independent registered public accounting firm.
(31.1) Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act.
(31.2) Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act.
(32.1) Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act.
(32.2) Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act.
(32) Certification pursuant to 28 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
FRONTIER FINANCIAL CORPORATION MARCH 14, 2006 /S/ JOHN J. DICKSON - ----------------------- ------------------------------------- John J. Dickson President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
MARCH 14, 2006 /S/ JOHN J. DICKSON - ----------------------- -------------------------------------------- John J. Dickson President and Chief Executive Officer (Principal Executive Officer)
MARCH 14, 2006 /S/ CAROL E. WHEELER - ----------------------- -------------------------------------------- Carol E. Wheeler Chief Financial Officer (Principal Financial and Accounting Officer)
MARCH 14, 2006 /S/ GEORGE E. BARBER - ----------------------- -------------------------------------------- George E. Barber, Director
MARCH 14, 2006 /S/ MICHAEL J. CLEMENTZ - ----------------------- -------------------------------------------- Michael J. Clementz, Director
MARCH 14, 2006 /S/ DAVID M. CUTHILL - ----------------------- -------------------------------------------- David M. Cuthill, Director
MARCH 14, 2006 /S/ LUCY DEYOUNG - ----------------------- -------------------------------------------- Lucy DeYoung, Director
MARCH 14, 2006 /S/ JOHN J. DICKSON - ----------------------- -------------------------------------------- John J. Dickson, Director
MARCH 14, 2006 /S/ ROBERT J. DICKSON - ----------------------- -------------------------------------------- Robert J. Dickson, Chairman of the Board
MARCH 14, 2006 /S/ PATRICK M. FAHEY - ----------------------- -------------------------------------------- Patrick M. Fahey, Director
MARCH 14, 2006 /S/ EDWARD D. HANSEN - ----------------------- -------------------------------------------- Edward D. Hansen, Director & Secretary of the Board
MARCH 14, 2006 /S/ WILLIAM H. LUCAS - ----------------------- -------------------------------------------- William H. Lucas, Director
MARCH 14, 2006 /S/ JAMES H. MULLIGAN - ----------------------- -------------------------------------------- James H. Mulligan, Director
MARCH 14, 2006 /S/ WILLIAM J. ROBINSON - ----------------------- -------------------------------------------- William J. Robinson, Director
MARCH 14, 2006 /S/ EDWARD C. RUBATINO - ----------------------- -------------------------------------------- Edward C. Rubatino, Director
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MARCH 14, 2006 /S/ DARRELL J. STORKSON - ----------------------- -------------------------------------------- Darrell J. Storkson, Director
MARCH 14, 2006 /S/ MARK O. ZENGER - ----------------------- -------------------------------------------- Mark O. Zenger, Director
EXHIBIT INDEX
The following is a list of exhibits including items incorporated by reference. Compensatory plans and arrangements are identified by an asterisk.
The following documents are filed as part of the report:
1. Financial Statements
Financial statements required by Item 8 of this report are incorporated by reference, from the 2005 Annual Report to Shareowners.
3. Exhibits
(3)(a) Articles of Incorporation are incorporated herein by reference to Appendix A to the registrant's definitive Proxy Statement on Schedule 14A filed on March 20, 1998 (File No. 000-15540).
(3)(b) By-Laws are incorporated herein by reference to Exhibit 3(ii) to Form 10Q filed on October 29, 2003.
*(10)(a) Amended and Restated Frontier Financial Corporation Incentive Stock Option Plan incorporated by reference to Exhibit 99.1 to Registration Statement on Form S-8, filed March 27, 1998 (File No. 333-48805).
*(10)(b) Frontier Financial Corporation 1999 Employee Stock Award Plan is incorporated herein by reference to Exhibit 99.1 to Registration Statement on Form S-8, filed March 2, 1999 (File No. 333-73217).
*(10)(c) Frontier Financial Corporation 2001 Stock Award Plan, is incorporated herein by reference to Exhibit 99.1 to Registration Statement on Form S-8, filed January 26, 2001, (File No. 333-54362).
*(10)(d) Frontier Financial Corporation Employee Stock Option Plan and Interbancorp, Inc. Director Stock Option Plan, is incorporated herein by reference to Exhibit 10.1 to Registration Statement on Form S-8, filed January 26, 2001 (File No. 333-37242).
*(10)(e) Interbancorp, Inc. Employee Stock Option Plan and Interbancorp, Inc. Director Stock Option Plan, is incorporated herein by reference to Exhibit 10.1 to Registration Statement on Form S-8, filed February 13, 2001 (File No. 333-50882).
(11) Statement Regarding Computation of Earnings Per Share.
(13) Annual Report to Shareowners for the year ended December 31, 2005, is incorporated herein by reference to the Annual Report on Schedule 14A, filed March 14, 2006.
(21) Subsidiaries of Registrant are incorporated by reference to Part I, pages 1 - 32 of this report.
(23.2) Consent of Moss Adams LLP, independent auditors.
(31.1) Certification of Chief Executive Officer.
(31.2) Certification of Chief Financial Officer.
(32) Certification pursuant to 28 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act.