Item 1. Business - -----------------
General - -------
Horizon Financial Corp. ("Horizon Financial"or the "Corporation") was formed under Washington law on May 22, 1995, and became the holding company for Horizon Bank ("Horizon Bank" or the "Bank"), effective October 13, 1995. At March 31, 2007, the Corporation had total assets of $1.3 billion, total deposits of $975.3 million and total equity of $123.9 million. The Corporation's business activities generally are limited to passive investment activities and oversight of its investment in the Bank. Accordingly, the information set forth in this report, including consolidated financial statements and related data, relates primarily to the Bank and its subsidiary.
The Bank was organized in 1922 as a Washington State chartered mutual savings and loan association and converted to a federal mutual savings and loan association in 1934. In 1979, the Bank converted to a Washington State chartered mutual savings bank, the deposits of which are insured by the Federal Deposit Insurance Corporation ("FDIC"). On August 12, 1986, the Bank converted to a Washington state chartered stock savings bank under the name "Horizon Bank, a savings bank." Effective March 1, 2000, the Bank changed its name to its current name, "Horizon Bank." The Bank became a member of the Federal Home Loan Bank ("FHLB") of Seattle in December 1998. Effective August 1, 2005, the Bank converted from a Washington chartered savings bank organized under Title 32 of the Revised Code of Washington ("RCW") to a Washington chartered commercial bank organized under Title 30 of the RCW.
The Bank's operations are conducted through 19 full-service office facilities, four commercial loan centers, and four real estate loan centers, located in Whatcom, Skagit, Snohomish, and Pierce counties in Northwest Washington. The Bank opened commercial banking/loan centers in Bellingham and Everett, Washington, and expanded its operations in Burlington, Washington during the first quarter of fiscal 2004. In November 2004, the Bank opened a full service office in Marysville, Washington. In April 2005, the Bank opened a full service office in Lakewood, Washington, located in Pierce County, just south of Tacoma. The Bank opened a full service regional facility in June 2006, which replaced the Bank's existing office and commercial banking center in south Everett. During the third quarter of fiscal 2007, the Bank entered into a lease agreement to open a branch in Puyallup, Washington which opened in June of 2007 to expand its presence in Pierce County.
Lending Activities - ------------------
General. The Bank's loan portfolio, net totaled $1.1 billion at March 31, 2007, representing approximately 83% of its total assets. On that date, 11.7% of net loans receivable consisted of loans secured by mortgages on one-to- four family residential properties, 5.0% consisted of loans secured by mortgages on multi-family residential properties, and 80% consisted of construction and land development loans, commercial loans and commercial real estate loans. The balance of the Bank's outstanding loans at that date consisted of secured and unsecured consumer loans and loans secured by savings deposits.
The Bank originates both fixed rate and adjustable rate mortgages ("ARMs") secured by residential, business, and commercial real estate.
The Bank has no significant concentration of credit risk other than that a substantial portion of its loan portfolio is secured by real estate located in the Bank's primary market area, which the Bank considers to be Whatcom, Skagit, Snohomish and Pierce counties in Washington. This concentration of credit risk could have a material adverse effect on the Bank's financial condition and results of operations to the extent there is a material deterioration in the counties' economic and real estate values.
In order to enable it to make the yields on its loan portfolio and investments more interest rate sensitive, the Bank has implemented a number of measures. Those measures include the: (i) origination of long-term, fixed-rate mortgage loans when such loans are written to specifications promulgated by the Federal Home Loan Mortgage
Corporation ("Freddie Mac") and qualify for sale in the secondary market, (ii) origination of ARM loans on residential and commercial properties subject to market conditions, (iii) origination of variable rate commercial and consumer loans, and (iv) increased emphasis on originating shorter term loans for its portfolio, and selling much of its long-term mortgage loan production into the secondary market.
The following table provides selected data relating to the composition of the Bank's loan portfolio by type of loan at the dates indicated. The changes represented in the table below reflect the changes in the Bank's lending strategies, which began in 1999 when the Bank shifted its focus from a traditional thrift institution to that of a community commercial bank. As part of this shift in strategy, the Bank began selling much of its one-to-four family loan production into the secondary market on a servicing released basis. In addition, as repayments were received on its one-to-four family loan portfolio, the funds were used to support the growth in the commercial loan categories, as shown in the table below.
Loan Maturity. The following table sets forth certain information at March 31, 2007 regarding the dollar amount of loans maturing in the Bank's portfolio based on their contractual terms to maturity. Demand loans and overdrafts are reported as due in one year or less. Loan balances are net of undisbursed loan proceeds, unearned discounts, unearned income and allowance for loan losses.
Due After Due Within 1 Through Due Over 1 Year 5 Years 5 Years After March After March After March 31, 2007 31, 2007 31, 2007 Total ----------- ----------- ----------- ------ (In thousands) Commercial, commercial real estate, multi- family, construction and land development.... $676,995 $165,644 $ 39,826 $ 882,465 One-to-four family construction............ -- -- 28,576 28,576 One-to-four family residential, home equity, and other consumer loans.......... 67,562 33,869 42,398 143,829 -------- -------- -------- ---------- Total.................. $744,557 $199,513 $110,800 $1,054,870 ======== ======== ======== ==========
The following table sets forth the dollar amount of all loans due after one year after March 31, 2007 which have fixed interest rates and have floating or adjustable interest rates. Loan balances do not include undisbursed loan proceeds, unearned discounts, unearned income, and allowance for loan losses.
Adjustable Fixed Rates Rates Total ----------- ---------- ---------- (In thousands) Commercial, commercial real estate, multi-family construction and land development....................... $ 73,965 $ 131,505 $ 205,470 One-to-four family construction.... 28,576 -- 28,576 One-to-four family residential, home equity, and other consumer loans.. 50,915 25,352 76,267 ---------- --------- ---------- Total............................ $ 153,456 $ 156,857 $ 310,313 ========== ========= ==========
Multi-Family, and Commercial Real Estate Lending. Commercial real estate loans, including multi-family, totaled $344.9 million, or 32.7% of net loans receivable at March 31, 2007. The Bank originates commercial real estate loans primarily secured by owner-occupied business facilities, apartment buildings, warehouses, mini-storage facilities, industrial use buildings, office and medical office buildings, hospitality facilities, commercial land development and retail shopping centers located in its market area. Commercial real estate loans typically range in principal amount from $500,000 to $10.0 million. At March 31, 2007, the largest commercial real estate loan on one property had an outstanding balance of $17.0 million and is secured by a destination resort and surrounding real estate located in the Bank's market area. This loan was performing according to its terms at March 31, 2007. At March 31, 2007, the Bank had two other loans with net balances in excess of $10.0 million, which are secured by commercial real estate.
Commercial adjustable rate mortgage loans are originated with variable rates which generally adjust annually after an initial period ranging from one to five years. These adjustable rate mortgage loans have generally utilized Prime or FHLB Advance Rates as indices, with principal and interest payments fully amortizing over terms of 15 to 25 years, and are generally due in ten years. The Bank has also originated fixed rate commercial loans due in five to 10 years, (with amortization terms of ten to 25 years), along with 15 year fully amortizing loans. Commercial loans originated with interest rates fixed for the initial three, five and ten year terms generally contain prepayment penalties during their fixed rate period ranging from 1.0% to 5.0% of the loan's outstanding balance.
The Bank requires appraisals or evaluations on all properties securing commercial real estate loans. The Bank considers the quality and location of the real estate, the credit of the borrower, the cash flow of the project and the quality of management involved with the property. The Bank generally imposes a minimum debt coverage ratio of approximately 1.20 times for originated loans secured by income producing commercial properties. The Bank generally obtains loan guarantees from financially capable parties based on a review of personal financial statements, or if the borrower is a corporation, the Bank also generally obtains personal guarantees from corporate principals based on a review of the principals personal financial statements.
Commercial real estate lending affords the Bank an opportunity to receive interest at rates higher than those generally available from one-to-four family residential lending. However, loans secured by such properties usually are greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater degree of risk than one-to-four family residential mortgage loans. Because payments on loans secured by commercial properties often depend upon the successful operation and management of the properties, repayment of such loans may be affected by adverse conditions in the real estate market or the economy. The Bank seeks to minimize these risks by limiting the maximum loan-to-value ratio to 80% and carefully reviewing the financial condition of the borrower, the quality of the collateral and the management of the property securing the loan. The year-over-year decline in the commercial real estate portfolio is attributable to the Bank's desire to focus its efforts on the more profitable adjustable rate construction and land developments loans. Due to the Bank's commitment to its pricing and profitability targets, the balances in the commercial real estate and multi-family loan portfolio declined in this aggressively priced arena during the year.
Construction and Land Development Loans. Construction lending provides the Bank the opportunity to achieve higher interest rates and fees with shorter terms to maturity than does its other real estate lending activities. Construction lending, however, generally involves a higher degree of risk than permanent financing for a finished residence or commercial building, because of the inherent difficulty in estimating both the estimated cost of the project and the property's value at completion. If the estimated cost of construction proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to complete the project.
The nature of these loans is such that they are generally more difficult to evaluate and monitor. To address this risk, and because of the level of construction loans in the Bank's portfolio, the Bank has personnel dedicated specifically to monitoring the progress of its construction projects, and making on-site inspections of the property. In addition, in an effort to monitor the available inventory in its markets, the Bank also regularly reviews the overall building and development activity in its markets. Also, to mitigate the risks related to construction lending, the Bank primarily deals with experienced builders, with acceptable credit histories, sound financial statements, and a proven track record in the industry. In addition, the Bank utilizes the services of experienced inspectors to monitor the progress and draw process in the more complex construction projects. The Bank also has an experienced appraisal staff, and members of senior management with related appraisal education and experience, who review each appraisal utilized by the Bank in analyzing prospective construction projects. Finally, members of the Bank's senior management and loan committees also have a significant amount of experience in the areas of construction lending, appraisals, and loan underwriting, further mitigating the Bank's risk in this area.
The Bank actively originates construction loans through both its Mortgage Loan Division and its Commercial Loan Division. The Bank's Mortgage Loan Division generally oversees the single family custom construction loans, and to a lesser extent, speculative construction loans (i.e., loans for homes that do not have a contract with a buyer for the purchase of the home upon completion of the construction) to smaller contractors building a limited number of speculative homes per year. These construction loans are further broken down in the first two lines of the table below (speculative construction one-to-four family and custom construction one-to-four family). The Bank's Commercial Lending Division is responsible for the speculative construction projects for the Bank's larger builders (including large one-to-four family developments), in addition to the Bank's multi-family construction loans, non-residential commercial construction loans, and the Bank's land development loans.
At March 31, 2007 and 2006, the composition of the Bank's construction loan portfolio was as follows:
At March 31, ---------------------------------------------- 2007 2006 -------------------- --------------------- Amount (1) Percent Amount (1) Percent --------- ------- --------- ------- (Dollars in thousands) Speculative construction one- to-four family............... $ 13,694 3.16% $ 8,675 3.10% Custom/presold construction one-to-four family........... 14,882 3.43 12,296 4.30 Commercial/speculative construction one-to-four family....................... 177,602 40.93 95,534 33.70 Commercial construction multi family................. 6,986 1.61 6,927 2.40 Commercial construction- nonresidential............... 84,417 19.45 56,328 19.90
Land development.............. 136,343 31.42 103,569 36.60 --------- ------ --------- ------ Total........................ $ 433,924 100.00% $ 283,329 100.00% ========= ======= ========= ======= - --------- (1) Includes loans in process.
Speculative construction one-to-four family loans increased 57.9% from the prior year to $13.7 million at March 31, 2007. These loans are made to home builders who generally build one or two speculative construction homes per year, and the increased activity in this period was a result of an active real estate market in the Bank's markets. Because of the nature of these loans, a buyer for these homes is found by the builder either during the construction phase or shortly after completion of the home's construction. If a buyer is not found in a timely manner, the builder will incur additional interest, marketing and other expenses until the home is sold. As a result, these loans carry a higher degree of risk than loans on homes already completed and custom construction loans (discussed below) for which there is a buyer.
Custom construction for one-to-four family loans increased 21.0% from the prior year to $14.9 million at March 31, 2007. Unlike speculative construction loans, custom construction loans are made to customers who have entered into a contract with a builder to build them a custom home. The construction portion of these loans are generally for a period of one year or less, and the Bank generally commits to the long-term take-out financing for the customer at the time the construction loan is originated. As a result, the risk for custom construction loans is generally less than for speculative construction loans.
Commercial speculative construction one-to-four family residential loans increased 85.9% from the prior year to $177.6 million at March 31, 2007. Commercial speculative construction loans include loans made to the Bank's larger contractors, who build a significant number of speculative construction one-to-four family homes each year. The Bank has established relationships with experienced builders in this regard, which, along with an active residential market in the Pacific Northwest, resulted in this significant year over year growth in this portion of the Bank's construction portfolio. The Bank generally limits the loan to value to 85% of the discounted value of the completed dwellings, and further manages its risk by limiting the number of homes that can be under construction at any one time, when appropriate.
The commercial construction multi-family portion of the Bank's portfolio increased 0.09% from the prior year, to $7.0 million at March 31, 2007, and is the smallest portion of the Bank's construction portfolio at this time. This is primarily because the Bank's relationships are more heavily concentrated with one-to-four family contractors and developers than multi-family contractors at this time. These loans are generally for the construction of apartment units in the Bank's primary market areas.
Non-residential commercial construction loans increased 49.9% from the prior year to $84.4 million at March 31, 2007. These loans are made for a variety of non-residential real estate properties, including but not necessarily limited to the retail properties, owner occupied commercial real estate, office space, mini-storage facilities, hospitality related uses, and other non-residential uses. These loans are generally made to the ultimate end user of the property (i.e., these loans are more similar to custom construction than speculative construction loans). However, as a result of the inherent risks noted above, these loans carry higher risks than completed properties. Non-residential commercial construction loans receive the same degree of monitoring by the Bank as other construction loans contained in the Bank's loan portfolio, to mitigate the inherent risks of these loans.
Land development loans increased 31.6% from the prior year, to $136.3 million at March 31, 2007. This has been a significant part of the Bank's strategy in each of its markets, and fiscal 2007 was a successful year of growth in this category. Most of these loans carry interest rates tied to Prime, which allows the Bank to fund the loans profitability with short-term borrowings. In addition to the Bank's extensive experience in this area (see the discussion regarding the Bank's subsidiary, Westward Financial Services, contained in the section entitled "-- Real Estate Development Subsidiary), the Bank has continued to expand its expertise by hiring additional members of senior management dedicated to monitoring this portion of the Bank's lending activities. In addition, the Bank has developed relationships with some of the area's strongest real estate developers, which has played a significant part of the Bank's success in this area. This, however, does not mitigate the inherent risks in this type of lending. While the Bank generally limits its exposure to 75% of the discounted value of the completed lots, it can take a year or more to complete a large development, therefore increasing the risk to the Bank and its valuations used at the time the loan is closed. During the period from the time the loan is closed until the lots are developed, the market conditions can change significantly, exposing the Bank to additional risks in the event the lots can not ultimately be sold at or near the values estimated at the time of the appraisal. The Bank's management regularly monitors the housing demand in its markets, the anticipated supply of building lots, absorption rates, home and finished lot prices, and related measures in its efforts to mitigate this risk. However, no assurances are made that these or other measures can or will fully mitigate such risks.
In addition, since the vast majority of the Bank's construction loan activity is concentrated in the Pacific Northwest, an economic downturn in this area could have a significant impact on the Bank's performance, especially in these higher risk construction lending categories.
Commercial Loans. The Bank's loan portfolio also includes a wide range of commercial loans to small and medium sized businesses. This portfolio presently includes lines of credit with floating rates and maturities of one year or less and term loans for the purchase of equipment, real estate and other operating purposes with maturities generally not exceeding ten years. These loans are secured by a variety of business assets including equipment, real estate, accounts receivable and inventory. These types of loans constituted $146.3 million, or approximately 13.9% of the Bank's net loan portfolio at March 31, 2007. Under certain conditions, the Bank also offers unsecured credit to qualified borrowers.
Commercial lending carries increased risks compared to residential mortgage lending due to the heavy reliance upon the future income of the borrower and the uncertain liquidation value of the collateral. In the event of default, the liquidation of collateral is often insufficient to cover the outstanding debt. To mitigate these inherent risks, the Bank combines a conservative lending policy with experienced lending personnel responsible for the ongoing management and monitoring their assigned accounts.
One-to-Four Family Residential Loans. In the past, a significant lending activity of the Bank was the granting of conventional loans to enable borrowers to purchase existing homes or construct new homes. The Bank's real estate loan portfolio also includes loans on two-to-four family dwellings, and loans made to purchase or refinance improved buildings to be used for residential housing. At March 31, 2007, approximately 11.7% of the Bank's net loans receivable consisted of loans secured by one-to-four residential real estate.
The Bank's lending practices generally limit the maximum loan-to-value ratio on one-to-four family residential mortgage loans to 97% of the appraised value as determined by an independent appraiser, with the condition that private mortgage insurance generally be required on any home loans with loan-to-value ratios in excess of 80% of the appraised value. The Bank places this insurance with carriers approved by the Freddie Mac. The coverage generally limits the Bank's exposure to 72% of the loan amount. If private mortgage insurance is required, the borrower pays the premium at loan closing and any recurring premiums through an escrow reserve account established with the Bank for such period of time as the Bank requires the insurance coverage to be in force.
The Bank presently originates both fixed-rate and ARMs secured by one-to-four family properties with a loan term not exceeding 30 years. Under certain conditions, ARM borrowers are allowed to convert to a fixed rate loan beginning on the first interest rate change date and ending on the fifth interest rate change date from the date of the loan note. In addition, certain consumer safeguards are built into the ARM instruments used by the Bank. These safeguards include limits on annual and lifetime interest rate adjustments. The Bank generally originates these loans in accordance with guidelines established by the secondary market.
Consumer Loans. The Bank makes a variety of loans for consumer purposes. Included among these are home equity loans, home equity lines of credit, loans secured by personal property, such as automobiles, boats, and other vehicles, loans secured by deposit accounts, unsecured loans, and loans for mobile homes located in mobile home parks.
Horizon Bank offers consumer loans in order to provide a wider range of financial services to its customers and to achieve shorter terms and higher interest rates normally typical of such loans. At March 31, 2007, the Bank held $50.3 million of consumer loans or 4.8% of net loans receivable, approximately $3.4 million of which is unsecured.
Consumer loans entail greater risk than do residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciating assets such as automobiles, boats and other vehicles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount that can be recovered on such loans.
Consumer loans are made based on an evaluation of the borrower's creditworthiness, including income, other indebtedness, and satisfactory credit history, and the value of the collateral. Designated officers of the Bank or members of the Bank's Loan Committee approve consumer loan requests.
Secured loan amounts typically do not exceed 90% of the value of the collateral, or 90% of the appraised value of the residence in the case of home equity loans.
Loan Solicitation and Processing. The primary sources for loan originations are attributable to deposit customers, current borrowers, walk-in customers, and referrals from existing customers, real estate agents, real estate developers, and builders. The Bank does not actively utilize mortgage brokers in the origination of loans.
The Bank accepts completed loan applications from all of its offices and processing is substantially centralized. Detailed information is obtained to determine the creditworthiness of the borrower and the borrower's ability to repay. Significant items appearing on the loan applications and accompanying material are verified through the use of written credit reports, financial statements, and confirmations. After analysis of the loan application, supporting documents and the property to be pledged as loan security, including an appraisal of the property by either a staff appraiser or an independent fee appraiser, the application is forwarded to the Bank's Loan Committee. Loan approval requires the signatures of two or three members of the Loan Committee depending on the size of the loan. The Loan Committee consists of officers of the Bank who are appointed by the Bank's Board of Directors. The Bank generally requires its mortgage notes to be co-signed individually by the principals on loans made to entities other than natural persons. Certain lending personnel have been given limited loan approval authority by the Board of Directors.
Loan assumption requests of adjustable rate loans are handled by the Bank in a manner similar to new loan requests. Secondary market standards are generally applied to each request and full credit underwriting is required. For fixed rate loans, a sale or transfer of the secured property generally results in the Bank enforcing its due on transfer rights contained in the mortgage instrument.
Loan Originations, Purchases and Sales. Currently, the Bank emphasizes the origination of 15 to 30 year fixed rate loans on terms and conditions which will permit them to be sold in the secondary market, while originating ARM loans and shorter term fixed-rate loans for its own portfolio.
In addition to originating loans, Horizon Bank may purchase real estate loans in the secondary market. The Bank's purchases in the secondary market depend upon the demand for mortgage credit in the local market area and the inflow of funds from traditional sources. Loan purchases enable the Bank to utilize funds more quickly, particularly where sufficient loan demand is not obtainable locally.
The Bank is a qualified servicer for both Freddie Mac and Federal National Mortgage Association ("Fannie Mae"). The Bank's general practice is to close its fixed-rate, one-to-four family residential loans on Freddie Mac loan documents in order to facilitate future sales to Freddie Mac as well as to other institutional investors. From time to time, depending upon interest rates and economic conditions, the Bank has sold participation interests in loans in order to provide additional funds for lending, to generate servicing fee income and to decrease the dollar amount of its intermediate and long-term fixed-rate loans. The sale of loans in the secondary mortgage market reduces the Bank's interest rate risk and allows the Bank to continue to make loans during periods when deposit flows decline or funds are otherwise unavailable for lending purposes. As of March 31, 2007, the Bank was servicing loans for others aggregating approximately $55.0 million for which it generally receives a fee payable monthly of 0.25% to 0.375% per annum of the unpaid balance of each loan. In February 2001, the Bank began selling much of its current loan production on a servicing released basis, and plans to continue doing so for many of the long-term fixed rate loan originations. All sales of loan interests by the Bank are made without right of recourse to the Bank by the buyer of the loan interests in the event of default by the borrower.
The Bank also buys and sells portions of commercial loans through participations with other financial institutions. As of March 31, 2007, the Bank was servicing commercial loans for others aggregating approximately $71.0 million for which it generally receives a fee payable monthly of 0.25% to 0.375% per annum of the unpaid balance of
each loan. The Bank has numerous options in this regard, and will continue to buy and sell, loan participations to assist its liquidity, concentration and diversification efforts.
Loan Commitments. The Bank is a party to financial instruments with off-balance-sheet risk (loan commitments) made in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. Loan commitments involve, to varying degrees, elements of credit and interest- rate risk in excess of the amount recognized in the balance sheet. The contract amounts of those commitments reflect the extent of the Bank's exposure to credit loss from these commitments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Because many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment and commercial properties.
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. Except for certain long-term guarantees, the majority of guarantees expire in one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral supporting those commitments, for which collateral is deemed necessary, generally amounts to 100% of the commitment amount at March 31, 2007.
The following is a summary of the off-balance-sheet financial instruments or contracts outstanding as of the dates indicated.
At March 31, ------------------------- 2007 2006 ----------- ----------- (In thousands)
Commitments to extend credit.................. $383,458(1) $286,188 Credit card arrangements...................... 10,105 9,775 Standby letters of credit..................... 3,056 5,237
- --------- (1)The increase in commitments to extend credit at March 31, 2007 was the result of growth in the Bank's construction and land development loan portfolio.
Loan Origination and Other Fees. In addition to interest earned on loans, the Bank receives fees for originating loans. Loan origination fees are a percentage of the principal amount of the mortgage loan which are charged to the borrower at the closing of the loan.
The Bank's loan origination fees are generally 0% to 2.5% on conventional residential mortgages and 0% to 2.0% for commercial real estate loans. The total amount of deferred loan origination fees and unearned discounts at March 31, 2007 was $5.1 million. Any unamortized loan fees are recognized as income at the time the loan is sold, paid down or paid off.
Income from loan origination and commitment fees varies with the volume and type of loans and commitments made and purchased and with competitive conditions in mortgage markets, which in turn responds to the demand for and availability of money. The Bank experiences an increase in loan fee income and other fee income, such as appraisal and loan closing fees, during periods of low interest rates because of the resulting demand for mortgage loans. The Bank also receives other fees and income from charges relating to existing loans, which include late charges, and fees collected in connection with a change in terms or other loan modifications. These fees and charges have not constituted a material source of income.
Loan Modifications. The Bank offers a loan modification program to assist existing customers who are considering refinancing their home loans. For a fee the Bank will modify customers' loans under the program. No new principal is required and only the interest rate and payment amounts are changed. All other terms and conditions remain the same. In fiscal 2007, the Bank modified $12.0 million of real estate loans, compared to $5.2 million during fiscal 2006 when interest rates were lower and there was greater refinance activity.
Delinquent Loans, Loans in Foreclosure and Foreclosed Property. Loans are defined as delinquent when any payment of principal and/or interest is past due. While the Bank generally is able to work out a satisfactory repayment schedule with a delinquent borrower, the Bank will undertake foreclosure proceedings if the delinquency is not otherwise resolved within 90 days. Property acquired by the Bank as a result of foreclosure or by deed in lieu of foreclosure is classified as "real estate owned" until such time as it is sold or otherwise disposed of. As of March 31, 2007 there were no loans in the loan portfolio over 90 days delinquent and five loans on non-accrual status. The Bank had one real estate owned at March 31, 2007. Total non-performing assets represented $1.0 million or 0.07% of total assets at March 31, 2007 compared to $1.2 million or 0.10% of total assets at March 31, 2006.
The following table sets forth information with respect to the Bank's non-performing assets at the dates indicated.
At March 31, --------------------------------------------- 2007 2006 2005 2004 2003 ------- ------- ------- ------ ------ (Dollars in thousands)
Non-accrual loans......... $ 226 $ 1,161 $ 1,481 $ -- $ 242 Loans 90 days or more delinquent and accruing interest................. -- -- -- 339 350 Restructured loans........ -- -- -- -- -- Real estate acquired through foreclosure.............. 725 -- -- 63 1,072 ------- ------- ------- ------ ------ Total.................... $ 951 $ 1,161 $ 1,481 $ 402 $1,664 ======= ======= ======= ====== ====== As a percentage of net loans.................... 0.02% 0.13% 0.18% 0.06% 0.29% As a percentage of total assets................... 0.07% 0.10% 0.15% 0.05% 0.20%
Additional interest income which would have been recorded had nonaccruing loans been current in accordance with their original terms was considered immaterial as of March 31, 2007. No interest income was recorded on nonaccrual loans for the year ended March 31, 2007.
Potential Problem Loans. At March 31, 2007, the Bank had identified loans totaling $4.1 million which were considered impaired. These loans are to one agricultural borrower where known information about possible credit problems, causes management to have doubts as to the ability to comply with present loan repayment terms.
Reserves for Losses. The Bank has an active ongoing credit review function. The provision for loan losses is maintained at a level sufficient to provide for probable loan losses based on evaluating known and inherent risks in the loan portfolio. These factors include changes in the size and composition of the loan portfolio, actual loan loss experience, historical industry loan loss experience, current and anticipated economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. The reserve is based upon factors and trends identified by management at the time financial statements are prepared, but the ultimate recovery of loans is susceptible to future market factors beyond the Bank's control, which may result in losses or recoveries differing significantly from those provided for in the financial statements.
The Bank maintains an allowance for credit losses sufficient to absorb losses inherent in the loan portfolio. The Bank has established a systematic methodology to ensure that the allowance is adequate. The Bank reviews the following information, on a quarterly basis, to estimate the necessary additions to its loan loss reserve:
* All loans classified during the previous analysis. Current information as to payment history, or actions taken to correct the deficiency are reviewed, and changes are made, as appropriate. If conditions have
not improved, the loan classification is reviewed to ensure that the appropriate action is being taken to mitigate loss.
* All loans past due on scheduled payments. The Bank reviews all loans that are past due 30 days or more, taking into consideration the borrower, nature of the collateral and its value, the circumstances that have caused the delinquency, and the likelihood of the borrower correcting the conditions that have resulted in the delinquent status.
* Composition of the Bank's portfolio. The Bank also analyzes its mix of loans when establishing appropriate allowances for loan losses. For example, reserves for losses on the Bank's one-to-four family mortgage portfolio (on a percentage basis) are lower than the percentage reserve estimates for commercial or credit card loans. Therefore, the Bank's allowance for loan losses is likely to change, as the composition of the Bank's loan portfolio changes.
* Current economic conditions. The Bank takes into consideration economic conditions in its market area, the state's economy, and national economic factors that could influence the quality of the loan portfolio in general.
* Trends in the Bank's delinquencies. Prior period statistics are reviewed and evaluated to determine if the current conditions warrant changes to the Bank's loan loss allowance.
* Historical loss rates. Industry loss rates and the Bank's loss rate experience (where applicable) are also considered when analyzing the adequacy of the Bank's loan loss allowance
As required by Statement of Accounting Standard ("SFAS") No. 114, Accounting by Creditors for Impairment of a Loan, each individual loan, previously classified by management, or newly classified during the quarterly review, is evaluated for loss potential, and a specific amount or percentage deemed to be at risk is added to the overall required reserve amount. For the remaining portion of the portfolio the Bank applies SFAS No. 5, Accounting for Contingencies. A reserve factor is applied to homogeneous loan pools that is consistent with the Bank's experience in that loan pool type or with historical industry experience if management believes such guidelines are more appropriate. The applied percentage is also influenced by other economic factors as noted above.
The calculated amount is compared to the actual amount recorded in the allowance at the end of each quarter and a determination is made as to whether the allowance is adequate, yet not excessive. Management increases the amount of the allowance for loan losses by charges to income and decreases the amount by loans charged off (net of recoveries).
The following comments represent management's view of the risks inherent in each portfolio category.
* One-to-Four Family Residential - Market conditions in the Bank's primary market area have, over the long term, supported a stable or increasing market value of real estate. Absent an overall economic downturn in the economy, experience in this portfolio indicates that losses are minimal provided the property is reasonably maintained, and marketing time to resell the property is relatively short.
* Multi-Family Residential - While there have been minimal losses in this segment of the portfolio, the rental market is susceptible to the effects of an economic downturn. Although the Bank monitors loan- to-value ratios, the conditions that would create a default would carry through to a new owner which may require that the Bank discount the property or hold it until conditions improve.
* Commercial Real Estate - As with multi-family loans, the classification of commercial real estate loans closely corresponds to economic conditions which will limit the marketability of the property, resulting in higher risk than a loan secured by a single-family residence. Commercial real estate loans have historically been assigned higher reserve levels than one-to-four family residential loans, but lower than commercial business loans.
* Commercial Business Loans - These types of loans carry a higher degree of risk, relying on the ongoing success of the business to repay the loan. Collateral for commercial credits is often difficult
to secure, and even more difficult to liquidate in the event of a default. If a commercial business loan demonstrates any credit weakness, the reserve is increased to recognize the additional risk.
* Consumer Loans - The consumer loan portfolio has a wide range of factors, determined primarily by the nature of the collateral and the credit history and capacity of the borrower. The loans tend to be smaller in principal amount and secured by second deeds of trust, automobiles, boats, and other vehicles. Loans for automobiles, boats, and other vehicles, generally experience higher than average wear in the environment and hold a higher degree of risk of loss in the event of repossession.
* Unsecured Credit Cards - Due to the unsecured nature of these accounts, these types of loans represent the highest degree of risk. The Bank, therefore, uses a higher percentage factor than any other loan classification, when estimating future potential loan losses.
Management believes that the allowance for loan losses at March 31, 2007 was adequate yet not excessive at that date. Although management believes that it uses the best information available to make these determinations, future adjustments to the allowance for loan losses may be necessary.
While the Bank believes it has established its existing allowance for loan losses in accordance with accounting principles generally accepted in the United States of America, there can be no assurance that regulators, in reviewing the Bank's loan portfolio, will not request the Bank to significantly increase or decrease its allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that substantial increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above. Any material increase in the allowance for loan losses may adversely affect the Bank's financial condition and results of operations.
The Bank established an allowance for losses for the year ended March 31, 2007 in the amount of $15.9 million and $14.2 million for the year ended March 31, 2006. The Bank's loan loss reserve as of March 31, 2007 and 2006, was 1.51% and 1.54% of net loans receivable, respectively.
The following table sets forth an analysis of the Bank's allowance for loan losses for the periods indicated. For each of these periods, management reviewed the changes in the composition and size of the Bank's loan portfolio, along with the economic conditions in effect during each period, using the methodologies presented in the paragraphs above within this section.
Year Ended March 31, --------------------------------------------- 2007 2006 2005 2004 2003 ------- ------- ------- ------- ------ (Dollars in thousands)
Allowance at beginning of period.................. $14,184 $11,767 $10,122 $ 8,506 $5,887 Provision for loan losses.................. 1,850 2,575 1,700 1,915 2,740 Recoveries: First mortgage loans.... -- -- -- -- -- Commercial loans........ 29 1 168 79 -- Credit card loans....... 12 6 5 6 8 Other consumer loans.... 9 -- 1 1 -- ------- ------- ------- ------- ------ Total recoveries....... 50 7 174 86 8
Charge-offs: First mortgage loans.... -- -- -- -- -- Commercial loans........ (75) (45) (105) (253) (54) Credit card loans....... (51) (54) (104) (124) (71) Other consumer loans.... (69) (66) (20) (8) (4) ------- ------- ------- ------- ------ Total charge-offs....... (195) (165) (229) (385) (129)
Net charge-offs......... (145) (158) (55) (299) (121) ------- ------- ------- ------- ------ Allowance at end of period................... $15,889 $14,184 $11,767 $10,122 $8,506 ======= ======= ======= ======= ======
(table continued on following page)
Year Ended March 31, ----------------------------------------------- 2007 2006 2005 2004 2003 ------- ------- ------- ------- ------ (Dollars in thousands) Allowance for loan losses as a percentage of net loans receivable at the end of the period......... 1.51% 1.54% 1.46% 1.48% 1.35%
Net charge-offs as a percentage of average loans outstanding during the period................ 0.01% 0.02% 0.01% 0.05% 0.02%
Allowance for loan losses as a percentage of nonperforming assets at end of period............. 1670.06% 1,221.35% 794.53% 2,518.51% 511.09%
The Bank had an allowance of $110,000, $0, $0, $0 and $0 for real estate acquired through foreclosure at March 31, 2007, 2006, 2005, 2004 and 2003, respectively.
Investment Activities - ---------------------
Under Washington law, banks are permitted to own U.S. government and government agency obligations, commercial paper, corporate bonds, mutual fund shares, and debt and equity obligations issued by creditworthy entities, whether traded on public securities exchanges or placed privately for investment purposes. The Bank holds a diverse portfolio of money market instruments, U.S. Treasury obligations, federal agency securities, municipal securities, common stock, preferred stock and corporate notes.
The FDIC has adopted the Federal Financial Institutions Examination Council statement of policy on securities activities and accounting procedures. This policy requires that institutions establish prudent policies and strategies for securities activities, identify certain securities trading practices that are unsuitable for an investment portfolio,
recommends procedures for selection of a securities dealer, and limits investment in high risk mortgage securities and disproportionately large holdings of long-term zero coupon bonds.
The policy addresses concerns about speculative or other non-investment activities in the securities investment portfolios of depository institutions. Speculative securities activities can impair earnings or capital and, in some cases, may cause the failure of the institution. The policy establishes a framework for structuring securities activities and clarifies various accounting issues concerning investment accounts versus trading accounts.
The amortized cost of the Bank's investment securities of the type described above at March 31, 2007 was $48.0 million with a market value of $53.2 million. For further information concerning the Bank's investment securities portfolio, see Notes 3 and 4 of the Notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K.
The Bank also invests in mortgage-backed securities. At March 31, 2007, these securities had an amortized cost of $26.4 million and a market value of $26.4 million.
The following table presents the amortized cost of the Bank's investment securities portfolio. The market value of the Bank's investment securities portfolio at March 31, 2007 was approximately $79.6 million. This table also includes interest-bearing deposits and cash equivalents.
At March 31, -------------------------------- 2007 2006 2005 --------- ---------- -------- (In thousands) Investment securities: U.S. Government: Available for sale....................... $ 41,350 $ 45,925 $ 54,034 Held to maturity......................... 370 370 370 -------- -------- -------- 41,720 46,295 54,404 Mortgage-backed securities(1): Available for sale....................... 26,220 23,559 18,353 Held to maturity......................... 148 482 885 -------- -------- -------- 26,368 24,041 19,238 Other securities(2): Available for sale....................... 6,325 8,836 12,762 Held to maturity......................... -- -- -- -------- -------- -------- 6,325 8,836 12,762 -------- -------- -------- Total investments........................ 74,413 79,172 86,404
Interest-bearing deposits and cash equivalents............................... 46,212 33,630 27,158 -------- -------- -------- $120,625 $112,802 $113,562 ======== ======== ======== - -------- (1) Consists of mortgage-backed securities and collateralized mortgage obligations ("CMOs"). (2) Consists of corporate debt securities, marketable equity securities and mutual funds.
At March 31, 2007, 2006 and 2005 the Bank did not have any investment securities (exclusive of obligations of the U.S. government and federal agencies) issued by any one entity with a total book value in excess of 10% of stockholders' equity.
- ---------- * At March 31, 2007, yields on the Bank's tax-exempt obligations had not been computed on a tax equivalent basis.
Real Estate Development Subsidiary - ----------------------------------
Westward Financial Services, Inc ("Westward"), a land development company, is a wholly owned subsidiary of the Bank. Westward has been in the real estate development business since the 1970s, primarily focused on residential land development. Westward completed a 110 lot residential development in north Bellingham ("Stoneybrook"), in fiscal 2006. Income attributable to Westward totaled $45,932, $364,668 and $491,143 for fiscal years 2007, 2006 and 2005, respectively. The majority of the lot sales for the "Stoneybrook" development occurred prior to fiscal 2007, which accounts for the differing income amounts in these periods.
In October 2004, Westward entered into a real estate development joint venture in Greenbriar Northwest LLC ("GBNW"), an established residential land development company headquartered in Bellingham,Washington (50% owned by Westward and 50% by Greenbriar Construction, a Bellingham based real estate development company). This joint venture involves approximately 85 acres of land in south Bellingham, and current plans include developing the property into 739 residential units, in a new neighborhood to be known as "Fairhaven Highlands." The investment in real estate is recorded as an asset on the Corporation's balance sheet, and the related debt is recorded as a liability. At March 31, 2007, the real estate joint venture has a carrying amount of approximately $17.2 million, with a related borrowing of approximately $20.2 million. One-half of the borrowing expense related to the joint venture is recognized as an expense on the Corporation's financial statements as incurred, with the remainder being capitalized. The Corporation is presently not recognizing any income related to this joint venture, as it is in the early stages of development. For additional details on this joint venture, please see Note 1 Nature of Operations and Summary of Significant Accounting Policies, of the Notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K.
Bank Owned Life Insurance - -------------------------
At March 31, 2007, the Bank held $19.4 million in bank owned life insurance ("BOLI"), compared to $13.7 million at March 31, 2006. These policies are with Northwestern Mutual Life, Mass Mutual and New York Life, three of the highest rated BOLI providers. All three of these firms continue to receive high ratings from AM Best, Fitch, Standard & Poors and Moodys.
Deposit Activities and Other Sources of Funds - ---------------------------------------------
General. Savings accounts and other types of deposits have traditionally been important sources of the Bank's funds for use in lending and for other general business purposes. In addition to deposit accounts, the Bank derives funds from loan repayments, loan sales, and borrowings and operations. The availability of funds from loan sales is influenced by general interest rates and other market conditions. Loan repayments are a relatively stable source of funds while deposit inflows and outflows vary widely and are influenced by prevailing interest rates and money market conditions. Borrowings may be used on a short-term basis to compensate for reductions in deposits or deposit inflows at less than projected levels and may be used on a longer term basis to support expanded lending activities.
Deposits. Horizon Bank offers several deposit accounts, including Regular Passbook and Statement Savings Accounts, Personal and Business Checking Accounts, Money Market with and without Check Access and Certificates of Deposit Accounts with maturities ranging from 30 days up to ten years. Certificates of deposit account requirements vary according to minimum principal balances, the time period the funds must remain on deposit and the interest rate determined for each term and minimum balance.
The following table sets forth certain information concerning the deposits at the Bank.
Year Ended March 31, ----------------------------------------------------- 2007 2006 2005 ----------------- ----------------- ----------------- Weighted Weighted Weighted Average Average Average Average Average Average Type Balance Rate Balance Rate Balance Rate - ------------------ ------- ---- ------- ---- ------- ---- (Dollars in thousands)
Savings............. $ 24,029 0.69% $ 35,275 0.54% $ 40,956 0.53% Checking............ 156,200 0.33 147,523 0.29 131,440 0.33 Money Market........ 173,483 3.64 143,434 2.41 134,144 1.26 Time Deposits....... 551,671 4.60 458,017 3.50 383,161 2.86 -------- ---- -------- ------ -------- ----- Total............. $905,383 3.56% $784,249 2.55% $689,701 1.92% ======== ==== ======== ====== ======== =====
The following table indicates the amount of the Bank's deposits by time remaining until maturity as of March 31, 2007 of $100,000 or more.
Certificates Maturity Period of Deposit -------------------------- -------------- (In thousands)
Three months or less........... $ 56,201 Over three through six months.. 94,327 Over six through twelve months. 123,226 Over twelve months............. 48,982 ---------- Total......................... $ 322,736 ==========
The Bank has a number of different programs designed to attract both short-term and long-term savings of the general public by providing a wide assortment of accounts and rates. These include traditional savings accounts, nonnegotiable time deposits with minimum deposits of $100,000 and terms of 30 days to five years called Jumbo Certificates of Deposit, nonnegotiable, nontransferable time deposits with minimum deposits of $500 and terms from 30 days to five years at fixed rates, 12-month to ten-year variable rate fixed term certificates, individual retirement accounts ("IRAs"), qualified retirement plans, transaction accounts such as regular checking, and money market deposit accounts ("MMDAs") with and without limited check access.
The Bank's practice on early withdrawal penalties is applicable only to time deposits. Management believes that in periods of rising interest rates this practice will discourage depositors from making premature withdrawals for the purpose of reinvesting in higher rate time deposits.
The minimum amount required to open a time deposit varies from $500 to $100,000, depending on the type of time deposit. Pricing of rates on time deposits with maturities from 30 days to ten years are determined periodically by the Bank, based upon competitive rates and local market rates, national money market rates, and yields on assets of the same maturity.
The Bank's Personal MMDA currently has a $1,000 minimum deposit and has a tiered pricing program, with interest rates that vary by account dollar balance -- $1,000, $10,000, $25,000, $50,000 and higher. The Bank's Business MMDA has tiers of $1,000, $10,000, $50,000, $100,000 and higher, with a $1,000 minimum deposit. These accounts have no maturity requirements, no regulatory interest rate ceilings, and limited check writing privileges. The interest rates on these accounts are adjusted by the Bank periodically, based on money market conditions. The Bank currently has a $10,000 minimum deposit money market and has a tiered pricing program, with interest rates that vary by account dollar balance -- $10,000, $25,000, $50,000 and higher. The Bank also offers a $25,000 and a $50,000 minimum deposit money market, which have tiered pricing programs, with interest rates that vary by account dollar balance -- $25,000,
$50,000, $100,000, $250,000 and higher. These accounts have no maturity requirements, no regulatory interest rate ceiling, and no check writing privileges. The interest rates on the account are adjusted by the Bank periodically or as dictated by money market conditions.
The large variety of deposit accounts offered by the Bank has increased its ability to retain deposits and has allowed it to be competitive in obtaining new funds, although the threat of disintermediation (the flow of funds away from the Bank into direct investment vehicles, such as common stocks and mutual funds) still exists. The Bank's ability to attract and retain deposits and its cost of funds have been, and will continue to be, significantly affected by capital and money market conditions.
Horizon Bank attempts to control the flow of deposits by pricing its accounts to remain competitive with other financial institutions in its market area but does not necessarily seek to match the highest rates paid by competing institutions.
The senior officers of the Bank meet periodically to determine the interest rates which the Bank will offer to the general public. These officers consider the amount of funds needed by the Bank on both a short-term and long-term basis, the rates being offered by the Bank's competitors, alternative sources of funds and the projected level of interest rates in the future.
The Bank's deposits are obtained primarily from residents of Northwest Washington. Horizon Bank attracts deposits by offering a wide variety of services and convenient branch locations and service hours.
For further information concerning the Bank's savings deposits, reference is made to Note 8 of the Notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K.
Brokered Deposits. The Bank also utilizes brokered deposits as a supplemental source of funding, when appropriate. During fiscal 2007, the Bank increased its balances in brokered deposits from $52.9 million at March 31, 2006 to $79.4 million at March 31, 2007. The rates paid on these deposits are comparable to the rates on similar term from the Bank's alternative sources of funding (such as wholesale borrowings, discussed below). The Bank intends to continue utilizing brokered deposits to support its funding needs, when appropriate.
Borrowings. In December 1998, the Bank joined the FHLB of Seattle which provides it with access to a variety of wholesale funding options. In addition, the Bank's securities portfolio provides additional borrowing capacity in the reverse repurchase markets. The Bank also has other borrowed funds in the form of retail repurchase agreements. These agreements are collateralized by securities held by a safekeeping agent not under control of the Bank. These funds are considered overnight borrowings and bear interest at rates that fluctuate daily based on current market rates. At March 31, 2007, the Bank had $159.0 million in borrowings, compared to $159.8 million at March 31, 2006. Access to these wholesale borrowings allows management to meet cyclical funding needs, and assists in interest rate risk management efforts.
The following table sets forth information regarding FHLB of Seattle advances to the Bank at the end of and during the periods indicated. The table includes both long- and short-term borrowings.
Year Ended March 31, ------------------------------ 2007 2006 2005 ---------- -------- -------- (Dollars in thousands)
Maximum amount of borrowings outstanding at any month end.......................... $195,000 $149,000 $129,500
Approximate average borrowings outstanding............................... 165,237 134,070 89,920
Approximate weighted average rate paid on borrowings................................ 4.74% 3.68% 3.26%
Balance outstanding at end of period....... $143,500 $149,000 $129,000
Weighted average rate paid on borrowings... 5.03% 4.39% 3.28%
The Bank also has other borrowed funds in the form of retail repurchase agreements. These agreements are collateralized by securities held by a safekeeping agent not under control of the Bank. These advances are considered overnight borrowings bearing interest rates that fluctuate daily based on current market rates. The Bank had $14.4 million and $10.8 million in retail repurchase agreements outstanding as of March 31, 2007 and 2006, respectively.
For additional information on borrowings, see Note 9 of the Notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K.
Competition - -----------
The Bank faces strong competition in its market area in originating loans and attracting deposits. Competition in originating loans is primarily from other commercial banks, thrift institutions, mortgage companies, credit unions and consumer finance companies. The Bank competes for loan originations primarily through interest rates and loan fees it charges and through the efficiency and quality of services it provides borrowers. Competition is affected by, among other things, the general availability of lendable funds, general and local economic conditions and current interest rate levels.
In attracting deposits, the Bank competes primarily with other commercial banks, thrift institutions, credit unions and brokerage firms. The Bank competes for customer deposits principally on the basis of convenience and quality of its banking services and the investment opportunities that satisfy the requirements of investors with respect to rate of return, liquidity, risk and other factors. The primary factors in competing for deposits are interest rates and the convenience of office locations. In light of the deregulation of interest rate controls on deposits, the Bank has faced increasing competition for deposits from commercial banks, other thrift institutions and non-regulated financial intermediaries.
Personnel - ---------
At March 31, 2007, Horizon Bank employed 253 full-time and 35 part-time employees. Horizon Bank employees are not represented by any collective bargaining agreement. Management of Horizon Bank considers its relations with its employees to be good.
Executive Officers of the Registrant
The executive officers of the Corporation and the Bank are as follows:
Age at Name March 31, 2007 Position - ---------------- -------------- -------------------------------------
V. Lawrence Evans 60 Chairman of the Board, Chief Executive Officer and President of the Corporation; and Chairman of the Board and Chief Executive Officer of the Bank
Dennis C. Joines 57 President, Chief Operating Officer and Director of the Bank; Executive Vice President and Director of the Corporation
Richard P. Jacobson 44 Vice President and Secretary of the Corporation and Executive Vice President and Secretary of the Bank
(table continued on following page)
Age at Name March 31, 2007 Position - ---------------- -------------- -------------------------------------
Steve L. Hoekstra 56 Executive Vice President of the Bank
Kelli J. Holz 38 Vice President of the Corporation and Senior Vice President of the Bank
The following is a description of the principal occupation and employment of the executive officers of the Corporation and the Bank during at least the past five years:
V. LAWRENCE EVANS joined the Bank in 1972 and served as the Bank's Executive Vice President from 1983 to 1990. Mr. Evans served as President of the Bank from May 14, 1990 to April 23, 2002. He has served as Chief Executive Officer of the Bank since March 26, 1991 and as Chairman of the Bank's Board of Directors since July 1997. Mr. Evans also serves as Chairman of the Board, President and Chief Executive Officer of the Corporation.
DENNIS C. JOINES became President and Chief Operating Officer of the Bank and a Director of the Corporation and the Bank on April 23, 2002. He joined the Bank following an extensive career in the Pacific Northwest banking industry for over 30 years. Most recently, Mr. Joines was Senior Vice President/National Small Business and SBA Manager for Washington Mutual Bank from 2001 to 2002. Prior to that time, he served in a variety of key roles at KeyBank from 1993 to 2001.
RICHARD P. JACOBSON joined the Bank in 1987 and was appointed Vice President/Finance and Corporate Secretary in December 1994. In March 1998, Mr. Jacobson was appointed Senior Vice President of the Bank. In March 2000, he was appointed Executive Vice President of the Bank and is currently the Chief Financial Officer.
STEVE L. HOEKSTRA joined the Bank in June, 2002 as Executive Vice President, Commercial Banking. Mr. Hoekstra has 25 years of experience in the local commercial banking industry. Most recently, he led the Bellingham commercial and retail team for Frontier Bank. Prior to that, Mr. Hoekstra was employed for 22 years by SeaFirst/Bank of America, where his titles included Commercial Credit Administrator, Sales Team Leader, Equipment Financing and Leasing Specialist and Dealer Banking.
KELLI J. HOLZ, CPA, joined the Bank in 1988. From 1991 to 1998 she was the Manager of the Internal Audit Department. In March 1998, she was appointed Vice President. In March 2007, she was appointed Senior Vice President of the Bank and is currently the Controller of the Bank.
Regulation and Supervision - --------------------------
The Bank.
General. As a state-chartered, federally insured commercial bank, Horizon Bank is subject to extensive regulation and must comply with various statutory and regulatory requirements, including prescribed minimum capital standards. Horizon Bank is regularly examined by the FDIC and its state regulators, and files quarterly and periodic reports concerning its activities and financial condition with its regulators. The Bank's relationship with depositors and borrowers also is regulated to a great extent by both federal and state law, especially in such matters as the ownership of deposit accounts and the form and content of loan documents.
Federal and state banking laws and regulations govern all areas of the operation of the Bank, including reserves, loans, mortgages, capital, issuance of securities, payment of dividends and establishment of branches. Federal and state bank regulatory agencies also have the general authority to limit the dividends paid by insured banks and bank holding companies if such payments are deemed to constitute an unsafe and unsound practice. The respective primary federal
regulators of the Corporation and the Bank have authority to impose penalties, initiate civil and administrative actions and take other steps intended to prevent banks from engaging in unsafe or unsound practices.
State Regulation and Supervision. As a state-chartered commercial bank, the Bank is subject to applicable provisions of Washington law and regulations of the Washington State Department of Financial Institutions. State law and regulations govern the Bank's ability to take deposits and pay interest, to make loans on or invest in residential and other real estate, to make consumer loans, to invest in securities, to offer various banking services to its customers, and to establish branch offices. The Bank is subject to periodic examination and reporting requirements by and of the Washington State Department of Financial Institutions, Division of Banks.
Federal Deposit Insurance Corporation. The Bank's deposits are insured up to applicable limits by the Deposit Insurance Fund of the FDIC. The Deposit Insurance Fund is the successor to the Bank Insurance Fund and the Savings Association Insurance Fund, which were merged effective March 31, 2006. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the fund. The FDIC also has the authority to initiate enforcement actions against savings institutions, after giving the OTS an opportunity to take such action, and may terminate the deposit insurance if it determines that the institution has engaged in unsafe or unsound practices or is in an unsafe or unsound condition.
The FDIC recently amended its risk-based assessment system for 2007 to implement authority granted by the Federal Deposit Insurance Reform Act of 2005, which was enacted in 2006 ("Reform Act"). Under the revised system, insured institutions are assigned to one of four risk categories based on supervisory evaluations, regulatory capital levels and certain other factors. An institution's assessment rate depends upon the category to which it is assigned. Risk category I, which contains the least risky depository institutions, is expected to include more than 90% of all institutions. Unlike the other categories, Risk Category I contains further risk differentiation based on the FDIC's analysis of financial ratios, examination component ratings and other information. Assessment rates are determined by the FDIC and currently range from five to seven basis points for the healthiest institutions (Risk Category I) to 43 basis points of assessable deposits for the riskiest (Risk Category IV). The FDIC may adjust rates uniformly from one quarter to the next, except that no single adjustment can exceed three basis points. No institution may pay a dividend if in default of the FDIC assessment.
The Reform Act also provided for a one-time credit for eligible institutions based on their assessment base as of December 31, 1996. Subject to certain limitations with respect to institutions that are exhibiting weaknesses, credits can be used to offset assessments until exhausted. The Bank's one-time credit is expected to be approximately $650,000. The Reform Act also provided for the possibility that the FDIC may pay dividends to insured institutions once the Deposit Insurance Fund reserve ratio equals or exceeds 1.35% of estimated insured deposits.
In addition to the assessment for deposit insurance, institutions are required to make payments on bonds issued in the late 1980s by the Financing Corporation to recapitalize a predecessor deposit insurance fund. This payment is established quarterly and during the calendar year ending March 31, 2007 averaged 1.22 basis points of assessable deposits.
The Reform Act provided the FDIC with authority to adjust the Deposit Insurance Fund ratio to insured deposits within a range of 1.15% and 1.50%, in contrast to the prior statutorily fixed ratio of 1.25%. The ratio, which is viewed by the FDIC as the level that the fund should achieve, was established by the agency at 1.25% for 2007.
The FDIC has authority to increase insurance assessments. A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank. There can be no prediction as to what insurance assessment rates will be in the future. Insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the OTS. Management of the Bank is not aware of any practice, condition or violation that might lead to termination of the Bank's deposit insurance.
Prompt Corrective Action. Federal statutes establish a supervisory framework based on five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. An institution's category depends upon where its capital levels are in relation to relevant capital measures, which include a risk-based capital measure, a leverage ratio capital measure and certain other factors. The federal banking agencies have adopted regulations that implement this statutory framework. Under these regulations, an institution is treated as well capitalized if its ratio of total capital to risk-weighted assets is 10% or more, its ratio of core capital to risk-weighted assets is 6% or more, its ratio of core capital to adjusted total assets (leverage ratio) is 5% or more, and it is not subject to any federal supervisory order or directive to meet a specific capital level. In order to be adequately capitalized, an institution must have a total risk-based capital ratio of not less than 8%, a Tier 1 risk-based capital ratio of not less than 4%, and a leverage ratio of not less than 4%. Any institution which is neither well capitalized nor adequately capitalized is considered undercapitalized.
Undercapitalized institutions are subject to certain prompt corrective action requirements, regulatory controls and restrictions which become more extensive as an institution becomes more severely undercapitalized. Failure by the Bank to comply with applicable capital requirements would, if unremedied, result in restrictions on its activities and lead to enforcement actions, including, but not limited to, the issuance of a capital directive to ensure the maintenance of required capital levels. Banking regulators will take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. Additionally, approval of any regulatory application filed for their review may depend on compliance with capital requirements.
At March 31, 2007, the Bank was categorized as "well capitalized" under the prompt corrective action regulations of the FDIC.
Capital Requirements. FDIC regulations recognize two types, or tiers, of capital: core ("Tier 1") capital and supplementary ("Tier 2") capital. Tier 1 capital generally includes common shareholders' equity and non-cumulative perpetual preferred stock, less most intangible assets. Tier 2 capital, includes Tier 1 capital, and such items as qualifying general loan loss reserves, cumulative perpetual preferred stock, mandatory convertible debt, term subordinated debt and limited life preferred stock; however, the amount of term subordinated debt and intermediate term preferred stock (original maturity of at least five years but less than 20 years) that may be included in Tier 2 capital is limited to 50% of Tier 1 capital.
The FDIC currently measures an institution's capital using a leverage limit together with certain risk-based ratios. The FDIC's minimum leverage capital requirement specifies a minimum ratio of Tier 1 capital to average total assets. Most banks are required to maintain a minimum leverage ratio of at least 4% to 5% of total assets. At March 31, 2007, the Bank had Tier 1 leverage capital of 9.6%. Horizon Bank has not been notified by the FDIC of any higher capital requirements specifically applicable to it. The FDIC retains the right to require an institution to maintain a higher capital level based on the institution's particular risk profile.
FDIC regulations also establish a measure of capital adequacy based on ratios of qualifying capital to risk-weighted assets. Assets are placed in one of four categories and given a percentage weight based on the relative risk of that category. In addition, certain off-balance-sheet items are converted to balance-sheet credit equivalent amounts, and each amount is then assigned to one of the four categories. Under the guidelines, the ratio of total capital (Tier 1 capital plus Tier 2 capital) to risk-weighted assets must be at least 8%, and the ratio of Tier 1 capital to risk-weighted assets must be at least 4%. In evaluating the adequacy of a bank's capital, the FDIC may also consider other factors that may affect the bank's financial condition. Such factors may include interest rate risk exposure, liquidity, funding and market risks, the quality and level of earnings, concentration of credit risk, risks arising from nontraditional activities, loan and investment quality, the effectiveness of loan and investment policies, and management's ability to monitor and control financial operating risks. At March 31, 2007, the Bank determined that its total risk-based ratio was 12.0% and its Tier 1 risk-based capital ratio was 10.5%.
The Washington State Department of Financial Institutions requires that net worth equal at least 5% of total assets. Intangible assets must be deducted from net worth and assets when computing compliance with this requirement. At March 31, 2007, Horizon Bank had a net worth of 9.7% of total assets.
Horizon Bank's management believes that, under the current regulations, the Bank will continue to meet its minimum capital requirements in the foreseeable future. However, events beyond the control of the Bank, such as a downturn in the economy in areas where the Bank has most of its loans, could adversely affect future earnings and, consequently, the ability of the Bank to meet its capital requirements. For additional information concerning the Bank's capital, see Note 12 of the Notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K.
Federal Deposit Insurance Improvement Act ("FDICIA"). Horizon Bank has more than $1.0 billion in assets and therefore, is required to comply with the provisions of FDICIA. In general, FDICIA requires the Bank to conduct an annual independent audit of its financial statements, appoint an independent audit committee of outside directors, report on and assess management's responsibilities for preparing financial statements, and establish an internal control structure.
An independent accountant must attest to and report on the assertions in management's reports concerning these internal controls with the desired outcome of efficient and effective operations; the safeguarding of assets; reliable financial reporting and compliance with applicable laws and regulations.
As the primary regulator of the Bank, the FDIC has outlined the requirements for compliance with FDICIA, but does not provide specific guidance on the internal control structure, documentation, or procedures to test the Bank's effectiveness. It is up to each bank to establish, document and design procedures to evaluate and test the internal control structure over financial reporting and compliance with designated laws and regulations that minimally include loans to insiders and dividend restrictions.
In brief, to ensure compliance, the Bank has established and coordinated a management team that identifies and documents existing controls with consideration given to the Bank's control environment, risk assessment, control activities, information and communication systems, and monitoring activities. In addition, management establishes internal control procedures, develops and selects criteria for evaluation, tests the effectiveness of controls, and ensures that proper written documentation is in place.
Under FDICIA, the Audit Committee has several responsibilities that include but are not limited to overseeing the internal audit function; conducting periodic meetings with management, the independent public accountant, and the internal auditors; review of significant accounting policies, and audit conclusions regarding significant accounting estimates; review of the assessments prepared by management and independent auditor on the adequacy of internal controls and the resolution of identified material weaknesses and reportable conditions in internal controls; and the review of compliance with laws and regulations.
Federal Home Loan Bank System. The FHLB of Seattle serves as a reserve or central bank for the member institutions within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLBs. It makes loans (i.e., advances) to members in accordance with policies and procedures established by the Federal Housing Finance Board and the Board of Directors of the FHLB of Seattle. As a member, the Bank is required to purchase and hold stock in the FHLB of Seattle, based on formulas established by the FHLB. As of March 31, 2007, Horizon Bank held stock in the FHLB of Seattle in the amount of $7.2 million. See "Business - -- Savings Activities and Other Sources of Funds -- Borrowings."
Federal Reserve System. The Federal Reserve Board requires, under Regulation D, that all depository institutions, maintain reserves on transaction accounts and nonpersonal time deposits. These reserves may be in the form of cash or non-interest bearing deposits with the regional Federal Reserve Bank. NOW accounts and other types of accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to Regulation D reserve requirements, as are any non-personal time deposits at a savings bank. Under Regulation D, a bank must establish reserves equal to 3% of the first $47.6 million of transaction accounts, of which the first $7.0 million is exempt, and 10% of the remainder. Currently, there is no reserve requirement on nonpersonal time deposits with original maturities of less than 1.5 years. As of March 31, 2007, the Bank was in compliance with the Federal Reserve Bank's reserve requirements.
Privacy Standards. The Gramm-Leach-Bliley Financial Services Modernization Act of 1999 ("GLBA"), which was enacted in 1999, modernized the financial services industry by establishing a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms and other financial service providers. The Bank is subject to FDIC regulations implementing the privacy protection provisions of the GLBA. These regulations require the Bank to disclose its privacy policy, including identifying with whom it shares "non-public personal information," to customers at the time of establishing the customer relationship and annually thereafter.
Anti-Money Laundering and Customer Identification. Congress enacted the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the "USA Patriot Act") on October 26, 2001 in response to the terrorist events of September 11, 2001. The USA Patriot Act gives the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. In March 2006, Congress re-enacted certain expiring provisions of the USA Patriot Act.
The Corporation.
General. The Corporation, as the sole stockholder of the Bank, is a bank holding company and is registered as such with the Federal Reserve. Bank holding companies are subject to comprehensive regulation by the Federal Reserve under the Bank Holding Company Act of 1956, as amended (the "BHCA"), and the regulations of the Federal Reserve. As a bank holding company, the Corporation is required to file with the Federal Reserve annual reports and such additional information as the Federal Reserve may require and will be subject to regular examinations by the Federal Reserve. The Federal Reserve also has extensive enforcement authority over bank holding companies, including, among other things, the ability to assess civil money penalties to issue cease and desist or removal orders and to require that a holding company divest subsidiaries (including its bank subsidiaries). In general, enforcement actions may be initiated for violations of law and regulations and unsafe or unsound practices.
The Bank Holding Company Act. Under the BHCA, the Corporation is supervised by the Federal Reserve. The Federal Reserve has a policy that a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, the Federal Reserve provides that bank holding companies should serve as a source of strength to its subsidiary banks by being prepared to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity, and should maintain the financial flexibility and capital raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company's failure to meet its obligation to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve to be an unsafe and unsound banking practice or a violation of the Federal Reserve's regulations or both.
The Corporation is required to file quarterly and periodic reports with the Federal Reserve and provide additional information as the Federal Reserve may require. The Federal Reserve may examine the Corporation and any of its subsidiaries, and charge the Corporation for the cost of the examination.
The Corporation and any subsidiaries that it may control are considered "affiliates" within the meaning of the Federal Reserve Act, and transactions between the Corporation's bank subsidiary and affiliates are subject to numerous restrictions. With some exceptions, the Corporation and its subsidiaries, are prohibited from tying the provision of various services, such as extensions of credit, to other services offered by the Corporation, or our affiliates.
Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act") was signed into law on July 30, 2002 in response to public concerns regarding corporate accountability in connection with the recent accounting scandals. The stated goals of the Sarbanes-Oxley Act are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. The Sarbanes-Oxley Act generally applies to all companies that file or are required to file periodic reports with the Securities and Exchange Commission ("SEC"), under the Securities Exchange Act of 1934 ("Exchange Act").
The Sarbanes-Oxley Act includes very specific additional disclosure requirements and new corporate governance rules. The Sarbanes-Oxley Act represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees.
Acquisitions. The BHCA prohibits a bank holding company, with certain exceptions, from acquiring ownership or control of more than 5% of the voting shares of any company that is not a bank or bank holding company and from engaging in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. Under the BHCA, the Federal Reserve may approve the ownership of shares by a bank holding company in any company, the activities of which the Federal Reserve has determined to be so closely related to the business of banking or managing or controlling banks as to be a proper incident thereto. These activities include: operating a savings institution, mortgage company, finance company, credit card company or factoring company; performing certain data processing operations; providing certain investment and financial advice; underwriting and acting as an insurance agent for certain types of credit-related insurance; leasing property on a full-payout, non-operating basis; selling money orders, travelers' checks and U.S. Savings Bonds; real estate and personal property appraising; providing tax planning and preparation services; and, subject to certain limitations, providing securities brokerage services for customers.
Dividends. The Federal Reserve's policy statement on the payment of cash dividends by bank holding companies expresses the Federal Reserve's view that a bank holding company should pay cash dividends only to the extent that the company's net income for the past year is sufficient to cover both the cash dividends and a rate of earning retention that is consistent with the company's capital needs, asset quality and overall financial condition. The Federal Reserve also indicated that it would be inappropriate for a company experiencing serious financial problems to borrow funds to pay dividends.
Capital Requirements. The Federal Reserve has established capital adequacy guidelines for bank holding companies that generally parallel the capital requirements of the FDIC for banks. The Federal Reserve regulations provide that capital standards will be applied on a consolidated basis in the case of a bank holding company with $150 million or more in total consolidated assets. The Corporation's total risk based capital must equal 8% of risk-weighted assets and one- half of the 8%, or 4%, must consist of Tier 1 (core) capital. At March 31, 2007, the Corporation's capital position was in excess of these requirements with total risk based capital of 12.0% of risk-weighted assets and Tier 1 (core) capital of 10.6% of risk-weighted assets.
Stock Repurchases. Bank holding companies, except for certain "well-capitalized" and highly rated bank holding companies, are required to give the Federal Reserve prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of their consolidated net worth. The Federal Reserve may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe or unsound practice or would violate any law, regulation, Federal Reserve order, or any condition imposed by, or written agreement with, the Federal Reserve.
Taxation - --------
Federal Taxation.
General. The Corporation and the Bank report their consolidated income on a fiscal year basis using the accrual method of accounting and are subject to federal income taxation in the same manner as other corporations with some exceptions, including particularly the Bank's reserve for bad debts discussed below. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to the Bank or the Corporation. Reference is made to Note 10 of the Notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K for additional information concerning the income taxes payable by the Bank.
Tax Bad Debt Reserves. Historically, savings institutions such as the Bank, which met certain definitional tests primarily related to their assets and the nature of their businesses, were permitted to establish a reserve for bad debts and
to make annual additions to the reserve. These additions may, within specified formula limits, have been deducted in arriving at the Bank's taxable income. For purposes of computing the deductible addition to its bad debt reserve, the Bank's loans were separated into "qualifying real property loans" (i.e., generally those loans secured by interests in residential real property) and all other loans ("non-qualifying loans"). The following formulas were used to compute the bad debt deduction with respect to qualifying real property loans: (i) actual loss experience or (ii) a percentage equal to 8% of taxable income. The deduction with respect to non-qualifying loans was computed under the experience method. Reasonable additions to the reserve for losses on non-qualifying loans were based upon actual loss experience and would reduce the current year's addition to the reserve for losses on qualifying real property loans, unless that addition was also determined under the experience method. The sum of the additions to each reserve for each year was the Bank's annual bad debt deduction.
The provisions repealing the current thrift bad debt rules were passed by Congress as part of "The Small Business Job Protection Act of 1996." The new rules eliminated the 8% of taxable income method for deducting additions to the tax bad debt reserves for all financial institutions for tax years beginning after December 31, 1995. These rules also required that all institutions recapture all or a portion of their bad debt reserves added since the base year (last taxable year beginning before January 1, 1988). The Bank has previously recorded a deferred tax liability equal to the bad debt recapture and as such the new rules will have no effect on the net income or federal income tax expense. For taxable years beginning after December 31, 1995, the Bank's bad debt deduction is determined under the experience method using a formula based on actual bad debt experience over a period of years or, if the Bank is a "large" association (assets in excess of $500 million) on the basis of net charge-offs during the taxable year. The rules allowed an institution to suspend bad debt reserve recapture for the 1996 and 1997 tax years if the institution's lending activity for those years was equal to or greater than the institution's average mortgage lending activity for the six taxable years preceding 1996 adjusted for inflation. For this purpose, only home purchase or home improvement loans were included and the institution could have elected to have the tax years with the highest and lowest lending activity removed from the average calculation. If an institution was permitted to postpone the reserve recapture, it must have begun its six year recapture no later than the 1998 tax year. The unrecaptured base year reserves would not be subject to recapture as long as the institution continues to carry on the business of banking. In addition, the balance of the pre-1988 bad debt reserves continue to be subject to provisions of present law referred to below that require recapture in the case of certain excess distributions to stockholders.
Distributions. If a stock institution distributes amounts to stockholders and the distribution is treated as being from its accumulated bad debt reserves, the distribution will cause the institution to have additional taxable income. A distribution to stockholder is deemed to have been made from accumulated bad debt reserves to the extent that (i) the reserves exceed the amount that would have been accumulated on the basis of actual loss experience, and (ii) the distribution is a "non-dividend distribution." A distribution in respect of stock is a non-dividend distribution to the extent that, for federal income tax purposes, (i) it is redemption of shares, (ii) it is pursuant to a liquidation or partial liquidation of the institution, or (iii) in the case of current distribution, together with all other such distributions during the taxable year, it exceeds the institution's current and post-1951 accumulated earnings and profits. The amount of additional taxable income created by a non-dividend distribution is an amount that, when reduced by tax attributable to it, is equal to the amount of the distribution.
Minimum Tax. In addition to regular corporate income tax, corporations are subject to an alternative minimum tax which generally is equal to 20% of alternative minimum taxable income (taxable income, increased by tax preference items and adjusted for certain regular tax items). The preference items which are generally applicable include an amount equal to 75% of the amount by which a financial institution's adjusted current earnings (generally alternative minimum taxable income computed without regard to this preference and prior to reduction for net operating losses) exceeds its alternative minimum taxable income without regard to this preference and the excess of the institution's bad debt deduction over the amount deductible under the experience method, as discussed below. Alternative minimum tax paid can be credited against regular tax due in later years.
Audits. The Bank has not been audited by the Internal Revenue Service during the past five years.
Washington Taxation.
The Bank is subject to a business and occupation tax which is imposed under Washington law at the rate of 1.50% of gross receipts; however, interest received on loans secured by mortgages or deeds of trust on residential properties is not subject to such tax. The Bank's business and occupation tax returns were audited in November 1995.
Available Information - ---------------------
The Corporation's Internet address is www.horizonbank.com. You may access, free of charge, copies of the following documents from the Corporation's website by using the "Investor Relations" button:
1. Annual Reports on Form 10-K;
2. Quarterly Reports on Form 10-Q; and
3. Current Reports on Form 8-K.
The Corporation makes these reports and certain other information that it files available on its website as soon as reasonably practicable after filing or furnishing them electronically with the SEC. These and other SEC filings the Corporation are also available, free of charge, from the SEC on its website at www.sec.gov. The information contained on the Corporation's website is not incorporated by reference into this document and should not be considered a part of this Annual Report on Form 10-K. The Corporation's website address is included in this document as an inactive textual reference only.
Item 1A.
Item 1A. Risk Factors. - -----------------------
An investment in our common stock is subject to risks inherent to our business. Before making an investment decision, you 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 that affect us. 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 stock could decline significantly, and you could lose all or part of your investment.
The Maturity and Repricing Characteristics of Our Assets and Liabilities are Mismatched and Subject Us to Interest Rate Risk Which Could Adversely Affect Our Net Earnings and Economic Value.
Our financial condition and operations are influenced significantly by general economic conditions, including the absolute level of interest rates as well as changes in interest rates and the slope of the yield curve. Our profitability is dependent to a large extent on our net interest income, which is the difference between the interest received from our interest-earning assets and the interest expense incurred on our interest-bearing liabilities.
Our activities, like all financial institutions, inherently involve the assumption of interest rate risk. Interest rate risk is the risk that changes in market interest rates will have an adverse impact on our earnings and underlying economic value. Interest rate risk is determined by the maturity and repricing characteristics of our assets, liabilities and off- balance-sheet contracts. Interest rate risk is measured by the variability of financial performance and economic value resulting from changes in interest rates. Interest rate risk is the primary market risk affecting the Corporation's financial performance.
The greatest source of interest rate risk to us results from the mismatch of maturities or repricing intervals for rate sensitive assets, liabilities and off-balance-sheet contracts. Additional interest rate risk results from mismatched repricing indices and formulae (basis risk and yield curve risk), and product caps and floors and early repayment or withdrawal provisions (option risk), which may be contractual or market driven, that are generally more favorable to customers than to us.
Our primary monitoring tool for assessing interest rate risk is asset/liability simulation modeling, which is designed to capture the dynamics of balance sheet, interest rate and spread movements and to quantify variations in net interest income resulting from those movements under different rate environments. The sensitivity of net interest income to changes in the modeled interest rate environments provides a measurement of interest rate risk. The net market value of equity is estimated by separately valuing our assets and liabilities under varying interest rate environments. The extent to which assets gain or lose value in relation to the gains or losses of liability values under the various interest rate assumptions determines the sensitivity of net equity value to changes in interest rates and provides an additional measure of interest rate risk.
The interest rate sensitivity analysis we perform incorporates beginning-of-the-period rate, balance and maturity data, using various levels of aggregation of that data, as well as certain assumptions concerning the maturity, repricing, amortization and prepayment characteristics of loans and other interest-earning assets and the repricing and withdrawal of deposits and other interest-bearing liabilities into an asset/liability computer simulation model. We update and prepare simulation modeling at least quarterly for review by senior management and the directors. We believe the data and assumptions are realistic representations of our portfolio and possible outcomes under the various interest rate scenarios. Nonetheless, the interest rate sensitivity of our net interest income and net market value of equity could vary substantially if different assumptions were used or if actual experience differs from the assumptions used.
Our Loan Portfolio Contains a Large Percentage of Construction and Land Development Loans, Commercial Real Estate Loans and Commercial Business Loans Which Involves a Higher Risk of Loss than Other Types of Lending.
We have had a significant increase in our commercial real estate and construction and land development lending since March 31, 2003. Commercial and multi-family real estate, construction and land development and commercial business loans may expose a lender to greater risk of loss than loans secured by residential real estate and consumer loans because the type of collateral securing these loans and the large dollar value typically involved. These loans also have greater credit risk than residential real estate for the following reasons and the reasons discussed under "Item 1. Business-Lending Activities."
* Commercial and Multi-family Mortgage Loans. These loans typically involve higher principal amounts than other types of loans, and repayment is dependent upon income being generated from the property securing the loan in amounts sufficient to cover operating expenses and debt service.
* Construction and Land Development Loans. This type of lending contains the inherent difficulty in estimating both a property's value at completion of the project and the estimated cost (including interest) of the project. If the estimate of construction cost proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to permit completion of the project. If the estimate of value upon completion proves to be inaccurate, we may be confronted at, or prior to, the maturity of the loan with a project the value of which is insufficient to assure full repayment. In addition, speculative construction loans to a builder are often associated with homes that are not pre-sold, and thus pose a greater potential risk to us than construction loans to individuals on their personal residences. Construction loans on land under development or held for future construction also poses additional risk because of the lack of income being produced by the property and the potential illiquid nature of the security.
* Commercial Loans. Repayment is dependent upon the successful operation of the borrower's business.
Joint Ventures in Real Estate Development May Expose Us to Additional Risk.
As indicated in the Real Estate Development Subsidiary section of Part 1, Item 1 of this Form 10-K, the Bank's wholly owned subsidiary (Westward) is a land development company which periodically enters into joint ventures to develop residential real estate. While Westward has successfully partnered in various real estate developments since the 1970s, there can be no guarantee that success in this area will necessarily continue into the future. This activity may present additional risk to us, as we are exposed as an equity investor in the land being developed. Adverse movements in the value of the raw land or the values of the fully developed lots would negatively affect our financial performance. Adverse changes in real estate development regulations (i.e. environmental regulations, project density requirements, and other related development regulatory matters) may also negatively impact our success in this regard. In addition, this development activity exposes us to potential reputation risk, as some members of our communities might not necessarily approve of our involvement as a real estate development partner. In addition, certain projects may be perceived negatively by residents of the area where the properties are being developed, instead of favoring to leave the land in an undeveloped state. For these and potentially other reasons related to real estate development, our joint ventures in real estate development may expose us to additional risk, and no assurances can be provided regarding continued success in this area.
Our Profitability Depends Significantly on Economic Conditions in Our Primary Market Area.
Our success depends primarily on the general economic conditions of the State of Washington and the specific local markets in which we operate. Unlike larger national or other regional banks that are more geographically diversified, we provide banking and financial services to customers located primarily in Whatcom, Skagit, Snohmish and Pierce Counties of Washington. The local economic conditions in our market areas have a significant 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 impact these local economic conditions and, in turn, have a material adverse effect on our financial condition and results of operations.
Housing Market Slowdown and the Effects of the Sub-Prime Market.
The potential impacts of sub-prime loans originated by others in the Bank's markets in recent years could adversely impact the Bank's performance. These sub-prime loans are cited as contributing to the slowdowns in the housing markets across the country. As homeowner's face significant increases in their housing payments when these sub-prime loans reset, this will likely have an adverse affect on the economy with an increasing supply of housing units on the market. It is predicted that these adverse impacts will result in increased numbers of houses listed for sale (for those facing unaffordable increases in their monthly housing payments) and it will also likely increase the number of foreclosures on residential units. This sub-prime impact is in its early stages and a significant amount of uncertainty remains (and will likely remain for some time until the actual impacts can be better quantified).
If Our Allowance for Loan Losses Is Not Sufficient to Cover Actual Loan Losses, Our Earnings Could Decrease.
We make various assumptions and judgments about the collectibility of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. In determining the amount of the allowance for loan losses, we review our loans and the loss and delinquency experience, and evaluate economic conditions. If our assumptions are incorrect, the allowance for loan losses may not be sufficient to cover losses inherent in our loan portfolio, resulting in the need for additions to our allowance. Material additions to the allowance could materially decrease our net income. Our allowance for loan losses was 1.51% of net loans at March 31, 2007.
In addition, bank regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs. Any increase in our allowance for loan losses or loan charge-offs as required by these regulatory authorities may have a material adverse effect on our financial condition and results of operations.
If External Funds Were Not Available, this Could Adversely Impact Our Growth and Prospects.
We rely on deposits and advances from the FHLB-Seattle and other borrowings to fund our operations. Although we have historically been able to replace maturing deposits and advances if desired, no assurance can be given that we would be able to replace such funds in the future if our financial condition or the financial condition of the FHLB or market conditions were to change.
Although we consider such sources of funds adequate for our liquidity needs, we may seek additional debt in the future to achieve our long-term business objectives. There can be no assurance additional borrowings, if sought, would be available to us or, if available, would be on favorable terms. If additional financing sources are unavailable or are not available on reasonable terms, our growth and future prospects could be adversely affected.
Strong Competition Within Our Market Area May Limit Our Growth and Profitability.
Competition in the banking and financial services industry is intense. We compete in our market areas with commercial banks, savings institutions, mortgage brokerage firms, credit unions, finance companies, mutual funds, insurance companies, and brokerage and investment banking firms operating locally and elsewhere. Some of these competitors have substantially greater resources and lending limits than we do, have greater name recognition and market presence that benefit them in attracting business, and offer certain services that we do not or cannot provide. In addition, larger competitors may be able to price loans and deposits more aggressively than we do. Our profitability depends upon our continued ability to successfully compete in our market areas. The greater resources and deposit and loan products offered by some of our competitors may limit our ability to increase our interest-earning assets. For additional information see Item 1, "Business Competition."
The Loss of Key Members of Our Senior Management Team Could Adversely Affect Our Business.
We believe that our success depends largely on the efforts and abilities of our senior management. Their experience and industry contacts significantly benefit us. The competition for qualified personnel in the financial services industry is intense, and the loss of any of our key personnel or an inability to continue to attract, retain and motivate key personnel could adversely affect our business.
If Our Common Stock Was No Longer Included in the Russell 2000 or Russell 3000 Indices There Could be a Reduction in Liquidity and Prices for Our Stock.
Our common stock is included in the Russell 2000 and Russell 3000 indices. Inclusion in these indices may have positively impacted the price, trading volume and liquidity of our common stock, in part, because index funds or other institutional investors often purchase securities that are in these indices. Conversely if our market capitalization falls below the minimum necessary to be included in either or both of these indices at any annual reconstitution date, the opposite could occur.
We Are Subject to Extensive Government Regulation and Supervision.
We are subject to extensive federal and state regulation and supervision primarily through the Bank and certain non-bank subsidiaries. Banking regulations are primarily intended to protect depositors' funds, federal deposit insurance funds and the banking system as a whole, not shareholders. 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, including changes in interpretation or implementation of statutes, regulations or policies, could
affect us in substantial and unpredictable ways. Such changes could subject us to additional costs, limit the types of financial services and products we may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies 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. While we have policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur. See Item 1, "Business -- Regulation and Supervision."
The Level Of Our Commercial Real Estate Loan Portfolio May Subject Us To Additional Regulatory Scrutiny.
The FDIC, the Federal Reserve and the Office of the Comptroller of the Currency, have recently promulgated joint guidance on sound risk management practices for financial institutions with concentrations in commercial real estate lending. Under the guidance, a financial institution actively involved in commercial real estate lending should perform a risk assessment to identify concentrations. A financial institution may have a concentration in commercial real estate lending if, among other factors, (i) total reported loans for construction, land development, and other land represent 100% or more of total capital or (ii) total reported loans secured by multifamily and non-farm residential properties, loans for construction, land development and other land and loans otherwise sensitive to the general commercial real estate market, including loans to commercial real estate related entities, represent 300% or more of total capital. Management should also employ heightened risk management practices including board and management oversight and strategic planning, development of underwriting standards, risk assessment and monitoring through market analysis and stress testing. While we believe we have implemented policies and procedures with respect to our commercial real estate loan portfolio consistent with the guidance, bank regulators could require us to implement additional policies and procedures consistent with their interpretation of the guidance which could result in additional costs to us.
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 limit the effect of the 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 Rely on Dividends From Our Subsidiaries For Most of Our Revenue.
Horizon Financial is a separate and distinct legal entity from its subsidiaries. We receive substantially all of our revenue from dividends from our subsidiaries. These dividends are the principal source of funds to pay dividends on our common stock and interest and principal on our debt. Various federal and/or state laws and regulations limit the amount of dividends that Horizon Bank and certain non-bank subsidiaries may pay to Horizon Financial. Also, our right to participate in a distribution of assets upon a subsidiary's liquidation or reorganization is subject to the prior claims of the subsidiary's creditors. In the event Horizon Bank is unable to pay dividends to Horizon Financial, Horizon Financial may not be able to service debt, pay obligations or pay dividends on Horizon Financial's common stock. The inability to receive dividends from Horizon Bank could have a material adverse effect on our business, financial condition and results of operations. See Item 1, "Business -- Regulation and Supervision."
If We Fail to Maintain an Effective System of Internal Control over Financial Reporting, We May Not Be Able to Accurately Report Our Financial Results or Prevent Fraud, and, as a Result, Investors and Depositors Could Lose Confidence in Our Financial Reporting, Which Could Adversely Affect Our Business, the Trading Price of Our Stock and Our Ability to Attract Additional Deposits.
In connection with the enactment of the Sarbanes-Oxley Act of 2002 ("Act") and the implementation of the rules and regulations promulgated by the SEC, we document and evaluate our internal control over financial reporting in order to satisfy the requirements of Section 404 of the Act. This requires us to prepare an annual management report on our internal control over financial reporting, including among other matters, management's assessment of the effectiveness of internal control over financial reporting and an attestation report by our independent auditors addressing these assessments. If we fail to identify and correct any significant deficiencies in the design or operating effectiveness of our internal control over financial reporting or fail to prevent fraud, current and potential shareholders and depositors could lose confidence in our Company's internal controls and financial reporting, which could adversely affect our business, financial condition and results of operations, the trading price of our stock and our ability to attract additional deposits.
Item 1B.
Item 1B. Unresolved Staff Comments - -----------------------------------
None.
Item 2.
Item 2. Properties - -------------------
The following table sets forth the location of the Bank's offices, as well as certain information relating to these offices.
Net Book Year Value as of Square Leased/ Opened March 31, 2007 Feet Owned ------ -------------- ------ ------- (In thousands)
Bellingham Main Office and Whatcom Mortgage Center....... 1971 $2,103 19,179 Owned 1500 Cornwall Avenue Bellingham, WA 98225
Bellingham/Meridian............ 1987 737 4,650 Owned 4110 Meridian Street Bellingham, WA 98226
Ferndale Office................ 1976 240 3,692 Owned Third and Main Ferndale, WA 98248
Lynden Office.................. 1981 580 3,702 Owned Third and Grover Streets Lynden, WA 98264
Blaine Office.................. 1976 581 3,610 Owned Fourth & "H" Streets Blaine, WA 98230
Mount Vernon Office............ 1976 199 3,275 Owned 1503 Riverside Dr. Mount Vernon, WA 98273
(table continued on the following page)
Net Book Year Value as of Square Leased/ Opened March 31, 2007 Feet Owned ------ -------------- ------ ------- (In thousands)
Anacortes Office................. 1987 $ 667 3,650 Owned 1218 Commercial Avenue Anacortes, WA 98221
Snohomish Office................. 1987 151 1,388 Owned 620 2nd Street Snohomish, WA 98290
Puyallup Office, Pierce Mortgage Center(4).............. 2007 171 3,402 Leased 413 29th Street NE Street Puyallup, WA 98372
Burlington Office, Skagit Commercial Center and Skagit Mortgage Center................. 1994 1,101 3,980 Owned 1020 S. Burlington Blvd Burlington, WA 98232
Edmonds Office................... 1994 1,934 15,265 Owned 130 Fifth Avenue South Edmonds, WA 98020
Murphy's Corner Office........... 2000 1,573 3,720 Owned 12830 Bothell Everett Hwy. Everett, WA 98208
Barkley Office................... 1999 2,800 14,691 Owned 2122 Barkley Blvd. Bellingham, WA 98228
Holly Street Office.............. 1999 359 4,000 Owned 211 E. Holly Street Bellingham, WA 98227
Alabama Office................... 1999 700 4,500 Owned 802 Alabama Street Bellingham, WA 98228
Marysville Office (1)............ 2004 2,203 4,126 Owned 3617 88th St NE Marysville, WA 98270
Lynnwood Office.................. 2003 2,183 4,230 Owned 19405 44th Avenue W. Lynnwood, WA 98036
Lakewood Office, Pierce Commercial Center and Pierce Mortgage Center (2)...................... 2005 2,109 4,773 Owned 10318 Gravelly Lake Dr. SW Lakewood, WA 98499
(table continued on following page)
Net Book Year Value as of Square Leased/ Opened March 31, 2007 Feet Owned ------ -------------- ------ ------- (In thousands) Everett Office, Snohomish Commercial Center and Snohomish Mortgage Center (3)............ 2006 $ 6,655 16,000 Owned 9929 Evergreen Way Everett, WA 98204
Whatcom Commercial Center....... 2003 302 5,200 Leased 2211 Rimland Drive, Suite 230 Bellingham, WA 98226 __________ (1) Opened in November 2004. (2) Opened in April 2005. (3) Opened in June 2006. (4) Opened in June 2007.
At March 31, 2007, the aggregate book value of the Corporation's premises and equipment was $27.6 million.
Item 3.
Item 3. Legal Proceedings - --------------------------
Neither the Corporation nor the Bank is engaged in any legal proceedings of a material nature at the present time. From time to time the Bank is a party to legal proceedings wherein it enforces its security interest in loans made by it.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders - ------------------------------------------------------------- Not applicable.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities - ---------------------------------------------------------------------------
Horizon Financial's common stock is traded on The NASDAQ Exchange under the symbol HRZB. The common stock began trading on the NASDAQ Exchange at the time of Horizon Bank's conversion to stock form in August 1986. The following table presents the high and low sales prices as reported by the NASDAQ Exchange and dividends paid for the last two fiscal years. All share prices shown below are adjusted for the 5-for-4 stock split, paid in the form of a stock dividend in October 2006. The Corporation has approximately 4,500 stockholders.
2007 Fiscal Year Quarter High Low Dividend ------------------ ------ ------- --------
Fourth $25.00 $20.47 $0.125 Third 25.90 22.24 0.125 Second 25.84 19.46 0.125 First 21.94 16.25 0.120
2006 Fiscal Year Quarter High Low Dividend ------------------ ------ ------- --------
Fourth $21.08 $16.98 $0.116 Third 18.74 15.08 0.116 Second 18.16 16.06 0.112 First 18.00 14.14 0.112
Dividend Policy - ---------------
Horizon Financial historically has paid cash dividends on its common stock. The Corporation must adhere to certain regulatory requirements governing the distribution of dividends, and there can be no assurance that the Corporation will continue to declare cash dividends in the future.
Stock Repurchases - -----------------
The Corporation has conducted various stock buy-back programs since August 1996. In March 2006, the Board of Directors approved a stock repurchase program that continued through the 2007 fiscal year, allowing the Corporation to repurchase up to 5% of total shares outstanding, or approximately 625,000 shares, adjusted for the 5-for-4 stock split paid in the form of a 25% stock dividend in October 2006. This marked the Corporation's seventh stock repurchase program. During the year ended March 31, 2007, the Corporation repurchased 144,580 shares at an average price of $20.31. On March 27,2007, the Board of Directors authorized the repurchase of 600,000 shares, or approximately 5% of the Corporation's outstanding shares of common stock for a 12 month period.
The following table sets forth the Corporation's repurchases of its outstanding common stock during the fourth quarter of the year ended March 31, 2007.
Issuer Purchases of Equity Securities --------------------------------------------------------- (d) Maximum (c) Number (or Total Number Approximate of Shares Dollar Value) (or Units) of Shares (or (a) Purchased as Units) that May Total (b) Part of Yet to Be Number of Average Publicly Purchased Shares (or Price Paid Announced Under the Units) per Share Plans or Plans or Period Purchased (or Unit) Programs Programs - ------------------ ----------- ---------- ------------ --------------
January 1, 2007 - January 31, 2007... 5,000 23.232 129,080(1) 495,920 February 1, 2007 - February 28, 2007.. 8,500 23.928 137,580(1) 487,420 March 1, 2007 - March 31, 2007..... 7,000 21.958 144,580(1) 480,420 -------- -------- ----------- ----------- Total............... 20,500 23.086 144,580(1) 600,000(2) ======== ======== =========== ===========
- --------- (1) Reflects purchases made under the repurchase plan authorized by the Board of Directors in March 2006. This program expired on March 31, 2007 (2) Reflects new repurchase plan authorized by the Board of Directors in March 2007.
Equity Compensation Plan Information
The equity compensation plan information presented under subparagraph (d) in Part III, Item 12 of this report is incorporated herein by reference.
Performance Graph. The following graph compares the cumulative total shareholder return on the Corporation's Common Stock with the cumulative total return on the NASDAQ Index and the SNL Western Bank Index which encompasses ten western states. Total return assumes reinvestment of all dividends.
[PERFORMANCE GRAPH APPEARS HERE]
Period Ending ------------------------------------------------------------ Index* 03/31/02 03/31/03 03/31/04 03/31/05 03/31/06 03/31/07 - ---------------- ---------- -------- -------- -------- -------- -------- Horizon Financial Corp. 100.00 153.01 194.10 203.19 284.09 313.45 NASDAQ - Composite 100.00 72.68 108.07 108.34 126.79 131.23 SNL Western Bank Index 100.00 94.47 129.32 141.60 159.89 170.18
*Source: SNL Financial LC, Charlottesville, VA Used with permission. All rights reserved.
Item 6.
Item 6. Selected Financial Data - --------------------------------
The following table sets forth certain information concerning the financial position of the Corporation at and for the dates indicated.
At March 31, ------------------------------------------------------ 2007 2006 2005 2004 2003 ------- -------- --------- -------- --------- (In thousands) Financial Condition Data: - ------------------------
Total Assets.........$1,270,327 $1,116,728 $997,570 $858,876 $819,872 Loans Receivable, net................. 1,054,870 918,510 804,981 658,226 582,269 Cash and Investment Securities.......... 133,075 125,216 125,966 161,071 197,296 Deposits............. 975,295 834,299 746,849 670,259 646,722 Borrowings........... 158,958 159,837 135,787 67,469 53,763 Stockholders' Equity.............. 123,855 113,323 107,024 109,307 106,244
Year Ended March 31, ------------------------------------------------------ 2007 2006 2005 2004 2003 ------- -------- --------- -------- --------- (In thousands) Operating Data: - ---------------
Interest Income...... $92,600 $69,388 $52,182 $48,979 $50,698 Interest Expense..... (40,133) (24,896) (16,144) (15,509) (19,461) ------- ------- ------- ------- ------- Net Interest Income.............. 52,467 44,492 36,038 33,470 31,237 Provision for Loan Losses......... (1,850) (2,575) (1,700) (1,915) (2,740) Noninterest Income.............. 5,838 5,411 5,713 7,415 6,907 Noninterest Expense............. (27,861) (24,770) (21,619) (19,772) (17,314) Income before Provision for Income Taxes........ 28,594 22,558 18,432 19,198 18,090 Provision for Income Tax.......... (9,566) (6,903) (5,369) (6,332) (5,950) ------- ------- ------- ------- ------- Net Income $19,028 $15,655 $13,063 $12,866 $12,140 ======= ======= ======= ======= ======= Per Common Share:(1) Fully-diluted earnings........... $1.53 $1.25 $1.01 $0.96 $0.90 Dividends........... 0.495 0.456 0.424 0.392 0.360 Book Value.......... 10.11 9.16 8.53 8.40 8.03 Weighted average shares outstanding........12,409,092 12,542,845 12,952,542 13,357,556 13,581,212 _________ (1) Restated for 25% stock split effective July 23, 2002 and 5-for-4 stock split paid in the form of a 25% stock dividend effective October 23, 2006.
Key Operating Ratios: - ---------------------
The table below sets forth certain performance ratios of the Corporation for the periods indicated. These ratios are calculated based on month end balances.
At and for the Year Ended March 31, ------------------------ 2007 2006 2005 ------ ------ ------ Return on average assets (net income divided by average total assets)........................... 1.57% 1.48% 1.43%
Return on average equity (net income divided by average equity)................................. 16.11 14.32 12.11
Dividend payout ratio (dividends declared per share divided by fully-diluted earnings per share)....... 32.35 36.54 42.06
Equity to assets ratio (average equity divided by average total assets).............................. 9.74 10.35 11.84
Interest rate spread (difference between average yield on interest-earning assets and average cost of interest bearing liabilities)................... 4.60 4.54 4.21
Net yield on earning assets (net interest income as a percentage of average interest earning assets)............................................ 4.73 4.66 4.34
Efficiency ratio (noninterest expense divided by the sum of net interest income and noninterest income) ........................................... 47.79 49.64 51.78
Non-performing loans ratio (non-performing loans divided by net loans).............................. 0.02% 0.13% 0.18%
Non-performing asset ratio (non-performing assets divided by total assets)........................... 0.07% 0.10% 0.15%
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - ------------------------------------------------------------------------
The following discussion is intended to assist in understanding the financial condition and results of operations of the Corporation and the Bank. The information contained in this section should be read in conjunction with the Consolidated Financial Statements and the accompanying Notes contained in Item 8 of this Form 10-K.
Forward Looking Statements - --------------------------
Management's Discussion and Analysis of Financial Condition and Results of Operations and this Form 10-K contain certain forward-looking statements which are based on assumptions and describe future plans, strategies and expectations of the Corporation. Management desires to take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and is including this statement for the express purpose of availing the Corporation of the protections of the safe harbor with respect to all forward-looking statement in this Form 10-K. These forward-looking statements are generally identified by use of the words "believe," "expect," "intend," "anticipate," "estimate," "project," or similar words. The Corporation's ability to predict results of the actual effect of future plans or strategies is uncertain. Factors which could have a material adverse effect on the Corporation's operations include, but are not limited to, changes in interest rates, general economic conditions, legislative/regulatory changes, monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition,
demand for financial services in the Corporation's market areas and accounting principles and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and you should not rely too much on these statements.
General - -------
The Corporation's results of operations depend primarily on revenue generated as a result of its net interest income and non-interest income. Net interest income is the difference between the interest income the Corporation earns on its interest-earning assets (consisting primarily of loans and investment securities) and the interest the Corporation pays on its interest-bearing liabilities (consisting primarily of customer savings and money market accounts, time deposits and borrowings). Non-interest income consists primarily of service charges on deposit and loan accounts, gains on the sale of loans and investments, and loan servicing fees. The Corporation's results of operations are also affected by the provisions for loan losses and other expenses. Other expenses consist primarily of noninterest expense, including compensation and benefits, occupancy, equipment, data processing, marketing, automated teller machine costs and, when applicable, deposit insurance premiums. The Corporation's results of operations may also be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities.
Business Strategy - -----------------
The Bank's business strategy is to operate as a well-capitalized, profitable and independent community bank, dedicated to commercial lending, home mortgage lending, consumer lending, small business lending and providing quality financial services to local personal and business customers. The Bank has sought to implement this strategy by: (i) focusing on commercial banking opportunities; (ii) continued efforts towards the origination of residential mortgage loans, including one-to-four family residential construction loans; (iii) providing high quality, personalized financial services to individuals and business customers and communities served by its branch network; (iv) selling many of its fixed rate mortgages to the secondary market; (v) focusing on asset quality; (vi) containing operating expenses; and (vii) maintaining capital in excess of regulatory requirements combined with prudent growth.
Operating Strategy - ------------------
The Corporation serves as a holding company for the Bank and other subsidiaries whereby it provides strategic oversight, management, access to capital and other resources and activities typically performed by bank holding companies. The operating strategy of the Corporation has been to expand and diversify its consolidated operations across a variety of companies and/or operating units that are engaged in complementary, but different, businesses and/or operating strategies. This diversification strategy is expected to continue as opportunities arise, although there are no specific acquisitions or new business formations planned at this time. The Bank currently has two offices in Pierce County (south of King County), with the remaining offices all located north of King County. Management has further indicated that the market areas just outside King County (including, but not necessarily limited to Snohomish, Pierce, Kitsap and Thurston counties) are logical areas for potential future expansion, as these markets have characteristics most similar to those in which the Bank has experienced previous success.
The primary business of the Bank is to acquire funds in the form of deposits and wholesale funds, and to use the funds to make commercial, consumer, and real estate loans in its primary market area. In addition, and to a lesser extent, the Bank invests in a variety of investment grade securities including, but not necessarily limited to U.S. Government and federal agency obligations, mortgage-backed securities, corporate debt, equity securities, and municipal securities. The Bank intends to continue to fund its assets primarily with retail and commercial deposits, although, FHLB advances, brokered deposits, and other wholesale borrowings, will also likely be used as a supplemental source of funds.
The Corporation's profitability depends primarily on its net interest income, which is the difference between the income it receives on the Bank's loan and investment portfolio and the Bank's cost of funds, which consists of interest paid on deposits and borrowings. The Bank reviews its opportunities with respect to both assets and liabilities. In the past two fiscal years, for example, the Bank chose to concentrate its commercial lending efforts on growing its Prime
based loan portfolio, at a time when many lenders were offering fixed rate real estate loans at sub-Prime rates. In this regard, the Bank's loan portfolio growth is heavily concentrated in the active real estate development and construction markets in the Puget Sound region. Through its excellent relationships with established real estate developers and builders, the Bank's experienced loan officers were successful at growing this portion of the Bank's portfolio, which is primarily Prime based business. This has been beneficial in recent years, with the Federal Reserve's Open Market Committee's (FOMC) efforts to increase short terms interest rates, which have in turn increased the Prime lending rate. The results of this strategy are discussed in more detail in the section entitled "Comparison of Operating Results for the Years Ended March 31, 2007 and March 31, 2006 Net Interest Income." On the liability side of the balance sheet, the impact of these increasing rates has also impacted the Bank's earnings. Management acknowledges that there is a lag effect in this regard, as the rates on the Bank's certificate of deposit liabilities do not adjust instantly, rather the impact occurs more gradually as the certificates of deposit mature and reprice in a higher rate environment.
Net interest income is also affected by the relative amounts of interest-earning assets and interest-bearing liabilities. When interest-earning assets equal or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. The Corporation's profitability is also affected by the level of the Bank's other income and expenses. Other noninterest income includes income associated with the origination and sale of mortgage loans, loan servicing fees, deposit account related fees, and net gains and losses on sales of interest-earning assets. This portion of the Bank's income is heavily dependent on the Bank's success at originating and selling one-to-four family mortgage loans into the secondary market. In addition, the Bank's ability to generate fee income on its deposit accounts impacts this portion of the Bank's income stream. In fiscal 2006, the Bank introduced an Overdraft Protection service, which increased the deposit related fee income and is discussed in more detail in the section entitled "Comparison of Operating Results for the Years Ended March 31, 2007 and March 31, 2006."
Other noninterest expenses include compensation and benefits, occupancy and equipment expenses, deposit insurance premiums, data servicing expenses and other operating costs. In fiscal 2006, the Bank began a Bank-wide efficiency initiative, soliciting input from all employees and implementing many of the suggestions it received. This is an ongoing process, as management continues to look for ways to improve efficiency. To encourage employees to participate in this initiative, the Bank includes a profitability component to the incentive portion of the employee's pay, and efficiency accounts for one-third of this profitability component. Also during fiscal 2006, the Bank formed a Core Data Processor task team, to analyze ways to best utilize its new data processing system. At the time of conversion in November 2004, the focus was appropriately placed on converting the data from the previous system. Subsequently, the focus shifted to ensuring that the Bank was taking advantage of the benefits offered by the new system, and this is a process that will continue in future years along with the efficiency initiative discussed above.
Finally, the Corporation's results of operations are also significantly affected by general economic and competitive conditions, particularly changes in market interest rates, government legislation, regulation, and monetary and fiscal policies.
Critical Accounting Estimate - ----------------------------
Management recognizes that loan losses occur over the life of a loan, and that the allowance for loan losses must be maintained at a level sufficient to absorb probable losses inherent in the loan portfolio. Management's determination of the allowance is based on a number of factors, including the level of non-performing loans, loan loss experience, credit concentrations, reviews of the quality of the loan portfolio, collateral values, historical industry loss experience, and uncertainties in economic conditions. The allowance is increased by the provision for loan losses, which is charged against current period operating results and decreased by the amount of actual loan charge-offs, net of recoveries.
Management believes that the accounting estimate related to the allowance for loan losses is a "critical accounting estimate" because: (i) it is highly susceptible to change from period to period because it requires management to make assumptions about future losses on loans; and (ii) the impact of a sudden large loss could deplete the allowance and potentially require increased provisions to replenish the allowance, which would negatively affect earnings.
The Corporation has an active ongoing credit review function. The allowance for loan losses is maintained at a level sufficient to provide for estimated, probable loan losses based on evaluating known and inherent risks in the loan portfolio. These factors include changes in the size and composition of the loan portfolio, actual loan loss experience, historical industry loss experience, current and anticipated economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. The reserve is based upon factors and trends identified by management at the time financial statements are prepared, but the ultimate recovery of loans is susceptible to future market factors beyond the Bank's control, which may result in losses or recoveries differing significantly from those provided for in the financial statements. The Bank maintains an allowance for credit losses sufficient to absorb losses inherent in the loan portfolio. The Bank has established a systematic methodology to ensure that the allowance is adequate, and continues to work on enhancing its methodologies in this regard.
As required by SFAS No. 114, Accounting by Creditors for Impairment of a Loan, each individual loan, previously classified by management, or newly classified during the quarterly review, is evaluated for loss potential, and a specific amount or percentage deemed to be at risk is added to the overall required reserve amount. For the remaining portion of the portfolio the Bank applies SFAS No. 5, Accounting for Contingencies. Reserve factors are applied to homogeneous loan pools which are consistent with the Bank's experience in that loan pool type or with industry guidelines if management believes such guidelines are more appropriate. The applied percentage is also influenced by other economic factors in the Bank's market area, the state's economy, and national economic factors that could influence the quality of the loan portfolio in general.
The calculated amount is compared to the actual amount recorded in the allowance at the end of each quarter and a determination is made as to whether the allowance is adequate. Management increases the amount of the allowance for loan losses by charges to income and decreases the amount by loans charged off (net of recoveries).
The Corporation's senior management reviews and analyzes the loan portfolio, charge-offs, and allowance on a quarterly basis. Management then discusses the development and calculation of this critical accounting estimate with the executive committee of the Board of Directors. Horizon's audit committee also reviews the Corporation's disclosures including this critical accounting estimate.
Management reviewed and evaluated the loan portfolio and the adequacy of the allowance at March 31, 2007 and believes that the allowance at 1.51% of net loans, or $15.9 million is adequate yet not excessive for the risk inherent in the loan portfolio and the current economic environment. The allowance was 1.54% of net loans or $14.2 million at March 31, 2006. In fiscal 2007, the loan portfolio grew 14.8% to $1.1 billion at March 31, 2007 from $919.0 million at March 31, 2006. The loan portfolio has experienced substantial growth especially in construction and land development loans. At March 31, 2007, construction and land development loans totaled $405.3 million, an increase of $142.9 million from $262.4 million at March 31, 2006. The increase in the allowance is primarily attributable to the substantial growth in this higher risk portion of the loan portfolio. The Bank's Allowance for Loan and Lease Losses ("ALLL") analysis also considered the potential impacts of sub-prime loans originated by others in the Bank's markets in recent years. These loans are cited as contributing to the slowdowns in the housing markets across the country. As homeowner's face significant increases in their housing payments when these sub-prime loans reset, this will have potential adverse affects on the economy with an increasing supply of housing units on the market. It is predicted that these adverse impacts will result in increased numbers of houses listed for sale (for those facing unaffordable increases in their monthly housing payments) and it will also likely increase the number of foreclosures on residential units. This sub-prime impact is in its early stages and a significant amount of uncertainty remains (and will likely remain for some time until the actual impacts can be better quantified).
Economic data from the Federal Reserve showed a slowdown in overall economic activity in recent quarters. Evidence of a slowing housing market exists in the Bank's primary markets as well (Whatcom, Skagit, Snohomish and Pierce Counties) with the housing inventories increasing from previous year levels in each market (based on number of months of housing inventories).
In June 2006, The Federal Reserve's Open Market Committee raised its Fed Funds target to its current level of 5.25%. This was the latest increase in a 24 month tightening cycle, which began with a quarter point increase in June 2004 (to a level of 1.25% at that time). These increases have a lag effect, which are still filtering through the economy.
The factors discussed above led management to increase the allowance to its current levels.
The Bank recorded net charge-offs of $145,000, $158,000, $55,000, $300,000 and $121,000 during the years ended March 31, 2007, 2006, 2005, 2004 and 2003, respectively. Consumer loans (including home equity) totaled $49.6 million or 4.7% of the net loan portfolio at March 31, 2007. Visa card loans and unsecured consumer loans accounted for the majority of the Bank's charge-offs.
The provision for loan losses has fluctuated depending on the growth and mix of the loan portfolio and the level of charge-offs. The provision for loan losses was $1.9 million, $2.6 million, $1.7 million, $1.9 million and $2.7 million for the fiscal years ended 2007, 2006, 2005, 2004 and 2003, respectively.
Critical Accounting Policies - ----------------------------
The Corporation's significant accounting principles are described in Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K and are essential to understanding Management's Discussion and Analysis of Financial Condition and Results of Operations. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions which affect the reported amounts and disclosures. Actual results may differ from these estimates under different assumptions or conditions. The following policies involve a higher degree of judgment than do our other significant accounting policies detailed in Note 1 of the Notes to Consolidated Financial Statements.
Allowance for Loan Losses. The Corporation reviews historical origination and charge-off relationships, charge-off experience factors, collection data, delinquency reports, estimates of the value of the underlying collateral, economic conditions and trends and other information in order to make the necessary judgments as to the appropriateness of the provision for loan losses and the allowance for loan losses. Loans are charged-off to the allowance for loan losses when the Corporation repossesses and disposes of the collateral or the account is otherwise deemed uncollectible. The Corporation believes that the allowance for loan losses is adequate yet not excessive to cover probable losses inherent in its loan portfolio; however, because the allowance for loan losses is based on estimates, there can be no assurance that the ultimate charge-off amount will not exceed such estimates.
Investments. The Corporation classifies its investments as either available-for-sale or held-to-maturity. Available for sale securities are reported at their fair value, which is determined by obtaining quoted market prices. Unrealized gains and losses on available for sale securities are included in other comprehensive income and excluded from earnings. Realized gains and losses and declines in fair value determined to be other than temporary are included in earnings. The fair value of investments is discussed in more detail in Notes 3 and 4 of the Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K.
Long-Lived Assets and Intangibles. The Corporation periodically assesses the impairment of its long-lived assets and intangibles using judgment as to the effects of external factors, including market conditions. If actual external conditions and future operating results differ from the Corporation's judgments, impairment charges may be necessary to reduce the carrying value of these assets to the appropriate market value.
Accrued Taxes. The Corporation estimates tax expense based on the amount it expects to owe various tax authorities. Taxes are discussed in more detail in Note 10 of the Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K. Accrued taxes represent the net estimated amount due or to be received from taxing authorities. In estimating accrued taxes, management assesses the relative merits and risks of the appropriate tax treatment of transactions taking into account statutory, judicial and regulatory guidance in the context of the Corporation's tax position.
Comparison of Financial Condition at March 31, 2007 and March 31, 2006 - ----------------------------------------------------------------------
Total consolidated assets for the Corporation as of March 31, 2007, were $1.3 billion, a 13.8% increase from the March 31, 2006 level of $1.1 billion. This increase in assets was primarily attributable to the growth in loans receivable to $1.1 billion at March 31, 2007 from $918.5 million at March 31, 2006. The growth in loans receivable was primarily attributable to a $142.9 million, or 54.5%, increase in construction and land development loans since March 31, 2006. The Bank continued its focus on expanding its relationships with established residential real estate developers and one-to-four family residential builders, which resulted in the continued growth in this component of loans receivable during the period. Also increasing during the period is the commercial loan category, as the Bank continues to focus on increasing its commercial lines of credit balances to diversify its loan portfolio and expand its relationships with businesses in its markets. Commercial real estate loans, primarily consisting of loans with initial fixed rate periods of three to five years, declined during the period as the Bank continued its trend away from the lower returns available in this segment in favor of the returns available in the construction and land development category. One-to-four family mortgage loans increased slightly during the period. The Bank continued its practice of selling most of its single-family fixed rate loan production into the secondary market. The Bank sold $83.0 million of real estate loans during fiscal year ended March 31, 2007, compared to $103.7 million during the fiscal year ended March 31, 2006, due to an overall decline in activity from the Bank's single family mortgage division.
The following is an analysis of the loan portfolio by major type of loan at March 31, 2007 and 2006.
At March 31, ----------------------------- 2007 2006 -------- ------ (Dollars in thousands) First mortgage loans: One-to-four family........................... $ 149,885 $148,515 One-to-four family construction.............. 28,576 20,971 Less participations sold..................... (54,592) (56,546) ---------- -------- Subtotal.................................. 123,869 112,940
Construction and land development................................. 405,348 262,358 Residential commercial real estate................................. 52,727 70,080 Nonresidential commercial real estate...................................... 292,212 314,299 Commercial loans............................. 146,265 123,445 Home equity secured.......................... 45,307 44,001 Other consumer loans......................... 5,031 5,571 ---------- -------- Subtotal................................... 946,890 819,754 ---------- -------- Total loans receivable..................... 1,070,759 932,694 ---------- -------- Less: Allowance for loan losses.................... (15,889) (14,184) ---------- -------- Total loans receivable, net................ $1,054,870 $918,510 ========== ========
Net residential loans......................... $ 122,839 12% $111,967 12% Net commercial loans.......................... 143,604 13 121,117 13 Net commercial real estate loans (1).......... 738,861 70 636,657 70 Net consumer loans (2)........................ 49,566 5 48,769 5 ---------- ---- -------- ---- $1,054,870 100% $918,510 100% ========== ==== ======== ==== (1) Includes construction and development, multi-family and commercial real estate loans. (2) Includes home equity and other consumer loans.
As reflected in the table above, approximately 38% of our total loan portfolio consists of construction and land development loans and 33% are in commercial real estate loans. These types of lending afford the Bank an opportunity to receive interest at rates higher than those generally available from one-to-four family residential lending. These loans, however, also typically are greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater degree of risk than one-to-four family residential mortgage loans. Because payments on loans secured by commercial real estate often depend upon the successful operation and management of the properties, repayment of such loans may be affected by adverse conditions in the real estate market or the economy. The Bank seeks to minimize these risks by limiting the maximum loan-to-value ratio to 80% and carefully reviewing the financial condition of the borrower, the quality of the collateral and the management of the property securing the loan.
Construction and land development lending generally involves a higher degree of risk than permanent financing for a finished residence or commercial building, because of the inherent difficulty in estimating both the estimated cost of the project and the property's value at completion. If the estimated cost of construction proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to complete the project. To address this risk, and because of the level of construction loans in the Bank's portfolio, the Bank has personnel dedicated specifically to monitoring the progress of its construction projects, and making on-site inspections of the property. In addition, in an effort to monitor the available inventory in its markets, the Bank also regularly reviews the overall building and development activity in its markets. Also, to mitigate the risks related to construction lending, the Bank primarily deals with experienced builders, with acceptable credit histories, sound financial statements, and a proven track record in the industry. In addition, the Bank utilizes the services of experienced inspectors to monitor the progress and draw process in the more complex construction projects. The Bank also has an experienced appraisal staff, and members of senior management with related appraisal education and experience, who regularly review the appraisals utilized by the Bank in analyzing prospective construction projects. Finally, members of the Bank's senior management and loan committees also have a significant amount of experience in the areas of construction lending, appraisals, and loan underwriting, further mitigating the Bank's risk in this area.
The Bank actively originates construction loans through both its Mortgage Loan Division and its Commercial Loan Division. The Bank's Mortgage Loan Division generally oversees the single family custom construction loans, and to a lesser extent, speculative construction loans (i.e., loans for homes that do not have a contract with a buyer for the purchase of the home upon completion of the construction) to smaller contractors building a limited number of speculative homes per year. These construction loans are further broken down in the first two lines of the table below (speculative construction one-to-four family and custom construction one-to-four family). The Bank's Commercial Lending Division is responsible for the speculative construction projects for the Bank's larger builders (including large one-to-four family developments), in addition to the Bank's multi-family construction loans, non-residential commercial construction loans, and the Bank's land development loans.
The following table is provided to show additional details on the Corporation's construction and land development loan portfolio:
March 31, 2007 March 31, 2006 -------------------- ------------------ Amount Percent Amount Percent ---------- -------- -------- -------- (Dollars in thousands) Speculative construction one-to-four family........... $ 13,694 3.2% $ 8,675 3.1%
Custom construction one-four-family.............. 14,882 3.4 12,296 4.3 -------- ----- -------- ----- Total one-to-four family..... 28,576 6.6 20,971 7.4 Commercial speculative construction one-to-four family....................... 177,602 40.9 95,534 33.7 Commercial construction multi-family................. 6,986 1.6 6,927 2.4 Commercial construction nonresidential............... 84,417 19.5 56,328 19.9 Land development.............. 136,343 31.4 103,569 36.6 -------- ----- -------- ----- Total construction and land development................. 405,348 93.4 262,358 92.6 -------- ----- -------- ----- Total construction loans.... $433,924 100.0% $283,329 100.0% ======== ===== ======== =====
The tables below display the characteristics of the available for sale and held to maturity portfolios at March 31, 2007:
At March 31, 2007 ------------------------------------ Unrealized Amortized Gain/ Estimated Cost (Loss) Fair Value ----------- ----------- ----------- Available For Sale Securities State and political subdivisions and U.S. government agency securities............................ $41,350 $ (242) $41,108 Marketable equity securities........... 323 5,559 5,882 Mutual funds........................... 5,000 (126) 4,874 Corporate debt securities.............. 1,002 (1) 1,001 Mortgage-backed securities and CMOs.... 26,220 13 26,233 ------- ------- ------- Total available-for-sale securities... 73,895 5,203 79,098 ------- ------- ------- Held To Maturity Securities State and political subdivisions and U.S. government agency securities............................ 370 2 372 Mortgage-backed securities and CMOs.... 148 9 157 ------- ------- ------- Total held to maturity securities..... 518 11 529 ------- ------- ------- Total securities...................... $74,413 $ 5,214 $79,627 ======= ======= =======
Maturity Schedule of Securities at March 31, 2007 -------------------------------------------- Available For Sale Held To Maturity --------------------- --------------------- Amortized Estimated Amortized Estimated Cost Fair Value Cost Fair Value ---------- ---------- --------- ---------- (In thousands) Maturities: Less than one year............. $23,870 $23,780 $ 4 $ 4 Over one year to five years.... 11,294 11,157 488 491 Over five to ten years......... 10,863 10,856 16 23 Over ten years................. 22,545 22,549 10 11 ------- ------- ------- ------- 68,572 68,342 518 529 ------- ------- ------- ------- Mutual funds and marketable equity securities.............. 5,323 10,756 -- -- ------- ------- ------- ------- Total investment securities... $73,895 $79,098 $ 518 $ 529 ======= ======= ======= =======
Total liabilities also increased 14.3% to $1.1 billion at March 31, 2007, from $1.0 billion at March 31, 2006. This increase was the result, in large part, of growth in deposits, which increased 16.9% to $975.3 million at March 31, 2007 from $834.3 million at March 31, 2006. The following is an analysis of the deposit portfolio by major type of deposit at March 31, 2007 and 2006:
At March 31, -------------------- 2007 2006 -------- -------- (In thousands) Demand Deposits Savings............................... $ 21,628 $ 30,808 Checking.............................. 78,294 79,774 Checking (noninterest-bearing)........ 91,703 80,778 Money Market.......................... 187,912 156,867 -------- -------- 379,537 348,227 -------- -------- Time certificates of deposit Less than $100,000.................... 273,022 246,136 Greater than or equal to $100,000..... 322,736 239,936 -------- -------- 595,758 486,072 -------- -------- Total deposits........................ $975,295 $834,299 ======== ========
Also included in the March 31, 2007 balance sheet is an investment in real estate for a joint venture and the corresponding borrowing. During the year ended March 31, 2005, the Bank's subsidiary (Westward Financial Services), as a 50% partner in the Greenbriar NW LLP (GBNW), purchased an 85 acre parcel of land in Bellingham, Washington for future residential development. GBNW intends to develop the property in future years, into a neighborhood community to be known as Fairhaven Highlands. The $17.2 million shown on the Corporation's balance sheet as an asset at March 31, 2007 represents the current level of the investment in real estate joint ventures, including the Fairhaven Highlands joint venture. This amount also includes the remaining net investment in other residential development joint ventures. The $20.2 million shown in the liability section of the balance sheet represents the corresponding wholesale borrowing used to fund the investment in the Fairhaven Highlands joint venture, which includes costs that have been incurred and capitalized since the acquisition of the property. At this time, the partnership is in the process of meeting with the appropriate public and private entities, in its preliminary planning efforts relating to the future development of the property.
Stockholders' equity at March 31, 2007 increased 9.3% to $123.9 million from $113.3 million at March 31, 2006. This increase was primarily attributable to the increase in net income to $19.0 million at March 31, 2007 from $15.7 million at March 31, 2006. This change includes the effects of the $6.1 million in dividends paid to stockholders and the Corporation's share repurchase program. The Corporation repurchased shares totaling $2.9 million during the year ended March 31, 2007 compared to $4.4 million for the year ended March 31, 2006. The Corporation remains strong in terms of its capital position, with a stockholder equity-to-assets ratio of 9.8% at March 31, 2007, compared to 10.2% at March 31, 2006.
Comparison of Operating Results for the Years Ended March 31, 2007 and March 31, 2006 - ----------------------------------------------------------------------------
Net Interest Income. Net interest income in fiscal 2007 was $52.5 million, a 17.9% increase from $44.5 million in fiscal 2006. Total interest income increased 33.5% in fiscal 2007 to $92.6 million from $69.4 million in fiscal 2006.
Interest income on loans in fiscal 2007 was $88.6 million, a 34.5% increase from $65.9 million in fiscal 2006. The increase in fiscal 2007 was as a result of a combination of factors, including: 1) the growth in loans receivable, as the Bank experienced significant loan growth during the year, increasing to $1.1 billion at March 31, 2007, compared to $918.5 million at March 31, 2006; and 2) an increasing Prime lending rate throughout the fiscal year. With a portfolio of Prime based loans in excess of $450 million throughout the year ($605.5 million at March 31, 2007) each quarter point increase in the Prime lending rate equated to an annualized increase in interest income on those types of loans of over $1.0 million. The Prime lending rate increased to 8.25% in June 2006, where it remained at March 31, 2007, compared to 7.75% at March 31, 2006.
Also included in interest income for the year ended March 31, 2007 and 2006 were approximately $4.8 million and $3.5 million, respectively, of deferred fee income recognition. In fiscal 2007 and 2006, most of these fees were related to the Bank's commercial loan portfolio, that resulted in large part from the success in increasing the real estate development loan portfolio. These development loans typically are shorter term in nature, so the deferred fee recognition during the life of the loan is greater than what would be recognized for a comparable loan fee on a longer amortizing loan. The table below presents an analysis of deferred fee recognition for the past two fiscal years:
Year Ended March 31, ---------------------- 2007 2006 --------- --------- (In thousands)
Commercial loan deferred fees................. $ 4,076 $ 2,960 One-to-four real estate mortgage loan deferred fees............................... 684 519 -------- -------- Total....................................... $ 4,760 $ 3,479 ======== ========
Interest and dividends on investments and mortgage-backed securities was $4.0 million in fiscal 2007, a 13.6% increase from $3.5 million in fiscal 2006. Contributing to this increase was the restructuring of approximately $13.0 million of the investment securities portfolio during the quarter ended March 31, 2006. The proceeds from those lower-yielding securities were reinvested in highly rated, higher-yielding investments. Also contributing to the change in fiscal 2007 was a reduction in dividend income on the Bank's FHLB stock. At March 31, 2007, Horizon Bank held $7.2 million in FHLB of Seattle stock and received dividends in the amounts of $14,500 in fiscal 2007 compared to $29,500 in fiscal 2006. The FHLB of Seattle has been operating under a regulatory directive since May 2005. In December 2006, the FHLB of Seattle announced that quarterly cash dividends would resume with payment of a cash dividend in December 2006. On January 29, 2007, the FHLB of Seattle declared a similar dividend ($0.10 per share), payable in February 2007. Subsequently, on May 2, 2007, the FHLB announced a cash dividend of $0.15 per share, payable May 18, 2007. The Bank's stock ownership in the FHLB of Seattle is expected to remain stable, increasing only if necessary to support its borrowing needs. The FHLB of Seattle also revised its requirements related to borrowings outstanding and stock levels required to support borrowings, and, therefore, the Bank's existing level of FHLB stock will
support a higher level of wholesale borrowings, decreasing the likelihood that the Bank will need to purchase additional stock to support its borrowing activities.
Total interest expense in fiscal 2007 increased 61.2% to $40.1 million from $24.9 million in fiscal 2006. Interest on deposits increased significantly to $32.3 million in fiscal 2007 from $20.0 million in fiscal 2006. Also contributing to the increase was the increasing level of interest rates during the year which resulted in an increase in interest expense, including interest paid on the Bank's deposits. At March 31, 2007, approximately 61% of the Bank's deposits were in the form of certificates of deposit, including $79.4 million in brokered certificates of deposit. As such, an increasing interest rate environment affects the Bank's deposit interest expense more dramatically than if a larger portion of the Bank's funding were in the form of lower cost checking and liquid savings accounts. While management continues its efforts to decrease its reliance on certificates of deposit as a funding source, the competitive marketplace for core deposit dollars has resulted in only moderate success in this regard. During fiscal 2007, the Bank's increase in deposit interest expense lagged the increase in its interest income on loans (in dollar terms). This was the result, in large part, to the immediate impact to interest income from the Bank's Prime based loan portfolio (with each increase in the Prime lending rate), and the lagged effect of increased interest expense on certificates of deposit, since these certificate of deposit rate increases do not occur instantaneously, instead lagging until the maturity of the certificate of deposit. In addition, even if current market interest rates were not increasing, the Bank's interest on deposits would continue to increase, since the current prevailing market rates to attract deposits are higher than the rates being paid on its renewing deposits.
Interest on borrowings increased to $7.9 million in fiscal 2007 from $4.9 million in fiscal 2006. The increase was a result of a higher level of average borrowings outstanding during the year ended March 31, 2007 of $166.3 million compared to $127.3 million during the year ended March 31, 2006 along with the increasing interest rate environment in fiscal 2007. The significant increase in fiscal 2007 was related to funding the Bank's loan growth during the year. The vast majority of this borrowing growth was in short term borrowings, consistent with the shorter term, Prime based loan growth the Bank experienced during the year. The Bank continues to utilize wholesale borrowings in order to further leverage its balance sheet and better manage its interest rate risk profile.
Provision for Loan Losses. Provisions for loan losses are charges to earnings to bring the total allowance for loan losses to a level considered by management as adequate to provide for known and inherent risks in the loan portfolio, based on management's continuing analysis of factors underlying the quality of the loan portfolio. These factors include changes in portfolio size and composition, actual historical industry loss experience, current economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans.
Year Ended March 31, --------------------------- 2007 2006 2005 -------- ------- -------- (Dollars in thousands)
Allowance at beginning of period.......... $14,184 $11,767 $ 10,122 Provision for loan losses................. 1,850 2,575 1,700 Charge offs, net of recoveries............ (145) (158) (55) -------- ------- -------- Allowance at end of period................ $15,889 $14,184 $ 11,767 ======== ======= ======== Allowance for loan losses as a percentage of net loans receivable at the end of the period............................... 1.51% 1.54% 1.46%
Net charge-offs as a percentage of average loans outstanding during the period...... 0.01% 0.02% 0.01%
Allowance for loan losses as a percentage of nonperforming assets at the end of period................................ 1670.06% 1221.35% 794.53%
The provision for loan losses was $1.9 million for the year ended March 31, 2007 compared to $2.6 million for the year ended March 31, 2006. This change resulted from management's ongoing analysis of changes in loan portfolio composition by collateral categories, overall credit quality of the portfolio, peer group analysis, and current economic conditions. The allowance for loan losses was $15.9 million, or 1.51% of net loans receivable at March 31, 2007 compared to $14.2 million, or 1.54% of net loans receivable at March 31, 2006. The increased allowance level resulted from continued loan portfolio growth in the higher-risk lending categories of construction and land development, commercial real estate and commercial business loans during the period, which comprised $896.6 million, or 83.7% of total loans receivable at March 31, 2007, versus $770.2 million, or 82.6% at March 31, 2006.
In addition, commercial and multi-family loans have larger individual loan amounts, which have a greater single impact on the total portfolio quality in the event of delinquency or default. The Corporation considers the allowance level to be appropriate, as a result of the changing portfolio mix and the current economic environment. While the Bank believes it has established its existing allowance for loan losses in accordance with generally accepted accounting principles, there can be no assurance that regulators, in reviewing the Bank's loan portfolio, will not request the Bank to significantly increase or decrease its allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that substantial increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed elsewhere in this document. Any material increase in the allowance for loan losses may adversely affect the Bank's financial condition and results of operations.
As of March 31, 2007, there were no loans in the loan portfolio over 90 days delinquent and five loans on non- accrual status. The Bank had one real estate owned at March 31, 2007. Total non-performing assets were $951,000, or 0.07% of total assets at March 31, 2007 compared to $1.2 million, or 0.10% of total assets at March 31, 2006.
At March 31, -------------------- 2007 2006 ------- -------- (Dollars in thousands) Non-Performing Assets Accruing loans-90 days past due.......... $ -- $ -- Non-accrual loans........................ 226 1,161 Restructured loans....................... -- -- ------- -------- Total non-performing loans.............. 226 1,161 Total non-performing loans/net loans.... 0.02% 0.13% Real estate owned........................ 725 -- ------- -------- Total non-performing assets............. 951 1,161 ------- -------- Total non-performing assets/total assets................................. 0.07% 0.10%
Noninterest Income. Noninterest income in fiscal 2007 increased to $5.8 million, from $5.4 million in fiscal 2006. Service fees increased 12.7% to $3.3 million in fiscal 2007 from $2.9 million in fiscal 2006. The primary reason for this increase was the implementation of our overdraft protection service during fiscal 2006, which, together with the increase in deposits, resulted in increased fee income.
There was a net loss on sales of investment securities of $(10,000) in fiscal 2007 compared to a net loss of $(476,000) in fiscal 2006. The losses in fiscal 2007 were a result of management's decisions to replace certain investment securities during the year in its efforts to improve future returns. The losses in fiscal 2006 were a result of the restructuring of approximately $13.0 million of lower-yielding securities during the fourth quarter of fiscal 2006. The proceeds from these sales have since been reinvested in highly rated, higher-yielding investments. The securities sold were yielding approximately 170 basis points lower than the securities purchased, therefore the effect of this restructuring was to increase interest income from these securities by over $220,000 in fiscal 2007. Other noninterest income decreased slightly to $1.7 million for the year ended March 31, 2007 from $1.9 million for the year ending March 31, 2006.
Noninterest Expense. Noninterest expense in fiscal 2007 increased to $27.9 million, a 12.5% increase from $24.8 million in fiscal 2006. Compensation and employee benefits increased 11.7% in fiscal 2007 to $16.3 million from $14.6 million in fiscal 2006. Building occupancy expense was $4.3 million in fiscal 2007, a 19.7% increase from $3.6 million in fiscal 2006. Increases in compensation and employee benefits and building and occupancy expenses resulted primarily from the opening of a full service retail office in Lakewood, Washington in fiscal 2006 and a full service regional facility in Everett, Washington in June 2006.
Other noninterest expenses increased 13.4% to $5.6 million in fiscal 2007 from $5.0 million in fiscal 2006. The increase in fiscal 2007 was primarily attributable to additional transfer agent and investor relations expenses, and increased business & occupation tax as a result of the shifting loan portfolio from non-taxable mortgage loans to taxable commercial loans.
Comparison of Operating Results for the Years Ended March 31, 2006 and March 31, 2005 - ----------------------------------------------------------------------------
Net Interest Income. Net interest income in fiscal 2006 was $44.5 million, a 23.5% increase from $36.0 million in fiscal 2005. Total interest income increased 33.0% in fiscal 2006 to $69.4 million from $52.2 million in fiscal 2005.
Interest income on loans in fiscal 2006 was $65.9 million, a 23.5% increase from $48.1 million in fiscal 2005. The increase in fiscal 2006 was as a result of a combination of factors, including: 1) the growth in loans receivable, as the Bank experienced significant loan growth during the year, increasing to $918.5 million at March 31, 2006, compared to $805.0 million at March 31, 2005; and 2) an increasing Prime lending rate throughout the fiscal year. With a portfolio of Prime based loans in excess of $400 million throughout the year ($444.9 million at March 31, 2006) each quarter point increase in the Prime lending rate equated to an annualized increase in interest income on those types of loans of over $1.0 million. The Prime lending rate increased to 7.75% at March 31, 2006, compared to 5.75% at March 31, 2005.
Also included in interest income for the year ended March 31, 2006 and 2005 were approximately $3.5 million and $2.6 million, respectively, of deferred fee income recognition. In fiscal 2006 and 2005, most of these fees were related to the Bank's commercial loan portfolio, that resulted in large part to the success in increasing the real estate development loan portfolio. These development loans typically are shorter term in nature, so the deferred fee recognition during the life of the loan is greater than what would be recognized for a comparable loan fee on a longer amortizing loan. The table below presents an analysis of deferred fee recognition for the past two fiscal years:
Year Ended March 31, ---------------------- 2006 2005 --------- --------- (In thousands)
Commercial loan deferred fees................ $ 2,960 $ 1,793 One-to-four real estate mortgage loan deferred fees............................... 519 813 -------- -------- Total....................................... $ 3,479 $ 2,606 ======== ========
Interest and dividends on investments and mortgage-backed securities was $3.5 million in fiscal 2006, a 12.8% decrease from $4.1 million in fiscal 2005. This decrease was attributable to lower levels of investments and mortgage-backed securities outstanding during the respective periods, as average total investments decreased 17.5% to $92.2 million at March 31, 2006 compared to $111.8 million at March 31, 2005. The decline in the investment portfolio balances in these years was primarily attributable to the funding of the Bank's lending activities. To enhance the Bank's profitability, management chose to direct its available funds to fund loans receivable, in lieu of purchasing securities for its investment portfolio. Also contributing to the decline in fiscal 2006 was a reduction in dividend income on the Bank's FHLB stock. At March 31, 2006, Horizon Bank held $7.2 million in FHLB of Seattle stock and received dividends in the amounts of $29,500 in fiscal 2006 compared to $162,800 in fiscal 2005. The FHLB of Seattle announced that, despite the dividend paid to shareholders on March 31, 2005, it had indefinitely suspended the payment of dividends. The FHLB of Seattle is operating under a regulatory directive and in April 2005 announced that all future dividends would be
suspended until its financial position and performance improves. On May 18, 2005, the FHLB of Seattle announced a three-year dividend suspension; therefore, the Bank's investment income will be reduced accordingly over this time period. Stock ownership in the FHLB of Seattle is expected to remain stable, increasing only if necessary to support the Bank's borrowing needs. The FHLB of Seattle recently revised its stock requirement related to borrowings outstanding, therefore the Bank's existing level of FHLB stock will support a higher level of wholesale borrowings, decreasing the likelihood that the Bank will need to purchase additional stock to support its borrowing activities.
Total interest expense in fiscal 2006 increased 54.2% to $24.9 million from $16.1 million in fiscal 2005. Interest on deposits increased significantly to $20.0 million in fiscal 2006 from $13.2 million in fiscal 2005. As discussed in the paragraphs above, the increasing level of interest rates during the year resulted in an increase in interest income, however, it also caused an increase in interest expense, including interest paid on the Bank's deposits. At March 31, 2006, approximately 58% of the Bank's deposits were in the form of certificates of deposit, including $52.9 million in brokered certificates of deposit. As such, an increasing interest rate environment affects the Bank's deposit interest expense more dramatically than if a larger portion of the Bank's funding were in the form of lower cost checking and liquid savings accounts. While management continues its efforts to decrease its reliance on certificates of deposit as a funding source, the competitive marketplace for core deposit dollars has resulted in only moderate success in this regard. During fiscal 2006, the Bank's increase in deposit interest expense lagged the increase in its interest income on loans (in dollar terms). This was the result, in large part, to the immediate impact to interest income from the Bank's Prime based loan portfolio (with each increase in the Prime lending rate), and the lagged effect of increased interest expense on certificates of deposit, since these certificate of deposit rate increases do not occur instantaneously, instead lagging until the maturity of the certificate of deposit. In addition, even if interest rates were not increasing, the Bank's interest on deposits would continue to increase, as long as the prevailing market rates to attract deposits are higher than the rates being paid on its renewing deposits.
Interest on borrowings increased to $4.9 million in fiscal 2006 from $2.9 million in fiscal 2005. The increase was a result of a higher level of borrowings outstanding during the year ended March 31, 2006 of $159.8 million compared to $135.8 million during the year ended March 31, 2005 along with the increasing interest rate environment in fiscal 2006. The significant increase in fiscal 2006 was related to funding the Bank's significant loan growth during the year. The vast majority of this borrowing growth was in short term borrowings, consistent with the shorter term, Prime based loan growth the Bank experienced during the year. The Bank continues to utilize wholesale borrowings in order to further leverage its balance sheet and better manage its interest rate risk profile.
Provision for Loan Losses. Provisions for loan losses are charges to earnings to bring the total allowance for loan losses to a level considered by management as adequate to provide for known and inherent risks in the loan portfolio, based on management's continuing analysis of factors underlying the quality of the loan portfolio. These factors include changes in portfolio size and composition, actual historical industry loss experience, current economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans.
Year Ended March 31, ---------------------- 2006 2005 -------- -------- (Dollars in thousands)
Allowance at beginning of period.......... $ 11,767 $ 10,122 Provision for loan losses................. 2,575 1,700 Charge offs, net of recoveries............ (158) (55) -------- -------- Allowance at end of period................ $ 14,184 $ 11,767 ======== ======== Allowance for loan losses as a percentage of net loans receivable at the end of the period............................... 1.54% 1.46%
Net charge-offs as a percentage of average loans outstanding during the period...... 0.02% 0.01%
Allowance for loan losses as a percentage of nonperforming assets at the end of period................................ 1221.35% 794.53%
The provision for loan losses was $2.6 million for the year ended March 31, 2006 compared to $1.7 million for the year ended March 31, 2005. This change resulted from management's ongoing analysis of changes in loan portfolio composition by collateral categories, overall credit quality of the portfolio, peer group analysis, and current economic conditions. The allowance for loan losses was $14.2 million, or 1.54% of net loans receivable at March 31, 2006 compared to $11.8 million, or 1.46% of net loans receivable at March 31, 2005. The increased allowance level resulted from continued loan portfolio growth in the higher-risk lending categories of construction and land development, commercial real estate and commercial business loans during the period, which comprised $770.2 million, or 82.6% of total loans receivable at March 31, 2006, versus $658.2 million, or 80.6% at March 31, 2005.
In addition, commercial and multi-family loans have larger individual loan amounts, which have a greater single impact on the total portfolio quality in the event of delinquency or default. The Corporation considers the allowance level to be appropriate, as a result of the changing portfolio mix and the current economic environment.
As of March 31, 2006, there were no loans in the loan portfolio over 90 days delinquent and nine loans on non- accrual status. The Bank had no real estate owned at March 31, 2006. Total non-performing assets were $1.2 million, or 0.10% of total assets at March 31, 2006 compared to $1.5 million, or 0.15% of total assets at March 31, 2005.
At March 31, -------------------- 2006 2005 -------- ------- (Dollars in thousands) Non-Performing Assets Accruing loans-90 days past due................ $ -- $ -- Non-accrual loans.............................. 1,161 1,481 Restructured loans ............................ -- -- ------- ------- Total non-performing loans.................... 1,161 1,481 Total non-performing loans/net loans.......... 0.13% 0.18% Real estate owned.............................. -- -- ------- ------- Total non-performing assets................... 1,161 1,481 ------- ------- Total non-performing assets/total assets...... 0.10% 0.15%
Noninterest Income. Noninterest income in fiscal 2006 decreased slightly to $5.4 million, from $5.7 million in fiscal 2005. Service fees increased 22.9% to $2.9 million in fiscal 2006 from $2.4 million in fiscal 2005. The primary reason for this increase was the implementation of our overdraft protection service during July 2005, which, together with the increase in deposits, resulted in increased fee income.
There was a net loss on sales of investment securities of $(476,000) in fiscal 2006 compared to a net gain of $476,000 in fiscal 2005. The losses in fiscal 2006 were a result of the restructuring of approximately $13.0 million of lower-yielding securities during the fourth quarter of fiscal 2006. The proceeds from these sales have since been reinvested in highly rated, higher-yielding investments. The securities sold were yielding approximately 170 basis points lower than the securities purchased, therefore the effect of this restructuring is expected to increase interest income from these securities by over $220,000 in fiscal 2007. Other noninterest income was essentially unchanged for the periods ending March 31, 2006 and 2005. Included in these numbers was the recognition of approximately $300,000 and $446,000, respectively, in profits on the real estate development project from a joint venture of the Bank's wholly owned subsidiary, Westward Financial Corp. As of March 31, 2006 all lot sales have been concluded for this project. As a result of the current status of the development of these lots, no sales activity is currently anticipated for fiscal 2007 from the Bank's real estate joint venture activities.
Noninterest Expense. Noninterest expense in fiscal 2006 increased to $24.8 million, a 14.6% increase from $21.6 million in fiscal 2005. Compensation and employee benefits increased 15.7% in fiscal 2006 to $14.6 million from $12.6 million in fiscal 2005. Building occupancy expense was $3.6 million in fiscal 2006, a 20.5% increase from $3.0 million in fiscal 2005. Increases in compensation and employee benefits and building and occupancy expenses resulted from the full year operating expenses for two full service retail offices in Marysville and Lakewood.
Other noninterest expenses increased 12.3% to $5.0 million in fiscal 2006 from $4.4 million in fiscal 2005. The increase in fiscal 2006 was primarily attributable to increased expenses related to the Bank's charter conversion and increased Businees & Occupation tax attributable to the shifting loan portfolio from non-taxable mortgage loans to taxable commercial loans.
Data processing expenses decreased in fiscal 2006 to $887,000 from $901,000 in fiscal 2005. Expenses for the year ended March 31, 2005 included one time conversion related costs related to the Bank's core processor conversion completed in November 2004.
Advertising and marketing expenses increased slightly to $720,000 in fiscal 2006 from $688,000 in fiscal 2005, due in part to increased advertising expenses to support the Bank's new Marysville and Lakewood offices. The decreases in fiscal 2005 were primarily attributable to management's decision to reduce this expense. The increases in fiscal 2006 and 2004 were related to market research and brand positioning of the Bank in its various markets.
Rate/Volume Analysis - ---------------------
The table below sets forth certain information regarding changes in interest income and interest expense for the Corporation for the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to (1) changes in volume (change in volume multiplied by old rate); (2) changes in rates (change in rate multiplied by old volume); (3) changes to rate-volume (changes in rate multiplied by the change in volume); and (4) the total changes (the sum of the prior columns).
Liquidity and Capital Resources - -------------------------------
The Bank maintains liquid assets in the form of cash and short-term investments to provide a source to fund loans, savings withdrawals, and other short-term cash requirements. At March 31, 2007, the Bank had liquid assets (cash and marketable securities with maturities of one year or less) with a book value of $75.8 million.
As of March 31, 2007, the total book value of investments and mortgage-backed securities was $74.4 million compared to a market value of $79.6 million with an unrealized gain of $5.2 million. As of March 31, 2006, the total book value of investments and mortgage-backed securities was $79.2 million compared to a market value of $84.4 million with an unrealized gain of $5.2 million. The Corporation foresees no factors that would impair its ability to hold debt securities to maturity.
As indicated on the Corporation's Consolidated Statement of Cash Flows contained in Item 8 of this Form 10-K, the Corporation's primary sources of funds are cash flow from operations, which consist primarily of mortgage loan repayments, deposit increases, loan sales, borrowings, and cash received from the maturity or sale of investment securities. The Corporation's liquidity fluctuates with the supply of funds and management believes that the current level of liquidity is adequate at this time. If additional liquidity is needed, the Corporation's options include, but are not necessarily limited to: (i) selling additional loans in the secondary market; (ii) entering into reverse repurchase agreements; (iii) borrowing from the FHLB of Seattle; (iv) accepting additional jumbo, brokered, and/or public funds deposits; or (v) accessing the discount window of the Federal Reserve Bank of San Francisco.
Stockholders' equity as of March 31, 2007 was $123.9 million, or 9.7% of assets, compared to $113.3 million, or 10.1% of assets at March 31, 2006. The Bank continues to exceed the 5.0% minimum tier one capital required by the FDIC in order to be considered well-capitalized. The Bank's total risk-adjusted capital ratio as of March 31, 2007
was 12.0%, compared to 12.6% as of March 31, 2006. These figures remain well above the well-capitalized minimum of 10% set by the FDIC.
The Corporation has conducted various buy-back programs since August 1996. In March 2007, the Board of Directors approved a new stock repurchase plan that runs concurrent with the 2008 fiscal year, allowing the Corporation to repurchase up to 5% of total shares outstanding, or approximately 600,000 shares. This marked the Corporation's ninth stock repurchase plan. In fiscal 2007, under the previous plan, the Corporation repurchased 144,580 shares at an average price of $20.31. For additional information concerning the Corporation's repurchase activities during the fourth quarter of fiscal 2007, see Item 5 of this Form 10-K.
Management intends to continue its stock buy-back programs from time to time as long as repurchasing the stock is perceived to contribute to the overall growth of stockholder value. The number of shares of stock to be repurchased and the price to be paid is the result of many factors, several of which are outside of the control of the Corporation. The primary factors, however, are market and economic factors such as the price at which the stock is trading in the market, the number of shares available in the market; the attractiveness of other investment alternatives in terms of the rate of return and risk involved in the investment; the ability to increase the value and/or earnings per share of the remaining outstanding shares, the Corporation's liquidity and capital needs, and regulatory requirements. Presently, it is management's belief that purchases made under the current Board approved plan will not materially affect the Corporation's capital or liquidity position.
Quantitative and Qualitative Disclosures About Market Risk - ----------------------------------------------------------
The Corporation continues to be exposed to interest rate risk. Currently, the Corporation's assets and liabilities are not materially exposed to foreign currency or commodity price risk. At March 31, 2007, the Corporation had no off-balance sheet derivative financial instruments, nor did it have a trading portfolio of investments.
In fiscal 2007 and fiscal 2006, the Corporation continued to outsource its interest rate risk modeling to a third party provider that utilizes an IPS Sendero@ model. This model analyzes the Corporation's major balance sheet components, and attempts to estimate the changes to the Corporation's income statement and economic value of equity, under a variety of interest rate change scenarios. The figures contained in the table presented under Item 7A
Item 7A. Quantitative and Qualitative Disclosures About Market Risk - -------------------------------------------------------------------
Quantitative Disclosures About Market Risk. The table below represents the balances of the Bank's financial instruments at March 31, 2007. The expected maturity categories take into consideration projected prepayment rates as well as actual amortization of principal. In preparation of the table, numerous assumptions were made regarding prepayment rates and deposit account interest sensitivity.
As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities, they may react in different degrees to changes in market interest rates. In addition, in the event of changes in interest rates, expected rates of prepayments on loans and withdrawals from savings accounts might deviate significantly from those assumed in presenting the table. Therefore, the data presented in the table should not be relied upon as necessarily indicative of actual future results.
Item 8.
Item 8. Financial Statements and Supplementary Data - ----------------------------------------------------
(a) (1) Financial Statements. Page --------------------- ----
Management's Annual Report on Internal Control Over Financial Reporting 59 Report of Independent Registered Public Accounting Firm 60 Consolidated Statement of Financial Position as of March 31, 2007 and 2006 62 Consolidated Statement of Income for the Years Ended March 31, 2007, 2006 and 2005 63 Consolidated Statement of Stockholders' Equity for the Years Ended March 31, 2007, 2006 and 2005 64 Consolidated Statement of Cash Flows for the Years Ended March 31, 2007, 2006 and 2005 65 Notes to Consolidated Financial Statements 66
Management's Annual Report on Internal Control Over Financial Reporting: - ------------------------------------------------------------------------
MANAGEMENT'S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of Horizon Financial Corp. and its subsidiaries ("the Company") 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 March 31, 2007. The Company's internal control over financial reporting is a process designed under the supervision of the Company'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 Company'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 Company; (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 Company are being made only in accordance with authorizations of Management and Directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company'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 Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, the Company performed an assessment of the effectiveness of the Company's internal control over financial reporting as of March 31, 2007 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 Company's internal control over financial reporting was effective as of March 31, 2007.
The Company's independent registered public accounting firm, Moss Adams LLP who audits the Company's consolidated financial statements, have issued an attestation report on Management's assessment and on the effectiveness of the Company's internal control over financial reporting. This report follows.
Dated June 13, 2007
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders Horizon Financial Corp. and Subsidiary
We have audited the accompanying consolidated statement of financial position of Horizon Financial Corp. and Subsidiary (the "Company") as of March 31, 2007 and 2006, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended March 31, 2007. We also have audited management's assessment included in the accompanying Management Report on Internal Control over Financial Reporting that Horizon Financial Corp. maintained effective internal control over financial reporting as of March 31, 2007, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). Horizon Financial Corp. and Subsidiary's management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management's assessment, and an opinion on the effectiveness of Horizon Financial Corp. and Subsidiary's internal control over financial reporting based on our audits.
We conducted our audits in accordance with auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement in all material respects. Our audits of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinion.
The Company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A Company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and Directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Horizon Financial Corp. and Subsidiary as of March 31, 2007 and 2006, and the results of their operations and cash flows for each of the three years in the period ended March 31, 2007, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, management's assessment that Horizon Financial Corp. and Subsidiary maintained effective internal control over financial reporting as of March 31, 2007, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Furthermore, in our opinion, Horizon Financial Corp. and Subsidiary maintained, in all material respects, effective internal control over financial reporting as of March 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
/s/ MOSS ADAMS LLP
Everett, Washington June 13, 2007
HORIZON FINANCIAL CORP. Consolidated Statement of Financial Position March 31, 2007 and 2006 - ------------------------------------------------------------------------------
ASSETS Dollars in Thousands ------------------------- 2007 2006 ---------- ----------
Cash and cash equivalents $ 40,833 $ 24,190 Interest-bearing deposits 5,379 9,439 Investment securities Available-for-sale (amortized cost 2007: $47,675; 2006: $54,761) 52,865 60,137 Held-to-maturity (estimated fair value 2007: $372; 2006: $374) 370 370 Mortgage-backed securities Available-for-sale (amortized cost 2007: $26,220; 2006: $23,559) 26,233 23,351 Held-to-maturity (estimated fair value 2007: $157; 2006: $497) 148 482 Federal Home Loan Bank ("FHLB") Stock 7,247 7,247 Loans held for sale 4,493 5,252 Loans receivable, net of allowance for loan losses of $15,889 in 2007 and $14,184 in 2006 1,054,870 918,510 Investment in real estate in a joint venture 17,169 16,928 Accrued interest and dividends receivable 6,626 5,185 Premises and equipment, net 27,631 26,317 Net deferred income tax assets 3,733 2,254 Income tax currently receivable -- 808 Real estate owned 725 --
Other assets 22,005 16,258 ---------- ---------- TOTAL ASSETS $1,270,327 $1,116,728 ========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits $ 975,295 $ 834,299 Accrued interest payable and other liabilities 9,508 6,919 Other borrowed funds 138,715 141,561 Borrowing related to investment in real estate in a joint venture 20,243 18,276 Advances by borrowers for taxes and insurance 454 467 Income tax currently payable 237 -- Deferred compensation 2,020 1,883 ---------- ---------- Total liabilities 1,146,472 1,003,405 ---------- ---------- COMMITMENTS AND CONTINGENCIES (Notes 14 & 17)
STOCKHOLDERS' EQUITY Serial preferred stock, $1 par value, 10,000,000 shares authorized; none issued or outstanding Common stock, $1 par value, 30,000,000 shares authorized; 12,254,476 and 9,898,168 issued and outstanding, respectively 12,254 9,898 Additional paid-in capital 51,489 54,116 Retained earnings 56,770 45,991 Accumulated other comprehensive income 3,342 3,318 ---------- ---------- Total stockholders' equity 123,855 113,323 ---------- ---------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $1,270,327 $1,116,728 ========== ==========
See accompanying notes to these financial statements
HORIZON FINANCIAL CORP. Consolidated Statement of Income Years Ended March 31, 2007, 2006, and 2005 - ------------------------------------------------------------------------------
Dollars in Thousands --------------------------------- 2007 2006 2005 --------- --------- --------- INTEREST INCOME Interest on loans $ 88,589 $ 65,857 $ 48,131 Investments and mortgage-backed securities Taxable interest 3,492 3,136 3,598 Nontaxable interest income 293 196 149 Dividends 226 199 304 --------- --------- --------- Total interest income 92,600 69,388 52,182 --------- --------- --------- INTEREST EXPENSE Interest on deposits 32,251 19,988 13,219 Interest on other borrowings 7,882 4,908 2,925 --------- --------- --------- Total interest expense 40,133 24,896 16,144 --------- --------- --------- Net interest income 52,467 44,492 36,038
PROVISION FOR LOAN LOSSES 1,850 2,575 1,700 --------- --------- --------- Net interest income after provision for loan losses 50,617 41,917 34,338 --------- --------- --------- NONINTEREST INCOME Service fees 3,274 2,905 2,364 Net gain on sales of loans - servicing retained 23 55 66 Net gain on sales of loans - servicing released 827 1,040 983 Net gain (loss) on sale of investment securities (10) (476) 476 Other 1,724 1,887 1,824 --------- --------- --------- Total noninterest income 5,838 5,411 5,713 --------- --------- --------- NONINTEREST EXPENSE Compensation and employee benefits 16,328 14,614 12,635 Building occupancy 4,280 3,575 2,967 Data processing 862 887 901 Advertising 751 720 688 Other expenses 5,640 4,974 4,428 --------- --------- --------- Total noninterest expense 27,861 24,770 21,619 --------- --------- ---------
INCOME BEFORE PROVISION FOR INCOME TAX 28,594 22,558 18,432
PROVISION FOR INCOME TAX Current 11,058 6,903 5,948 Deferred (1,492) -- (579) --------- --------- --------- Total provision for income tax 9,566 6,903 5,369 --------- --------- --------- NET INCOME $ 19,028 $ 15,655 $ 13,063 ========= ========= =========
BASIC EARNINGS PER SHARE $1.55 $1.26* $1.02* ===== ===== ===== DILUTED EARNINGS PER SHARE $1.53 $1.25* $1.01* ===== ===== ===== *restated for the 5 for 4 stock split in the form of a 25% stock dividend distributed on October 23, 2006.
See accompanying notes to these financial statements
HORIZON FINANCIAL CORP. Consolidated Statement of Cash Flows Years Ended March 31, 2007, 2006 and 2005 - ------------------------------------------------------------------------------ Increase (Decrease) in Cash and Cash Equivalents
Dollars in Thousands ---------------------------------- 2007 2006 2005 --------- --------- --------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 19,028 $ 15,655 $ 13,063 Adjustments to reconcile net income to net cash provided by operating activities Depreciation 1,878 1,608 1,249 Amortization and deferrals, net 212 (482) (774) Stock dividends - FHLB stock -- (29) (203) Provision for loan losses 1,850 2,575 1,700 Provision for loss - Real Estate Owned 110 -- -- Stock award plan compensation 292 22 -- Excess tax benefits from the exercise of stock options (55) (179) -- Provision for deferred income tax (1,492) -- (579) Changes in assets and liabilities Interest and dividends receivable (1,441) (686) (467) Interest payable 1,448 1,116 595 Federal income tax payable 1,045 (477) (1,706) Net change in loans held for sale 759 (1,183) (2,735) Other assets (5,691) (818) 684 Other liabilities 1,168 341 (3,206) --------- --------- --------- Net cash flows from operating activities 19,111 17,463 7,621 --------- --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES Investment in interest-bearing deposits, net 4,060 (5,532) 16,860 Purchases of investment securities - available-for-sale (3,395) (23,555) (11,465) Proceeds from sales and maturities of investment securities - available- for-sale 10,482 35,590 22,331 Purchases of mortgage-backed securities - available-for-sale (18,319) (12,174) -- Proceeds from sales and maturities of mortgage-backed securities - available- for-sale 15,658 6,969 9,010 Proceeds from maturities of mortgage-backed securities - held-to-maturity 334 403 659 Net change in loans (139,257) (115,550) (147,546) Purchases of bank premises and equipment (3,192) (5,143) (6,837) Net change in investment in joint venture (241) 276 (17,204) --------- --------- --------- Net cash flows from investing activities (133,870) (118,716) (134,192) --------- --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES Net change in deposits 140,996 87,450 76,590 Advances of other borrowed funds 369,654 229,995 142,297 Repayments of other borrowed funds (372,500) (207,500) (90,700) Borrowing related to inv. in real estate in a joint venture 1,967 1,555 16,721 Common stock issued, net 149 464 497 Tax benefit associated with stock options 55 179 -- Cash dividends paid (5,977) (5,572) (5,328) Treasury stock purchased (2,942) (4,378) (8,688) --------- --------- --------- Net cash flows from financing activities 131,402 102,193 131,389 --------- --------- --------- NET CHANGE IN CASH AND CASH EQUIVALENTS 16,643 940 4,818
CASH AND CASH EQUIVALENTS, beginning of year 24,190 23,250 18,432 --------- --------- --------- CASH AND CASH EQUIVALENTS, end of year $ 40,833 $ 24,190 $ 23,250 ========= ========= =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW Information Cash paid during the year for interest $ 38,684 $ 23,780 $ 15,548 ========= ========= ========= Cash paid during the year for income tax $ 9,949 $ 7,201 $ 7,661 ========= ========= ========= NONCASH INVESTING AND FINANCING TRANSACTIONS Property taken in settlement of loans $ 835 $ -- $ -- ========= ========= =========
See accompanying notes to these financial statements
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
Note 1 - Nature of Operations and Summary of Significant Accounting Policies
Nature of Operations - Horizon Financial Corp. (the "Company"), through its wholly-owned subsidiary, Horizon Bank (the "Bank"), provides a full range of commercial and mortgage lending services to borrowers and a full range of customer services to depositors through 18 full-service offices, four commercial loan centers, and four real estate loan centers located in Whatcom, Skagit, Snohomish, and Pierce Counties of Washington State. The Bank is a state-chartered commercial bank, the deposits of which are insured by the Federal Deposit Insurance Corporation ("FDIC").
Financial Statement Presentation and Use of Estimates - The financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and reporting practices applicable to the banking industry. All per share data included in the financial statements have been restated to reflect all stock splits and dividends as well as the Company's ongoing share repurchase activities.
In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of revenues and expenses for the period and assets and liabilities as of the balance sheet date. Actual results could differ from estimated amounts. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for losses on loans, the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans and deferred tax assets. In connection with the determination of the estimated losses on loans and foreclosed assets held for sale, management obtains independent appraisals for significant properties.
Principles of Consolidation - As of March 31, 2007, 2006, and 2005, and for the years then ended, the consolidated financial statements include the accounts of the Company, and its wholly-owned subsidiary, the Bank. Westward Financial Services, Inc. ("Westward"), a land development Company, is a wholly-owned subsidiary of the Bank, and its accounts are also included in the consolidation. All material inter-Company balances and transactions have been eliminated.
In October 2004, the Bank's wholly-owned subsidiary, Westward, entered into a real estate development joint venture in Greenbriar Northwest LLC ("GBNW"), an established residential land development company headquartered in Bellingham, Washington. The Company believes that GBNW is a variable interest entity. Under the Financial Accounting Standards Board ("FASB") Interpretation No. ("FIN") 46, GBNW is consolidated in the accompanying financial statements. The Company accounts for the unowned portion of the joint ventures' real estate as a minority interest. The assets of the real estate joint venture have a carrying value of approximately $17.2 million, with a related borrowing of approximately $20.2 million.
Cash and Cash Equivalents - For purposes of reporting cash flows, cash and cash equivalents include cash on hand and noninterest-bearing amounts due from banks with maturities of three months or less.
Included in cash and cash equivalents are legally reserved amounts which are required to be maintained on an average basis in the form of cash and balances due from the Federal Reserve Bank and other banks. Reserve requirements were $500,000 and $7.5 million for the years ended March 31, 2007 and 2006, respectively.
The Company maintains cash balances at several banks. Accounts at each institution are insured by the FDIC up to $100,000.
Investments in Interest-Bearing Deposits - Investments in interest-bearing deposits consist principally of funds on deposit with the FHLB and short-term certificates of deposit with Western Washington financial institutions. They mature within one year and are carried at cost. Amounts, at times, may exceed FDIC insured limits.
Investments and Mortgage-Backed Securities - The Company classifies its securities into one of three categories: (1) held-to-maturity, (2) available-for-sale, or (3) trading. The Company had no trading securities at March 31, 2007 and 2006. Investment securities are categorized as held-to-maturity when the Bank has the positive intent and ability to hold those securities to maturity. Securities which are held-to-maturity are stated at cost, adjusted for amortization of premiums, and accretion of discounts which are recognized as adjustments to interest income.
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
Note 1 - Nature of Operations and Summary of Significant Accounting Policies (Continued)
Investment securities categorized as available-for-sale are generally held for investment purposes (to maturity), although unanticipated future events may result in the sale of some securities. Available-for-sale securities are recorded at fair value, with the net unrealized gain or loss included as other comprehensive income within the statement of stockholders' equity, net of the related tax effect. Realized gains or losses on dispositions are based on the net proceeds and the adjusted carrying amount of securities sold, using the specific identification method.
Declines in the fair value of individual held-to-maturity and available-for- sale securities below their cost that are other than temporary are recognized by write-downs of the individual securities to their fair value. Such write-downs would be included in earnings as realized losses. In estimating other-then-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.
Premiums and discounts are recognized in interest income using the interest method over the period to maturity.
Federal Home Loan Bank Stock - The Bank's investment in FHLB stock is a restricted investment carried at par value ($100 per share), which reasonably approximates its fair value. As a member of the FHLB system, the Bank is required to maintain a minimum level of investment in FHLB stock based on specific percentages of its outstanding FHLB advances. The Bank may request redemption at par value of any stock in excess of the amount the Bank is required to hold. Stock redemptions are at the discretion of the FHLB.
Loans Held for Sale - Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Net unrealized losses, if any, are recognized through a valuation allowance by changes to income.
Mortgage loans held for sale can be sold with the mortgage servicing rights retained by the Company. The carrying value of mortgage loans sold is reduced by the cost allocated to the associated mortgage servicing rights. Gains or losses on sales of mortgage loans are recognized based on the difference between the selling price and the carrying value of the related mortgage loans sold.
Loans Receivable - Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal adjusted for any charge-offs, the allowance for loan losses, and any net deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. Interest income is accrued on the daily unpaid principal balance using the simple-interest method. Loan origination fees, net of certain direct loan origination costs, are deferred and recognized as an adjustment of the yield on the related loans, using the interest method.
Impaired Loans and Related Income - A loan is considered impaired when management determines that it is probable that all contractual amounts of principal and interest will not be paid as scheduled in the loan agreement. These loans include nonaccruing loans past due 90 days or more and other loans that management considers to be impaired.
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 when the loan is brought current, or 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 new loan agreements. Interest income on impaired loans is monitored and is recognized 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, the observable fair market value of the loan, or the fair value of the loan's collateral.
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
Note 1 - Nature of Operations and Summary of Significant Accounting Policies (Continued)
Provision for Loan Losses - Management estimates the provision for loan losses by evaluating known and inherent risks in the loan portfolio. These factors include changes in the size and composition of the loan portfolio, actual loan loss experience, current and anticipated economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. The allowance for loan losses is based upon factors and trends identified by future market factors beyond the Company's control, which may result in losses or recoveries differing significantly from those provided for in the financial statements.
The majority of the Company's loan portfolio consists of commercial loans and single-family residential loans secured by real estate in the Whatcom, Skagit, Snohomish, and Pierce County areas of Washington. Real estate prices in these markets are stable at this time. However, the ultimate collectibility of a substantial portion of the Company's loan portfolio may be susceptible to changes in local market conditions in the future.
The allowance for loan losses is established as losses are estimated to have occurred through the provision for loan losses charged to earnings. Loan losses are charges against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.
While management uses available information to recognize losses on loans, further reductions in the carrying amounts of loans may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process periodically review the estimated losses on loans. Such agencies may require the Company to recognize additional losses based on their judgment about information available to them at the time of their examination.
Mortgage Servicing Rights - Servicing assets are recognized as separate assets when rights are acquired through sale of financial assets. Generally, for sales of mortgage loans, a portion of the cost of originating the loan is allocated to the servicing right based on relative fair value. Fair value is based on market prices for comparable mortgage servicing contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. Capitalized servicing rights are reported in other assets and are amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets.
Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights into tranches based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual tranche, to the extent that fair value is less than the capitalized amount for the tranche. If the Company later determines that all or a portion of the impairment no longer exists for a particular tranche, a reduction of the allowance may be recorded as an increase to income.
Servicing fee income is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal or a fixed amount per loan and are recorded as income when earned. The amortization of mortgage servicing rights is netted against loan servicing fee income. Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation. Major renewals or betterments are capitalized and depreciated over their estimated useful lives. Depreciation is computed by the straight-line method over the estimated useful lives of thirty-five years for buildings and three to ten years for equipment.
Bank Owned Life Insurance - The carrying amount of bank owned life insurance approximates its fair value. Fair value of bank owned life insurance is estimated using the cash surrender value net of surrender charges. The Bank owns approximately $19.4 and $13.7 million in bank owned life insurance as of March 31, 2007 and 2006, which is included in Other Assets.
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
Note 1 - Nature of Operations and Summary of Significant Accounting Policies (Continued)
Goodwill - Goodwill was recognized in connection with the purchase of branch assets and related liabilities. The Company performs periodic evaluations for impairment. During the years ended March 31, 2007 and 2006, impairment testing was performed and Goodwill was found not to be impaired. At March 31, 2007 and 2006, Goodwill in the amount of $545,000 was included in Other Assets.
Other Real Estate Owned - Other real estate owned includes properties acquired through foreclosure. These properties are recorded at the lower of cost or estimated fair value. Losses arising from the acquisition of property, in full or partial satisfaction of loans, are charged to the allowance for loan losses.
Subsequent to their transfer to other real estate owned, these assets continue to be recorded at the lower of cost or fair value (less estimated cost to sell), based on periodic evaluations. Generally, legal and professional fees associated with foreclosures are expensed as incurred. Costs incurred to improve property prior to sale are capitalized, however, in no event are recorded costs allowed to exceed fair value. Subsequent gains, losses, or expenses recognized on the sale of these properties are included in noninterest income or expense.
Income Taxes - The Company reports income and expenses using the accrual method of accounting and files a consolidated tax return which includes its subsidiary. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled using the liability method. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Deferred taxes result from temporary differences in the recognition of certain income and expense amounts between the Company's financial statements and its tax returns.
Earnings Per Share - Basic earnings per share amounts are computed based on the weighted average number of shares outstanding during the period after giving retroactive effect to stock dividends and stock splits. Diluted earnings per share amounts are computed by determining the potential number of additional shares that may be outstanding from the exercise of stock options using the treasury stock method.
Financial Instruments - All financial instruments held or issued by the Company are held or issued for purposes other than trading. In the ordinary course of business, the Bank enters into off-balance-sheet financial instruments consisting of commitments to extend credit. These commitments are recorded in the financial statements when they are funded.
Advertising Costs - The Company expenses advertising costs as they are incurred.
Share Based Payment - The Company adopted Statement of Financial Accounting Standard No. 123R, Share-Based Payment, (SFAS 123R) on April 1, 2006 using the "modified prospective" method. Under this method, awards that are granted, modified, or settled after March 31, 2006 are measured and accounted for in accordance with Statement 123R. Also under this method, expense is recognized for unvested awards that were granted prior to April 1, 2006 based upon the fair value determined at the grant date under Statement 123, Accounting for Stock-based Compensation. For the twelve months ended March 31, 2007, the Company recognized $292,000 in stock option and restricted stock award compensation expense as a component of salaries and benefits. As of March 31, 2007, there was approximately $461,000 of total unrecognized compensation cost related to nonvested options and restricted stock awards which is scheduled to amortize over the next four years.
Prior to the adoption of Statement 123R, the Company recognized the financial effects of stock options under the intrinsic value method as permitted by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and as such, previously recognized no compensation cost for employee stock options.
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
Note 1 - Nature of Operations and Summary of Significant Accounting Policies (Continued)
The following table provides pro forma disclosures for the years ended March 31 had the Company accounted for stock-based compensation using Statement 123R for the years presented: (Dollars in Thousands) ---------------------- 2006 2005 -------- --------
Net income as reported $ 15,655 $ 13,063
Additional compensation for fair value of stock options, net of tax (31) (20) -------- -------- Pro forma net income $ 15,624 $ 13,043 ======== ======== Earnings per share Basic As reported $1.26 $1.02 ===== ===== Pro forma $1.26 $1.02 ===== ===== Diluted As reported $1.25 $1.01 ===== ===== Pro forma $1.25 $1.01 ===== =====
Prior to the adoption of Statement 123R, the Company presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the Statement of Cash Flows. Statement 123R requires the cash flows resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. The $55,000 excess tax benefit classified as a financing cash inflow would have been classified as an operating cash inflow if the Corporation had not adopted Statement 123R.
Transfers of Financial Assets - Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Comprehensive Income - Accounting principles generally require that recognized revenue, expenses, gains, and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income.
The components of other comprehensive income and related tax effects are as follows for the years ended March 31:
2007 2006 2005 ------- ------- -------- (Dollars in Thousands) Unrealized holding gains (losses) on available-for-sale securities $ 27 $ (574) $ (2,318) Reclassification adjustment for losses (gains) realized in income 10 476 (476) Net unrealized gains 37 (98) (2,794) Tax effect (13) 34 950 ------- ------ -------- Net-of-tax amount $ 24 $ (64) $ (1,844) ======= ====== ========
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
Note 1 - Nature of Operations and Summary of Significant Accounting Policies (Continued)
Recent Accounting Pronouncements - In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets an amendment of FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (SFAS 156). SFAS 156 requires all separately recognized servicing assets and liabilities to be initially measured at fair value. In addition, entities are permitted to choose to either subsequently measure servicing rights at fair value and report changes in fair value in earnings, or amortize servicing rights in proportion to and over the estimated net servicing income or loss and assess the rights for impairment. Beginning with the fiscal year in which an entity adopts SFAS 156, it may elect to subsequently measure a class of servicing assets and liabilities at fair value. Post adoption, an entity may make this election as of the beginning of any fiscal year. An entity that elects to subsequently measure a class of servicing assets and liabilities at fair value should apply that election to all new and existing recognized servicing assets and liabilities within that class. The effect of remeasuring an existing class of servicing assets and liabilities at fair value is to be reported as a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption. SFAS 156 is effective as of the beginning of an entity's first fiscal year that begins after September 15, 2006. The statement also requires additional disclosures. The Corporation is currently evaluating the impact of the adoption of SFAS 156; however, it is not expected to have a material impact on the Corporation's financial position or results of operations.
In June 2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109 Accounting for Income Taxes. This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact of the adoption of FIN 48; however, it is not expected to have a material impact on the Company's financial position or results of operations.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. This Statement applies to other accounting pronouncements that require or permit fair value measurements. Accordingly, this Statement does not require any new fair value measurements. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years.
In February 2007, the Financial Accounting Standards Board released Statement No. 159, Fair Value Option for Financial Assets and Financial Liabilities. This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those years.
Reclassifications - Certain reclassifications have been made to prior years' financial statements to conform with the current year presentation. These reclassifications have no significant effect on the Company's previously reported financial position or results of operations.
Note 2 - Interest-Bearing Deposits
Interest bearing deposits consisted of the following at March 31:
2007 2006 ------- ------- (Dollars in Thousands)
FHLB interest-bearing demand $ 5,079 $ 9,139 Certificates of deposit 300 300 ------- ------- $ 5,379 $ 9,439 ======= =======
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
Note 2 - Interest-Bearing Deposits (Continued)
The Company has funds on deposit with the FHLB in a demand account. This account acts like a savings account and earns interest based on the daily federal funds rate. These funds are uninsured deposits held at the Federal Home Loan Bank of Seattle. The FHLB of Seattle, a federally chartered corporation, is one of 12 district FHLB institutions, which operate under the supervision of the Federal Housing Finance Board. The Finance Board is an independent agency of the executive branch within the U.S. Government which ensures that the FHLB operates in a safe and sound manner, remains adequately capitalized, and raises funds in the capital markets.
Note 3 - Investment Securities
The Company's investment policy requires that the Company purchase only high-grade investment securities. Purchases of debt instruments are generally restricted to those rated A or better by a nationally recognized statistical rating organization.
The amortized cost and estimated fair values of investments, together with unrealized gains and losses, are as follows as of March 31, 2007 and 2006, respectively:
Certain investment securities shown above currently have fair values less than amortized cost and therefore contain unrealized losses. At March 31, 2007, the Company has evaluated these securities and has determined that the decline in value is temporary and is related to the change in market interest rates since purchase. The decline in value is not related to any company or industry specific event. At March 31, 2007, there are approximately 39 investment securities with unrealized losses. The Company anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of more favorable market interest rates.
The amortized cost and estimated fair value of investment securities at March 31, 2007, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
(Dollars in Thousands) ------------------------------------------------ Available-For-Sale Held-To-Maturity ----------------------- ----------------------- Amortized Estimated Amortized Estimated Cost Fair Value Cost Fair Value -------- ---------- -------- ---------- State and political sub- divisions and U.S. government agencies One year or less $ 22,868 $ 22,779 $ -- $ -- More than one to five years 11,294 11,157 370 372 More than five to ten years 5,601 5,571 -- -- Over ten years 1,587 1,601 -- -- -------- -------- -------- -------- 41,350 41,108 370 372 -------- -------- -------- -------- Corporate debt securities One year or less 1,002 1,001 -- -- More than one to five years -- -- -- -- -------- -------- -------- -------- 1,002 1,001 -- -- -------- -------- -------- -------- Mutual funds and marketable equity securities (liquid) 5,323 10,756 -- -- -------- -------- -------- -------- Total investment securities $ 47,675 $ 52,865 $ 370 $ 372 ======== ======== ======== ========
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
Note 3 - Investment Securities (Continued)
Proceeds from sales of investments and gross realized gains and losses on investment sales were as follows for the year ended March 31:
2007 2006 2005 ------- -------- -------- (Dollars in Thousands)
Proceeds from sales of investments $ 3,748 $ 15,857 $ 9,576 ======= ======== ======== Gross gains realized on sales of investments $ 287 $ -- $ 485 ======= ======== ======== Gross losses realized on sales of investments $ (316) $ (565) $ (9) ======= ======== ========
Information about concentrations of investments in particular industries for marketable equity securities and corporate debt securities at March 31 consists of the following: 2007 2006 ----------------- ----------------- Market Market Cost Value Cost Value ------- ------- ------- ------- (Dollars in Thousands) Marketable equity securities Banking $ 309 $ 1,933 $ 309 $ 2,026
Government agency stocks 14 3,949 1,515 6,024 ------- ------- ------- ------- $ 323 $ 5,882 $ 1,824 $ 8,050 ======= ======= ======= ======= Corporate debt securities Private utilities 1,002 1,001 1,009 1,009
Manufacturing companies -- -- 1,003 1,001 ------- ------- ------- ------- Total $ 1,002 $ 1,001 $ 2,012 $ 2,010 ======= ======= ======= =======
At March 31, 2007 and 2006, U.S. government agency and corporate debt securities of $5.6 million and $3.4 million, respectively, were pledged as collateral for deposits of state and local government agencies and deposits for trust accounts in excess of $100,000, as required by Washington State Law.
Note 4 - Mortgage-Backed Securities
Mortgage-backed securities at March 31 consist of the following:
(Dollars in Thousands) --------------------------------------------------------- Gross Gross Unrealized Unrealized Gross Losses Losses Estimated Amortized Unrealized 12 Months Greater Than Fair Cost Gains or Less 12 Months Value ------- ------- ------- ------- ------- Available-for-sale securities $26,220 $ 178 $ (37) $ (128) $26,233 Held-to-maturity securities 148 9 -- -- 157 Total mortgage- backed ------- ------- ------- ------- ------- securities $26,368 $ 187 $ (37) $ (128) $26,390 ======= ======= ======= ======= =======
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
Note 4 - Mortgage-Backed Securities (Continued)
Certain investment securities shown above currently have fair values less than amortized cost and therefore contain unrealized losses. At March 31, 2007, the Company has evaluated these securities and has determined that the decline in value is temporary and is related to the change in market interest rates since purchase. The decline in value is not related to any company or industry specific event. At March 31, 2007, there are approximately 34 mortgage-backed securities with unrealized losses. The Company anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of a more favorable market interest rate environment.
(Dollars in Thousands) --------------------------------------------------------- Gross Gross Unrealized Unrealized Gross Losses Losses Estimated Amortized Unrealized 12 Months Greater Than Fair Cost Gains or Less 12 Months Value --------- ---------- --------- ------------ --------- Available-for-sale securities $23,559 $103 $ (3) $(308) $23,351 Held-to-maturity securities 482 15 - - 497 ------- ---- ---- ----- ------- Total mortgage- backed securities $24,041 $118 $ (3) $(308) $23,848 ======= ==== ==== ===== =======
The amortized cost and estimated fair value of mortgage-backed securities at March 31, 2007, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to prepay obligations with or without prepayment penalties.
(Dollars in Thousands) --------------------------------------------- Available-For-Sale Held-To-Maturity --------------------- --------------------- Amortized Estimated Amortized Estimated Cost Fair Value Cost Fair Value --------- ---------- --------- ---------- Mortgage-backed securities One year or less $ - $ - $ 4 $ 4 More than two to five years - - 118 119 More than five to ten years 5,262 5,285 16 23 After ten years 20,958 20,948 10 11 ------- ------- ----- ----- Total $26,220 $26,233 $ 148 $ 157 ======= ======= ===== =====
All of the above mortgage-backed securities are rated AAA by a nationally recognized statistical rating organization.
Proceeds from sales of mortgage-backed securities and gross realized gains and losses on mortgage-backed security sales were as follows for the year ended March 31: 2007 2006 2005 ------ ------ ----- (Dollars in Thousands)
Proceeds from sales of mortgage-backed securities $8,748 $1,054 $ - ====== ====== ===== Gross gains realized on sales of mortgage-backed securities $ 28 $ 65 $ - ====== ====== ===== Gross losses realized on sales of mortgage-backed securities $ (9) $ - $ - ====== ====== =====
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
NOTE 5 - LOANS RECEIVABLE
Loans receivable (collateralized principally by properties in the Whatcom, Skagit, Snohomish, and Pierce Counties of Washington State) at March 31 consist of the following:
(Dollars in Thousands) ---------------------- 2007 2006 -------- -------- First mortgage loans 1-4 Family $ 149,885 $148,515 1-4 Family construction 28,576 20,971 Less participations (54,592) (56,546) ---------- -------- Net first mortgage loans 123,869 112,940 Construction and land development 405,348 262,358 Multi family residential 52,727 70,080 Commercial real estate 292,212 314,299 Commercial loans 146,265 123,445 Home equity secured 45,307 44,001 Other consumer loans 5,031 5,571 ---------- -------- 1,070,759 932,694 Less: Allowance for loan losses (15,889) (14,184) ---------- -------- $1,054,870 $918,510 ========== ========
The Company originates both adjustable and fixed interest rate loans. At March 31, 2007, the Company had adjustable and fixed rate loans as follows:
Fixed Rate Adjustable Rate - ------------------------------- -------------------------------- (Dollars in (Dollars in Thousands) Thousands) Term to Maturity Book Value Term to Maturity Book Value - ---------------- ----------- ---------------- ----------- Less than one year $20,282 Less than one year $740,163 One to three years 25,118 One to three years 136,079 Three to five years 19,309 Three to five years 19,007 Five to fifteen years 65,784 Five to fifteen years 1,772 Over fifteen years 43,245 Over fifteen years -
Loans serviced for others were approximately $126.0 and $99.5 million, respectively, as of March 31, 2007 and 2006. The Bank generally receives a monthly fee of 0.25% to 0.375% per annum of the unpaid balance of each loan that is serviced for others. Loans sold are without right of recourse to the Bank by the buyer of the loan interests in the event of default by the borrower.
The allowance for loan losses at March 31, and changes during the year are as follows:
2007 2006 2005 ------- ------- ------- (Dollars in Thousands)
Balance, beginning of year $14,184 $11,767 $10,122 Provision for loan losses 1,850 2,575 1,700 Loan chargeoffs (195) (165) (229) Loan recoveries 50 7 174 ------- ------- ------- Balance, end of year $15,889 $14,184 $11,767 ======= ======= =======
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
NOTE 5 - LOANS RECEIVABLE (Continued)
The following is a summary of information pertaining to impaired and non-accrual loans:
March 31, ------------------ 2007 2006 ------ ------ (Dollars in Thousands)
Impaired loans without a valuation allowance $ - $ - Impaired loans with a valuation allowance 4,172 5,114 ------ ------ Total impaired loans $4,172 $5,114 ====== ====== Valuation allowance related to impaired loans $ 577 $ 856 Total non-accrual loans $ 226 $1,161 Total loans past-due 90 days or more and still accruing $ - $ -
Years Ended March 31, ------------------------ 2007 2006 2005 ------ ------ ------ (Dollars in Thousands)
Average investment in impaired loans $5,063 $5,070 $964 ====== ====== ==== Interest income recognized on impaired loans $ 276 $ - $ - ====== ====== ==== Interest income recognized on a cash basis on impaired loans $ - $ - $ - ====== ====== ====
No additional funds are committed to be advanced in connection with impaired loans.
NOTE 6 - ACCRUED INTEREST AND DIVIDENDS RECEIVABLE
Accrued interest and dividends receivable at March 31 is summarized as follows: 2007 2006 ------ ------ (Dollars in Thousands)
Investment securities $ 528 $ 574 Mortgage-backed securities 111 116 Loans receivable 5,980 4,492 Dividends on marketable equity securities 7 3 ------ ------ $6,626 $5,185 ====== ======
NOTE 7 - PREMISES AND EQUIPMENT
Premises and equipment at March 31 consisted of: 2007 2006 ------ ------ (Dollars in Thousands)
Buildings $ 19,988 $ 15,043 Equipment 12,576 15,852 -------- -------- 32,564 30,895 Accumulated depreciation (11,925) (11,570) -------- -------- 20,639 19,325 Land 6,992 6,992 -------- -------- Balance, end of year $ 27,631 $ 26,317 ======== ========
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
NOTE 8 - DEPOSITS
A comparative summary of deposits at March 31 follows: 2007 2006 ------ ------ (Dollars in Thousands) Demand deposits Savings $ 21,628 $ 30,808 Checking 78,294 79,774 Checking (noninterest-bearing) 91,703 80,778 Money Market 187,912 156,867 -------- -------- 379,537 348,227 -------- -------- Time certificates of deposit Less than $100,000 273,022 246,136 Greater than or equal to $100,000 322,736 239,936 -------- -------- 595,758 486,072 -------- -------- Total deposits $975,295 $834,299 ======== ========
Time certificate of deposit accounts, classified by variable and fixed rates, and their maturities at March 31 were as follows:
------------------------------ (Dollars in Thousands) Variable Fixed Rate Rate Total 2006 ------- -------- -------- -------- Within one year $ 8,092 $503,970 $512,062 $323,641 One to two years 2,545 39,475 42,020 111,315 Two to three years 6,853 7,672 14,525 19,553 Three to four years 1,112 8,314 9,426 17,353 Four to five years 403 13,500 13,903 9,810 Over five years 3,822 - 3,822 4,400 ------- -------- -------- -------- $22,827 $572,931 $595,758 $486,072 ======= ======== ======== ========
The terms of variable rate certificates of deposit allow customers to make additional deposits to existing certificates of deposit at any time.
The weighted average nominal interest rate on all deposits at March 31, 2007 and 2006, was 3.56% and 2.54%, respectively.
Interest expense on all deposit accounts for the years ended March 31 is summarized as follows: 2007 2006 2005 ------- ------- ------- (Dollars in Thousands) Money market $ 6,316 $ 3,456 $ 1,685 Checking 510 426 428 Savings 167 189 216 Certificates of deposit 25,258 15,917 10,890 ------- ------- ------- Balance, end of year $32,251 $19,988 $13,219 ======= ======= =======
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
NOTE 9 - OTHER BORROWED FUNDS
The Bank is a member of the FHLB of Seattle. As a member, the Bank has a committed line of credit up to 25% of total assets, subject to the Bank pledging sufficient collateral and maintaining the required stock investment in the FHLB. Committed lines of credit agreements totaling approximately $248.5 million and $205.6 million were available to the Bank, of which, $143.5 million and $149.0 million were outstanding at March 31, 2007 and 2006, respectively. Included in these amounts is the borrowing related to the investment in real estate in a joint venture of $20.2 million and $18.3 million as of March 31, 2007 and 2006, respectively. These advances bear interest ranging from 2.75% to 5.69% and 2.67% to 5.08% per annum in 2007 and 2006, respectively. Maturities for the advances are $103.0 million in fiscal 2008, $19.5 million in fiscal 2009, and $21.0 million in fiscal 2010.
The maximum outstanding and average outstanding balances and average interest rates on advances from the FHLB were as follows for the year ended March 31:
2007 2006 2005 ------ ------ ------ (Dollars in Thousands)
Maximum outstanding at any month end $195,000 $149,000 $129,500 Average outstanding 165,237 134,070 89,820
Weighted average interest rates:
Annual 4.74% 3.68% 3.26% ==== ==== ====
End of year 5.03% 4.39% 3.28% ==== ==== ====
The Bank has other borrowed funds in the form of retail repurchase agreements. These agreements are collateralized by securities held by a safekeeping agent not under control of the Bank. These advances are considered overnight borrowings and bear interest rates that fluctuate daily based on current market rates. The Bank had $14.4 million and $10.8 million outstanding as of March 31, 2007 and 2006, respectively.
As of March 31, 2007, The Bank also had $1.0 million and $32,000 outstanding as of March 31, 2007 and 2006, respectively, in the form of a TT&L note option which is included in other borrowed funds.
At March 31, 2007 and 2006, respectively, U.S. government agency and corporate debt securities of $16.3 million and $14.3 million were pledged as collateral for retail repurchase agreements.
NOTE 10 - INCOME TAX
A reconciliation of the Company's income tax provision to the statutory federal income tax rate for the years ended March 31 is as follows:
2007 2006 2005 ------ ------ ------ (Dollars in Thousands)
Provision for income tax at the statutory rate of 35 percent $10,008 $7,895 $6,451 Increase (decrease) in tax resulting from: Nontaxable income (469) (539) (640) Nondeductible expense 29 15 13 Dividends received deduction (52) (48) (35) Other, net 50 (420) (420) ------- ------ ------ Income tax provision $ 9,566 $6,903 $5,369 ======= ====== ======
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
NOTE 10 - INCOME TAX (Continued)
The nature and components of the Company's net deferred tax assets (liabilities), established at an estimated tax rate of 35% are as follows at March 31: 2007 2006 ------- ------- (Dollars in Thousands)
Deferred Tax Assets Deferred compensation agreements $ 707 $ 659 Financial reporting loan loss reserve not recognized for tax purposes 5,215 4,636 Financial reporting accrued expenses not recognized for tax purposes 403 264 Other deferred tax assets 1,404 708 ------- ------- Total deferred assets 7,729 6,267 ------- -------
Deferred Tax Liabilities Deferred loan fees for tax purposes in excess of amounts deferred for financial reporting (264) (275) Tax effect of unrealized gains on available-for- sale securities (1,862) (1,849) FLHB stock dividends (793) (793) Other deferred tax liabilities (1,077) (1,096) ------- ------- Total deferred liabilities (3,996) (4,013) ------- ------- Net deferred tax assets $ 3,733 $ 2,254 ======= =======
The Company believes, based upon the available evidence, that all deferred tax assets will be realized in the normal course of operations. Accordingly, these assets have not been reduced by a valuation allowance.
NOTE 11 - BENEFIT PLANS
Deferred Compensation Plan - The Company has entered into deferred compensation agreements with certain of its officers. The agreements provide for additional retirement benefits payable over a 12 to 20 year period following retirement. In connection with these agreements, the Company has acquired life insurance policies on the individual officers covered by the deferred compensation agreements. At March 31, 2007 and 2006, the cash surrender values of these policies included in Other Assets aggregated $1.9 million and $1.8 million, respectively.
The Company performs a present value calculation using an appropriate discount rate on an annual basis to ensure that deferred compensation plan obligations are adequately estimated in the accompanying financial statements. The discount rate was 2.67%, 2.72%, and 3.00% in 2007, 2006, and 2005, respectively. Deferred compensation expense amounted to $213,000, $137,500, and $150,000 in 2007, 2006, and 2005, respectively.
Employee Incentive Plan - The Company has an incentive plan with employees meeting certain service requirements. Payments made to employees pursuant to the plan are based upon earnings, growth in deposits and loans and attainment of certain corporate objectives. Costs of the plan were $2.3 million, $2.1 million, and $1.3 million for the years ended March 31, 2007, 2006, and 2005, respectively.
Employee Stock Ownership Plan - The Company has a noncontributory employee stock ownership plan ("ESOP") for those employees who have completed a minimum of two years of service. The Company's contribution is determined annually by the Board of Directors. Participants receive distributions from the ESOP only in the event of retirement, disability or termination of employment. The primary purpose of the ESOP is to acquire shares of the Company's common stock on behalf of ESOP participants.
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
NOTE 11 - BENEFIT PLANS (Continued)
In April 1996, the Company issued a loan to the ESOP in the amount of $500,000, to purchase 40,000 shares of common stock in the open market. The loan was to be repaid over a period of ten years, with annual payments including interest due on March 31 of each year. The ESOP shares initially were pledged as collateral for this debt. As the obligation was reduced, shares were released from collateral and allocated to the participants' accounts at a rate of 10% a year. In May 1997, the Company issued a 15% stock dividend which added an additional 5,400 shares to the unallocated ESOP shares. In May 1999, the Company made an additional loan to the ESOP in the amount of $154,725, to purchase 12,500 shares of common stock in the open market. The loan was to be repaid over seven years with annual payments including interest due March 31. In April 2001, the Company issued a 15% stock dividend which added an additional 4,789 shares to the unallocated ESOP shares. In July 2002, the Company issued a 25% stock split which added an additional 7,342 shares to the unallocated ESOP shares. In October 2006, the Company issued a 5-for-4 stock split paid in the form of a 25% stock dividend which added an additional 21,023 shares to the allocated ESOP shares. As of March 31, 2006, all loans secured by ESOP shares were paid off, and the remaining shares released. Shares released for allocation were 9,175 for the year ended March 31, 20076 and 9,180 for the year ended March 31, 2005. The ESOP shares relating to the loans outstanding as of March 31, 2006 and 2005 were as follows:
2006 2005 -------- -------- (Dollars in Thousands)
Number of shares Allocated shares $105,116 $ 93,648 Unallocated shares - 11,468 -------- -------- Total ESOP shares $105,116 $105,116 ======== ======== Fair value Unallocated shares $ - $171,206 ======== ========
Dividends paid on shares of stock are reinvested and the new shares purchased are allocated to the participants. Compensation expense for the ESOP plan was $10,000, $105,000, and $105,000 for the years ended March 31, 2007, 2006, and 2005 respectively.
401(k) Plan - Effective January 1, 1993, the Company adopted a defined contribution 401(k) retirement and savings plan (the "Plan") covering substantially all employees. The Company contributes three percent of participating employee's eligible salary to the Plan and a discretionary amount determined annually by the Board of Directors. Total Company contributions to the Plan which were recorded as employee benefits expense amounted to $490,000, $500,000, and $450,000 for the years ended March 31, 2007, 2006, and 2005, respectively.
Stock Option and Award Plans - The Company may grant stock options and/or awards for a maximum of 937,500 shares of authorized common stock to certain officers and key employees under the 2005 Incentive Stock Plan. Activity during the year ended March 31, 2006 also included options granted under the 1995 Stock Option and Incentive Plan, which allowed for a maximum of 743,906 shares, as restated, of authorized common stock to be awarded. Options and awards are granted at no less than fair market value and may or may not vest immediately upon issuance based on the terms established by the Board of Directors. Options and awards are generally exercisable within one to five years from date of grant and expire after ten years.
The Corporation measures the fair value of each stock option grant at the date of grant, using the Black Scholes option pricing model. The weighted average fair value of options granted during the twelve months ended March 31, 2007, 2006, and 2005 was $4.18, $3.81, and $3.48 per share, as adjusted, respectively. The following assumptions were used in arriving at the fair value of options granted during the twelve months ended March 31:
2007 2006 2005 ------ ------ ------ Risk-free interest rate 5.27% 4.17% 4.26% Dividend yield rate 2.417% 2.613% 2.875% Price volatility 24.77% 25.27% 25.47% Weighted average expected life of options 3.78 yr. 5.50 yr. 6.20 yr.
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
NOTE 11 - BENEFIT PLANS (Continued)
A summary of option activity under the Plan as of March 31, 2007 and 2006, and changes during the years then ended is as follows:
Shares of Common Stock ------------------------ Weighted Average of Available for Under Exercise Price of Option/Award Plan Shares Under Plan ------------- ----- ------------------- (Dollars in Thousands)
Balance, March 31, 2005 $ - $273,215 Authorized 937,500 - Restricted stock awards (12,600) Granted (18,850) 18,850 $16.37 - 17.72 Exercised - (100,776) $ 5.17 - 17.14 Lapsed 4,238 (4,053) $ 5.17 - 17.14 Expired (3,868) - -------- -------- Balance, March 31, 2006 906,420 187,236 Authorized - - Restricted stock awards (24,045) Granted (24,045) 24,045 $ 19.86 Exercised - (23,884) $ 5.17 - 17.72 Lapsed 4,678 (2,922) $ 5.17 - 17.72 Expired (995) - -------- -------- Balance, March 31, 2007 $862,013 $184,475 ======== ========
Options Outstanding Options Exercisable --------------------------------- --------------------------------- Weighted Weighted Average Weighted Average Range of Remaining Average Remaining Average Exercise Number Contractual Exercise Number Contractual Exercise Prices Outstanding Life Price Exercisable Life Price - -------- ----------- ---------- -------- ----------- ----------- ------- $5 to $10 124,317 3.454 years $ 6.696 124,317 3.454 years $ 6.696 $10 to $15 10,000 6.205 years $12.004 9,374 6.100 years $11.846 $15 to $20 50,158 8.789 years $17.978 12,537 8.158 years $16.022
At March 31, 2007, the aggregate intrinsic value of stock options outstanding and stock options exercisable was $2.2 million and $2.1 million, respectively.
NOTE 12 - STOCKHOLDERS' EQUITY
Capital Requirements - The Company and Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's and the Bank's financial statements. Under capital adequacy guidelines within the regulatory framework for prompt corrective action, the Bank must meet specific capital adequacy guidelines that involve quantitative measures of each entity's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
NOTE 12 - STOCKHOLDERS' EQUITY (Continued)
Quantitative measures are established by regulation to ensure capital adequacy, require maintenance of minimum amounts and ratios of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets, and of Tier 1 capital to average assets as illustrated in the following table. Management believes, as of March 31, 2007, that each entity meets all capital adequacy requirements to which they are subject. Additionally, as of March 31, 2007, the Bank was categorized as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the institution's category.
To Be Well Capitalized Under Prompt For Capital Corrective Actual Adequacy Purposes Action Provisions -------------- ----------------- ----------------- Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- As of March 31, 2007 (in thousands) Total Capital (to Risk Weighted Assets) Consolidated $136,606 12.03% $90,870 >8.00% N/A Horizon Bank $136,337 12.00% $90,862 >8.00% $113,578 >10.00% Tier I Capital (to Risk Weighted Assets) Consolidated $119,942 10.56% $45,435 >4.00% N/A Horizon Bank $119,674 10.54% $45,431 >4.00% $68,147 >6.00% Tier I Capital (to Average Assets) Consolidated $119,942 9.64% $49,751 >4.00% N/A Horizon Bank $119,674 9.63% $49,728 >4.00% $62,160 >5.00%
To Be Well Capitalized Under Prompt For Capital Corrective Actual Adequacy Purposes Action Provisions -------------- ----------------- ----------------- Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- As of March 31, 2006 (in thousands) Total Capital (to Risk Weighted Assets) Consolidated $124,523 12.63% $78,861 >8.00% N/A Horizon Bank $124,365 12.62% $78,861 >8.00% $98,576 >10.00% Tier I Capital (to Risk Weighted Assets) Consolidated $109,435 11.10% $39,431 >4.00% N/A Horizon Bank $109,277 11.09% $39,430 >4.00% $59,146 >6.00% Tier I Capital (to Average Assets) Consolidated $109,435 10.03% $43,655 >4.00% N/A Horizon Bank $109,277 10.02% $43,633 >4.00% $54,541 >5.00%
Holding Company Loans - Under federal regulations, the Bank is limited, unless previously approved, as to the amount it may loan to the holding company and any one affiliate, to 10% of its capital stock and surplus, and the total of loans to the holding company and affiliates must not exceed 20% of capital and surplus. Further, all such loans must be fully collateralized. In addition, dividends paid by the Bank to the Company would be prohibited if the effect thereof would cause the Bank's capital to be reduced below applicable minimum capital requirements.
Dividend Reinvestment Plan - As a service to its stockholders of record, the Bank offers a Dividend Reinvestment and Stock Purchase Plan ("Reinvestment Plan"). Under the terms of the Reinvestment Plan, dividends and optional cash payments may be reinvested toward the purchase of additional shares of stock. No brokerage commission or fees are charged to acquire shares through the Reinvestment Plan.
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
NOTE 12 - STOCKHOLDERS' EQUITY (Continued)
Stock Repurchase Plans - The Company has conducted various stock buy-back programs since August 1996. In March 2004, the Company announced a plan to repurchase up to 1,300,000 shares, or approximately 10% of the Company's outstanding common stock. During fiscal 2005, 563,600 shares were repurchased and subsequently retired at a cost of $8,687,765. In March 2005, the Company announced a plan to repurchase up to 1,250,000 shares, or approximately 10% of the Company's outstanding common stock. During fiscal 2006, 266,065 shares were repurchased and subsequently retired at a cost of $4,377,704. In March 2006, the Company announced a plan to repurchase up to 625,000 shares, or approximately 5% of the Company's outstanding common stock. During fiscal 2007, 144,580 shares were repurchased and subsequently retired at a cost of $2,942,428. Share information related to stock repurchases has been restated to reflect stock splits and dividends.
Stock Split - The Company's Board of Directors, at it's September 26, 2006 Board meeting, announced a 5 for 4 stock split paid in the form of a 25% stock dividend to be issued October 23, 2006 for shareholders of record October 6, 2006.
NOTE 13 - EARNINGS PER SHARE
The numerators and denominators, adjusted for stock splits and dividends, of basic and diluted earnings per share are as follows:
2007 2006 2005 ----------- ----------- ----------- (Dollars in Thousands)
Net income (numerator) $ 19,028 $ 15,655 $ 13,063 Shares used in the calculation (denominators) Basic earnings per weighted average share outstanding 12,287,805 12,422,000 12,765,238 Effect of dilutive stock options 121,287 120,845 187,304 ----------- ----------- ----------- Diluted shares 12,409,092 12,542,845 12,952,542 =========== =========== ===========
Basic earnings per share $1.55 $1.26 $1.02 ===== ===== =====
Diluted earnings per share $1.53 $1.25 $1.01 ===== ===== =====
At March 31, 2007, 2006, and 2005, there were options to purchase 184,475, 187,236, and 273,215 shares of common stock outstanding. As of March 31, 2007, 2006, and 2005, all options to purchase shares of common stock were included in the diluted net income per share calculation.
NOTE 14 - COMMITMENTS AND CONTINGENCIES
Employment Agreement - The Company has entered into employment agreements with members of senior management that provide for potential payments upon change in control, disability, termination without cause, or death. The arrangements generally provide severance payments at 2.99 times the then current compensation levels and continuation of certain benefits.
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
NOTE 14 - COMMITMENTS AND CONTINGENCIES (Continued)
Long-Term Lease Commitments - The Company has entered into lease agreements for certain parcels of land and branch offices. Future noncancelable lease payments under these agreements are as follows for the years ending March 31:
(Dollars in Thousands) ---------- 2008 $ 381 2009 273 2010 239 2011 243 2012 186 Thereafter 111 ------ $1,433 ======
Rent expense charged to operations was $293,000, $294,000, and $267,000 for the years ended March 31, 2007, 2006, and 2005.
NOTE 15 - RELATED PARTY TRANSACTIONS
Certain directors, executive officers, and principal stockholders are Bank customers and have had banking transactions with the Bank. All loans and commitments to loan included in such transactions were made in compliance with applicable laws on substantially the same terms (including interest rates and collateral) as those prevailing at the time for comparable transactions with other persons and do not involve more than the normal risk of collectibility or present any other unfavorable features.
The aggregate balances and activity during 2007 and 2006, are as follows and were within regulatory limitations: 2007 2006 ------- ------- (Dollars in Thousands)
Balance, beginning of year $15,528 $14,518 New loans or advances 5,155 8,975 Repayments (7,178) (7,965) ------- ------- Balance, end of year $13,505 $15,528 ======= ======= Interest earned on loans $ 1,130 $ 1,071 ======= =======
Deposits from related parties totaled approximately $3.8 million and $3.6 million at March 31, 2007 and 2006, respectively.
The Company leases office space from a limited partnership in which one of the Company's directors is a part owner. Lease expense for this office space was $151,000, $123,000, and $114,000 for the fiscal years ended March 31, 2007, 2006, and 2005, respectively. The future commitments related to this lease are included in the totals disclosed in Note 14 regarding Long-Term Lease Commitments.
NOTE 16 - SIGNIFICANT GROUP CONCENTRATIONS OF CREDIT RISK
Most of the Bank's business activity is with customers located within Whatcom, Skagit, Snohomish, and Pierce Counties. Investments in state and municipal securities involve governmental entities within the state of Washington. The Bank originates commercial, real estate, and consumer loans. Generally, loans are secured by deposit accounts, personal property, or real estate. Rights to collateral vary and are legally documented to the extent practicable. Although the Bank has a diversified loan portfolio, local economic conditions may affect borrowers' ability to meet the stated repayment terms.
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
NOTE 17 - FINANCIAL INSTRUMENTS
The Bank is a party to financial instruments with off-balance-sheet risk (loan commitments) in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. Loan commitments involve, to varying degrees, elements of credit and interest-rate risk in excess of the amount recognized in the balance sheet. The contract amounts of those commitments reflect the extent of the Bank's exposure to credit loss from these commitments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment, and income-producing commercial properties.
Unfunded commitments under commercial lines-of-credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines-of-credit are uncollateralized and usually do not contain a specified maturity date and may not be drawn upon to the total extent to which the Company is committed.
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. Except for certain long-term guarantees, the majority of guarantees expire in one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral supporting those commitments, for which collateral is deemed necessary, generally amounts to 100% of the commitment amount at March 31, 2007.
The Bank has not been required to perform on any financial guarantees and has not incurred any losses on its commitments for the years ended March 31, 2007, 2006, and 2005.
The following is a summary of the off-balance-sheet financial instruments or contracts outstanding at March 31:
2007 2006 ------ ------ (Dollars in Thousands)
Commitments to extend credit $383,458 $286,188 Credit card arrangements 10,105 9,775 Standby letters of credit 3,056 5,237
NOTE 18 - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair value of the following classes of financial instruments:
Cash Equivalents and Interest-Bearing Deposits - Due to the relatively short period of time between the origination of these instruments and their expected realization, the carrying amount is estimated to approximate fair value.
Investment and Mortgage-Backed Securities - Fair values are based on quoted market prices or dealer quotes, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
NOTE 18 - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)
Federal Home Loan Bank Stock - FHLB Stock is carried at $100 par value. This investment is considered restricted, as a minimum investment must be maintained in order to obtain borrowing commitments from FHLB. The Company may redeem its investment only at par value, which is used as the estimated market value.
Loan Receivables and Investment in Real Estate in a Joint Venture - For certain homogeneous categories of loans, such as those written to FHLMC standards, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.
Loans Held for Sale - The fair value of loans held for sale is based on the estimated value at which the loans could be sold in the secondary market.
Accrued Income and Expense Accounts - Due to the short-term nature of these amounts, recorded book value is believed to approximate fair value.
Deposit Liabilities, Repurchase Agreements, Other Borrowed Funds, and Borrowing Related to Investment in Real Estate in a Joint Venture - The fair value of demand deposits, savings accounts, certain money market deposits, and federal funds purchased, is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit, repurchase agreements and other borrowed funds are estimated by discounting the estimated future cash flows using the rates currently offered for these instruments with similar remaining maturities.
Off-Balance-Sheet Instruments - The Company's off-balance-sheet instruments include unfunded commitments to extend credit and borrowing facilities available to the Company. The fair value of these instruments is not considered practicable to estimate because of the lack of quoted market price and the inability to estimate fair value without incurring excessive costs.
The carrying amounts and estimated fair values of the Bank's financial instruments at March 31, are as follows:
2007 2006 ---------------------- --------------------- Carrying Carrying Amount Fair Value Amount Fair Value -------- ---------- -------- ---------- (Dollars in Thousands)
Financial Assets Cash and cash equivalents $ 40,833 $ 40,833 $ 24,190 $ 24,190 Interest-bearing deposits 5,379 5,379 9,439 9,439 Investment securities 53,235 53,237 60,507 60,511 Mortgage-backed securities 26,381 26,390 23,833 23,848 Federal Home Loan Bank stock 7,247 7,247 7,247 7,247 Loans receivable 1,054,870 1,049,670 918,510 912,192 Loans held-for-sale 4,493 4,493 5,252 5,252 Investment in real estate in a joint venture 17,169 17,169 16,928 16,928 Accrued interest and dividends receivable 6,626 6,626 5,185 5,185
Financial Liabilities Demand and savings deposits 379,537 379,537 348,227 348,227 Time deposits 595,758 590,370 486,072 483,555 Other liabilities 6,058 6,058 4,917 4,917 Accrued interest payable 3,450 3,450 2,002 2,002 Other borrowed funds 138,715 138,009 141,561 139,926 Borrowing related to investment in real estate in a joint venture 20,243 20,243 18,276 18,276
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
NOTE 19 - PARENT COMPANY (ONLY) FINANCIAL INFORMATION
Condensed balance sheet at March 31:
2007 2006 -------- -------- (Dollars in Thousands)
Cash $ 138 $ 151 Investment in Bank 123,586 113,165 Other assets 1,663 1,442 -------- -------- $125,387 $114,758 ======== ========
Other liabilities $ 1,532 $ 1,435 Stockholders' equity 123,855 113,323 -------- -------- $125,387 $114,758 ======== ========
Condensed statement of income for the years ended March 31, 2007, 2006, and 2005: 2007 2006 2005 ------- ------- ------- (Dollars in Thousands) Income Cash dividends from Bank subsidiary $ 9,149 $ 9,981 $14,081 Interest - 2 3 ------- ------- ------- Total income 9,149 9,983 14,084 ------- ------- ------- Expenses Compensation 426 164 126 Other 372 346 237 ------- ------- ------- Total expenses 798 510 363 ------- ------- ------- Income before undistributed income of subsidiary and benefit equivalent to income taxes 8,351 9,473 13,721 Benefit equivalent to income taxes 279 178 123 ------- ------- ------- Income before undistributed income of subsidiary 8,630 9,651 13,844 Undistributed income of subsidiary 10,398 6,004 (781) ------- ------- ------- Net income $19,028 $15,655 $13,063 ======= ======= =======
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
NOTE 19 - PARENT COMPANY (ONLY) FINANCIAL INFORMATION (Continued)
2007 2006 2005 ------- ------- ------- (Dollars in Thousands)
Cash flows from operating activities Net income $ 19,028 $15,655 $ 13,063 Adjustments to reconcile net income to net cash flows from operating activities Equity in undistributed income of subsidiary (10,398) (6,004) 781 Other operating activities 127 (66) (345) -------- ------- -------- Net cash flows from operating activities 8,757 9,585 13,499 -------- ------- -------- Cash flows from investing activities Other investing activities - 22 22 -------- ------- -------- Net cash flows from investing activities - 22 22 -------- ------- -------- Cash flows from financing activities Sale of common stock 149 464 497 Dividends paid (5,977) (5,572) (5,328) Treasury stock purchased (2,942) (4,378) (8,688) -------- ------- -------- Net cash flows from financing activities (8,770) (9,486) (13,519) -------- ------- -------- Net change in cash (13) 121 2 Cash, beginning of year 151 30 28 -------- ------- -------- Cash, end of year $ 138 $ 151 $ 30 ======== ======= ========
NOTE 20 - SELECTED QUARTERLY FINANCIAL DATA (IN THOUSANDS) (Unaudited)
Year Ended March 31, 2007 ----------------------------------------------------- 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter ----------- ----------- ----------- ----------- (Dollars in Thousands)
Interest income $21,183 $22,993 $24,299 $24,125 Interest expense 8,501 9,860 10,877 10,895 ------- ------- ------- ------- Net interest income 12,682 13,133 13,422 13,230 Provision for loan losses 700 700 450 - Noninterest income 1,474 1,437 1,419 1,508 Noninterest expense 6,550 6,876 7,054 7,381 ------- ------- ------- ------- Income before provision for income tax 6,906 6,994 7,337 7,357 Provision for income tax 2,324 2,344 2,454 2,444 ------- ------- ------- ------- Net income $ 4,582 $ 4,650 $ 4,883 $ 4,913 ======= ======= ======= =======
Basic earnings per share (adjusted for stock splits and dividends) $ 0.37 $ 0.38 $ 0.40 $ 0.40 ======= ======= ======= =======
Diluted earnings per share (adjusted for stock splits and dividends) $ 0.37 $ 0.37 $ 0.39 $ 0.40 ======= ======= ======= =======
HORIZON FINANCIAL CORP. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2007, 2006, AND 2005 - ------------------------------------------------------------------------------
NOTE 20 - SELECTED QUARTERLY FINANCIAL DATA (IN THOUSANDS) (Unaudited) (Continued)
Year Ended March 31, 2006 ----------------------------------------------------- (Dollars in Thousands)
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter ----------- ----------- ----------- -----------
Interest income $15,536 $16,666 $18,194 $18,992 Interest expense 5,262 5,908 6,604 7,122 ------- ------- ------- ------- Net interest income 10,274 10,758 11,590 11,870 Provision for loan losses 725 750 800 300 Noninterest income 1,544 1,439 1,487 941 Noninterest expense 5,864 5,991 6,477 6,438 ------- ------- ------- ------- Income before provision for income tax 5,229 5,456 5,800 6,073 Provision for income tax 1,516 1,661 1,817 1,909 ------- ------- ------- ------- Net income $ 3,713 $ 3,795 $ 3,983 $ 4,164 ======= ======= ======= =======
Basic earnings per share (adjusted for stock splits and dividends) $ 0.30 $ 0.30 $ 0.32 $ 0.34 ======= ======= ======= =======
Diluted earnings per share (adjusted for stock splits and dividends) $ 0.30 $ 0.30 $ 0.32 $ 0.33 ======= ======= ======= =======
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure - ------------------------------------------------------------------------
Not applicable.
Item 9A.
Item 9A. Controls and Procedures - ---------------------------------
(a) Evaluation of Disclosure Controls and Procedures: An evaluation of the Corporation's disclosure controls and procedures (as defined in Rule 13(a)-15(e) of the Exchange Act was carried out under the supervision and with the participation of the Corporation's Chief Executive Officer, Chief Financial Officer and several other members of the Corporation's senior management as of the end of the period covered by this report. The Corporation's Chief Executive Officer and Chief Financial Officer concluded that the Corporation's disclosure controls and procedures as currently in effect are effective in ensuring that the information required to be disclosed by the Corporation in the reports it files or submits under the Exchange Act is (i) accumulated and communicated to the Corporation's management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms.
(b) Changes in Internal Controls: There have been no changes in our internal control over financial reporting (as defined in 13a-15(f) of the Act) that occurred during the quarter ended March 31, 2007, that have materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. The Corporation continued, however, to implement suggestions from its internal auditor and independent auditors on ways to strengthen existing controls. The Corporation does not expect that its disclosure controls and procedures and internal controls over financial reporting will prevent all error and fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Corporation have been detected. These inherent limitations include the realities that judgements in decision-making can be faulty, and that breakdowns in controls or procedures can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any control procedure is based in part upon certain assumptions about the likelihood of future events and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in cost-effective control procedures, misstatements due to error or fraud may occur and not be detected.
(c) Management's Annual Report on Internal Control over Financial Reporting. Management's report and the independent registered public accounting firm's attestation report are included in Item 8 of this Annual Report on Form 10-K for the year ended March 31, 2007 under the captions entitled "Management's Annual Report on Internal Control over Financial Reporting" and " Report of Independent Registered Public Accounting Firm."
The Corporation intends to continually review and evaluate the design and effectiveness of its disclosure controls and procedures and to improve its controls and procedures over time and to correct any deficiencies that it may discover in the future. The goal is to ensure that senior management has timely access to all material financial and non-financial information concerning the Corporation's business. While the Corporation believes the present design of its disclosure controls and procedures is effective to achieve its goal, future events affecting its business may cause the Corporation to modify its disclosure controls and procedures.
Item 9B.
Item 9B. Other Information - ---------------------------
There was no information to be disclosed by the Corporation in a current report on Form 8-K during the fourth quarter of fiscal 2007 that was not so disclosed.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance - ----------------------------------------------------------------
Directors and Executive Officers
The information contained under the section captioned "Proposal I -- Election of Directors" is included in the Company's Definitive Proxy Statement for the 2007 Annual Meeting of Stockholders ("Proxy Statement") and is incorporated herein by reference.
For information regarding the executive officers of the Corporation and the Bank, see the information contained herein under the section captioned "Item 1. Business - Personnel - Executive Officers of the Registrant."
Audit Committee Financial Expert
The Audit Committee of the Corporation is composed of Directors Fred R. Miller (Chairman), James A. Strengholt and Robert C. Tauscher. Each member of the Audit Committee is "independent" as defined in the NASDAQ Stock Market listing standards. The Corporation's Board of Directors has determined that there is no "audit committee financial expert," as defined in the SEC's Regulation S-K. The Board believes that the current members of the Audit Committee are qualified to serve based on their experience and background.
Code of Ethics
The Board of Directors have adopted Officer and Director Codes of Ethics. The Codes are applicable to each of the Corporation's directors and officers, including the principal executive officer and senior financial officers, and requires individuals to maintain the highest standards of professional conduct. A copy of the Code of Ethics applicable to the principal executive officer and senior financial officers is filed as an exhibit to this Annual Report on Form 10-K. The Corporation has not made the Codes of Ethics available on its website. The Corporation will provide a copy of the Codes of Ethics free of charge upon request.
Compliance with Section 16(a) of the Exchange Act
The information contained under the section captioned "Section 16(a) Beneficial Ownership Reporting Compliance" is included in the Corporation's Proxy Statement and is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation - --------------------------------
Information regarding management and director compensation and transactions with management and others is incorporated by reference to the section captioned "Executive Compensation" and "Director's Compensation" in the Proxy Statement.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters - ----------------------------------------------------------------------------
(a) Security Ownership of Certain Beneficial Owners.
The information contained under the section captioned "Security Ownership of Certain Beneficial Owners and Management" is included in the Corporation's Proxy Statement and is incorporated herein by reference.
(b) Security Ownership of Management
The information contained under the sections captioned "Security Ownership of Certain Beneficial Owners and Management" and "Proposal I -- Election of Directors" is included in the Corporation's Proxy Statement and are incorporated herein by reference.
(c) Changes In Control
The Corporation is not aware of any arrangements, including any pledge by any person of securities of the Corporation, the operation of which may at a subsequent date result in a change in control of the Corporation.
(d) Equity Compensation Plan Information
The following table summarizes share and exercise price information about the Corporation's equity compensation plans as of March 31, 2007.
Number of securities remaining available for Number of future issuance securities under equity to be issued Weighted-average compensation upon exercise of exercise price plans (excluding outstanding of outstanding securities options, warrants options, warrants reflected in Plan category and rights and rights column (a)) - -------------------- ----------------- ----------------- ------------------ (a) (b) (c) Equity compensation plans approved by security holders: 1995 Stock Option and Incentive Plan............. 143,692 7.67 -- 2005 Incentive Stock Plan....... 40,783 18.46 862,013
Equity compensation plans not approved by security holders........... -- --------- ------ -------- Total............ 184,475 10.06 862,013 ========= ====== ========
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence - ---------------------------------------------------------------------
The information contained under the sections captioned "Meetings and Committees of the Board of Directors and Corporate Governance -- Corporate Governance -- Related Party Transactions" and "Meetings and Committees of the Board of Directors and Corporate Governance Matters -- Corporate Governance -- Director Independence" are included in the Company's Proxy Statement and are incorporated herein by reference.
Item 14.
Item 14. Principal Accounting Fees and Services - ------------------------------------------------
The information contained under the section captioned "Independent Auditors" is included in the Corporation's Proxy Statement and is incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules - ----------------------------------------------------
(a) Exhibits --------
3.1 Articles of Incorporation of Horizon Financial, Corp. (incorporated by reference to Exhibit 3.1 to the Registrant's Current Report on Form 8-K dated October 13, 1995)
3.2 Bylaws of Horizon Financial Corp. (incorporated by reference to Exhibit 3.2 to the Registrant's Current Report on Form 8-K dated October 13, 1995)
10.1 Amended and Restated Employment Agreement with V. Lawrence Evans (incorporated by reference to the Registrant's Annual Report on Form 10-K for the year ended March 31, 1996)
10.2 Deferred Compensation Plan (incorporated by reference to the Registrant's Annual Report on Form 10-K for the year ended March 31, 1996)
10.3 1986 Stock Option and Incentive Plan (incorporated by reference to Exhibit 99.1 to the Registrant's Registration Statement on Form S-8 (File No. 33-99780)) 10.4 1995 Stock Option Plan (incorporated by reference to Exhibit 99.2 to the Registrant's Registration Statement on Form S-8 (File No. 33-99780)) 10.5 Bank of Bellingham 1993 Employee Stock Option Plan (incorporated by reference to Exhibit 99 to the Registrant's Registration Statement on Form S-8 (File No. 33-88571)) 10.6 Severance Agreement with Dennis C. Joines (incorporated by reference to the Registrant's Annual Report on Form 10-K for the year ended March 31, 2002) 10.7 Severance Agreement with Richard P. Jacobson (incorporated by reference to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 2002) 10.8 Severance Agreement with Steve Hoekstra (incorporated by reference to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 2002) 10.9 Stock Incentive Plan (incorporated by reference to Exhibit 99 to the Registrant's Registration Statement on Form S-8 (File No. 333-127178)) 10.10 Form of Incentive Stock Option Award Agreement under the 2005 Stock Incentive Plan (incorporated by reference to Exhibit 99.1 contained in the Registrant's Current Report on Form 8-K dated July 27, 2005) 10.11 Form of Non-qualified Stock Option Award Agreement under the 2005 Stock Incentive Plan (incorporated by reference to Exhibit 99.1 contained in the Registrant's Current Report on Form 8-K dated July 27, 2005) 10.12 Form of Restricted Stock Award Agreement under the 2005 Stock Incentive Plan (incorporated by reference to Exhibit 99.1 contained in the Registrant's Current Report on Form 8-K dated July 27, 2005) 14 Code of Ethics 21 Subsidiaries of the Registrant 23 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 Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act
(b) Financial Statement Schedules
The Consolidated Financial Statements and Notes thereto are included in Item 8 of this Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 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.
HORIZON FINANCIAL CORP.
Date: June 13, 2007 By: /s/V. Lawrence Evans ---------------------------- V. Lawrence Evans Chairman of the Board, Chief Executive Officer, and President (Duly Authorized Representative)
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.
By: /s/V. Lawrence Evans By: /s/Robert C. Diehl -------------------------- ---------------------------- V. Lawrence Evans Robert C. Diehl Chairman of the Board, Chief Director Executive Officer, and President
Date: June 13, 2007 Date: June 13, 2007
By: /s/Richard P. Jacobson By: /s/Fred R. Miller -------------------------- ---------------------------- Richard P. Jacobson Fred R. Miller Principal Financial Officer Director
Date: June 13, 2007 Date: June 13, 2007
By: /s/Dennis C. Joines By: /s/James A. Strengholt -------------------------- ---------------------------- Dennis C. Joines James A. Strengholt President, Chief Operating Officer Director and Director of Horizon Bank, and Executive Vice President and Director of Horizon Financial Corp.
Date: June 13, 2007 Date: June 13, 2007
By: /s/Kelli J. Holz By: /s/Robert C. Tauscher -------------------------- ---------------------------- Kelli J. Holz Robert C. Tauscher Principal Accounting Officer Director
Date: June 13, 2007 Date: June 13, 2007
By: /s/Richard R. Haggen By: /s/Gary E. Goodman -------------------------- ---------------------------- Richard R. Haggen Gary E. Goodman Director Director
Date: June 13, 2007 Date: June 13, 2007
EXHIBIT INDEX
Exhibit 14 Code of Ethics
Exhibit 21 Subsidiaries of the Registrant
Exhibit 23 Consent of Moss Adams LLP, Independent Registered Public Accounting Firm
Exhibit 31.1 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act
Exhibit 31.2 Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act
Exhibit 32 Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act
Exhibit 14
Code of Ethics
CODE OF ETHICS FOR OFFICER, DIRECTOR AND EMPLOYEE (HORIZON FINANCIAL CORP)
The Business of Horizon Financial Corp.
The business of Horizon Financial Corp. ("Horizon") and its affiliates includes a full array of retail banking and related services. During the performance of our duties, it is necessary to interact with customers, suppliers and professional groups. These groups place their trust in us and accordingly, we have the responsibility to keep this trust and be in strict compliance with all applicable laws and regulations.
Horizon requires corporate and affiliate officers, directors, and employees to observe a high standard of ethics in business and personal matters. The following Code of Ethics specifies certain standards for the guidance of all officers, directors and employees. The Code should be considered as illustrative, but not regarded as all-inclusive.
Failure to comply with all policies and procedures may result in disciplinary action, up to and including termination of employment. Any questions regarding proper code of conduct should be referred to the Corporation's Human Resources Department.
Conflict of Interest/Outside Interests
All officers, directors and employees should avoid situations which could result in, or give the appearance of, a conflict of interest concerning either Horizon or its stockholders, or any affiliate or its customers. Personal interest which could affect the proper exercise of judgment must be avoided. In those cases where personal interests do exist, or may appear to exist, the officer, director or employee in question should disqualify himself or herself and permit other members of our staff to handle the transaction.
In determining whether a conflict of interest could exist, officers, directors and employees should remember that the rules also apply to their spouses and adult children, where appropriate. For example, a conflict of interest would arise where the spouse of an employee was offered a business opportunity on account of the employee's position at Horizon.
Having a business or other employment outside Horizon is permissible provided that it does not conflict with the officer or employee's duties or the time and attention required of his or her position at Horizon. Also, the business or employment cannot be directly competitive with Horizon.
Acceptance of membership on outside boards involves possible conflicts of interest. Officers, directors, and employees are encouraged to participate in civic, charitable and religious organizations; any other such organization, or position therewith, should be authorized by appropriate management. Situations which might be in conflict with this policy should be cleared with Human Resources.
Confidential Information
The confidential nature of bank accounts and company resources in general is a fundamental precept in financial services. It is important that our officers, directors and employees be constantly alert to the responsibility of maintaining confidentiality.
All information obtained by virtue of employment with Horizon should be held in strictest confidence. This includes financial and personal information of customers, including fellow employees, as well as Horizon's financial information and information related to its internal affairs, competitive position, strategic planning and regulator actions. Confidential information must not be disclosed to anyone except as required for business transactions or as required by law.
Confidential information pertaining to Horizon or its customers, suppliers, stockholders and employees is to be used solely for corporate purposes and not as a basis for personal gain by officers, directors, or employees.
In certain instances, confidential information could be considered "insider information" within the meaning of federal and state securities laws. Disclosure or use of such information for personal gain or for avoiding personal loss could result in substantial civil and criminal penalties to individuals who disclose or who use this information. Officers and employees must be extremely cautious in discussing the corporate affairs of Horizon with its customers or with outsiders, including with stockholders of Horizon who do not have a right to such information before an announcement is made to all stockholders of Horizon.
Trading in Horizon's Stock
Officers and employees are encouraged to participate and maintain ownership in the stock of Horizon. While there are occasions that dictate the purchase or sale of any investment, active buying and selling of Horizon's common stock in order to make short term profits is discouraged. Officers and employees are cautioned that the Securities and Exchange Commission has stringent rules and regulations related to trading securities while in the possession of material, non-public information.
There may be occasions when, in the course of your normal duties, you become aware of certain facts related to Horizon such as earnings, expansion plans, potential acquisition or other similar situations which may reasonably be expected to be important to the investing public. Insider information is information that has not been publicly released and which a reasonable person would consider important in determining whether to buy, sell or hold securities. Until such information is disseminated to the general public through a press release or other public announcement, officers and employees are prohibited from either purchasing or selling Horizon's stock. Violation of this policy could subject officers or employees to possible action by the Securities and Exchange Commission, the result of which may include fines and/or imprisonment. More detailed information in this regard is contained in the Corporation's Insider Trading Guidelines.
Gifts and Entertainment
In the matter of gratuities to officers or employees, circumstances must govern. Substantial gifts and excessive entertainment from our customers and suppliers should be courteously and tactfully declined. Commissions, fees or propositions involving personal gain to an
officer or employee in connection with the handling of a transaction are highly improper and in some cases, illegal.
No officer or employee or member of his or her immediate family should give or accept cash, gifts, special accommodations or other favors from anyone with whom the person is negotiating, soliciting or doing business with on behalf of Horizon. Similarly, officers and employees may not solicit or accept personal fees, commissions or other forms of remuneration because of any transaction or business involving Horizon.
The preceding prohibitions are not applicable to entertainment or hospitality of a reasonable value, or gifts (but never cash), which under the circumstances, are of limited or nominal value. The acceptance of gifts of more than a nominal value could be considered as an attempt at bribery and could subject both the giver and the recipient to felony charges as well as the penalties prescribed under the Bank Bribery Act. 18 U.S.C. Section 215. The Bank Bribery Act also covers agents or attorneys of a financial institution.
Full and timely disclosure to a supervisor must be made with respect to entertainment, hospitality or gifts received. Any question or doubt as to the appropriateness of their receipt should be referred to the Corporation's Human Resources Manager. If necessary, personnel in the human resources department will consult with legal counsel in this regard. The tactful communication of the limitations of this policy to the donors of gifts is also strongly encouraged.
Personal Reputation
Loyalty, fidelity and good morals are assumed qualities of those who represent Horizon but, nevertheless, need to be emphasized. It is imperative that each individual display conduct at all times so as to reflect credit on Horizon and its directors, officers and employees. A reputation for good morals, ethics and integrity is within the reach of all, and officers and employees must remain above reproach throughout their business career.
Community and Political Activity
As an institution, Horizon cannot and should not engage in politics. Officers and employees, however, are encouraged to stay well informed on local, state and national affairs and to meet their responsibility to vote in all elections. Officers and employees should ensure that their participation in political activities in no way reflects unfavorably on Horizon. Community and political activities by officers and employees are encouraged, provided that participation:
* is accomplished in a legal manner; * does not interfere with work performance for Horizon; and * occurs in such a manner which clearly indicates that the officer or employee does not speak for Horizon.
Before running for an elected political office or accepting an appointment to a federal, state or local government office, the officer or employee must discuss the position with Horizon's Chief Executive Officer.
Federal law prohibits Horizon from making political contributions to parties or candidates. The use of any corporate funds, supplies, special services, equipment or labor for political purposes must be avoided as such use is illegal. Additionally, no reimbursement will be
made to any individual for political contributions or for the cost of attendance at any political function. Fund-raising efforts for any purpose should be avoided if there is any possibility of an adverse effect on the reputation of Horizon.
Illegal Activity
Officers, directors and employees are expected to abide by all local, state and federal laws, regulations and guidelines. Officers or employees engaged in activities found to be in conflict with and against these laws, regulations or guidelines will be subject to disciplinary action, up to and including termination of employment. Examples of illegal activity include, but are not limited to:
* embezzlement; * unauthorized sale of information; * frauds such as forgery, counterfeiting and check kiting; * unauthorized use of funds, revenues and fees; * abuse of expense, asset and liability accounts; and * sexual harassment or discrimination.
In addition, any officer or employee who is charged with, or is entering into a pretrial diversion or similar program for, any crime involving breach of trust, dishonesty, money laundering, a drug-related offense, a crime of violence or a felony must immediately notify the Corporation's Chief Executive Officer.
Integrity
Horizon presents its organization honestly to its officers and employees, and in turn, expects officers and employees to be honest in their dealings with Horizon,its customers and fellow employees. We expect people to be honest in their handling of money, merchandise and property with which they are entrusted. Officers and employees are also expected to be honest with respect to the time, effort and complete performance of their jobs as well as when dealing with others. The vast majority of officers and employees are of high ethical character; however, if a dishonest individual is discovered, the individual will be dealt with quickly and effectively.
Board Approved 07/2006
Exhibit 21
Subsidiaries of the Registrant
Parent - ------
Horizon Financial Corp.
Jurisdiction Percentage or State of Subsidiaries (a) of Ownership Incorporation - ---------------- ------------ -------------
Horizon Bank 100% Washington
Westward Financial Services, Inc. (b) 100% Washington
_______ (a) The operation of the Corporation's wholly owned subsidiaries are included in the Consolidated Financial Statements contained in the Item 8 of this Form 10-K.
(b) Wholly-owned subsidiary of Horizon Bank.
Exhibit 23
Consent of Independent Registered Public Accounting Firm
CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors Horizon Financial Corp. and Subsidiary
We consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 33-99780) of Horizon Financial Corp. pertaining to the 1995 Stock Option Plan and the Registration Statement on Form S-8 (No. 333-127178) pertaining to the Horizon Financial Corp. 2005 Incentive Stock Plan; of our report dated June 13, 2007 relating to the consolidated statement of financial position of Horizon Financial Corp. and Subsidiary as of March 31, 2007 and 2006, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the years in the three-year period ended March 31, 2007, and in our same report, with respect to Horizon Financial Corp. and Subsidiary management's assessment of the effectiveness of internal control over financial reporting and the effectiveness of internal control over financial reporting, appearing in this Annual Report on Form 10-K of Horizon Financial Corp. and Subsidiary, for the year ended March 31, 2007.
/s/Moss Adams LLP
Everett, Washington June 13, 2007
Exhibit 31.1
Certification Required by Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934
I, V. Lawrence Evans, certify that:
1 I have reviewed this Annual Report on Form 10-K of Horizon Financial Corp.;
2 Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3 Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4 The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and
5 The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):
a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.
Date: June 13, 2007 /s/V. Lawrence Evans ------------------------------ V. Lawrence Evans Chief Executive Officer and President
Exhibit 31.2
Certification Required by Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934
I, Richard P. Jacobson, certify that:
1 I have reviewed this Annual Report on Form 10-K of Horizon Financial Corp.;
2 Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3 Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4 The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and
5 The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):
a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.
Date: June 13, 2007 /s/Richard P. Jacobson ------------------------------ Richard P. Jacobson Chief Financial Officer
Exhibit 32
CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER OF HORIZON FINANCIAL CORP. PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
The undersigned hereby certify, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and in connection with this Annual Report on Form 10-K, that:
1. the report fully complies with the requirements of Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, and
2. the information contained in the report fairly presents, in all material respects, the company's financial condition and results of operations.
/s/V.Lawrence Evans /s/Richard P. Jacobson - ------------------------------ ---------------------------- V. Lawrence Evans Richard P. Jacobson Chief Executive Officer Chief Financial Officer
Dated: June 13, 2007