| STERLING FINANCIAL CORP /WA/ Item 1A Risk Factors Set forth below and elsewhere in this Annual Report on Form 10-K and in other documents Sterling files with the SEC are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this Annual Report on Form 10-K As a bank holding company, Sterling’s earnings are dependent upon the performance of its bank and non-bank subsidiaries as well as by business, economic and political conditions |
| Sterling is a legal entity separate and distinct from Sterling Savings Bank, although the principal source of its cash is dividends from Sterling Savings Bank |
| Sterling’s right to participate in the assets of any subsidiary upon such subsidiary’s liquidation, reorganization or otherwise will be subject to the claims of the subsidiary’s creditors, which will take priority except to the extent that Sterling may be a creditor with a recognized claim |
| Sterling Savings Bank is also subject to restrictions under federal law which limit the transfer of funds to Sterling or to other affiliates, whether in the form of loans, extensions of credit, investments, asset purchases or otherwise |
| Such transfers by Sterling Savings Bank to Sterling or any other affiliate are limited in amount to 10prca of Sterling Savings Bank’s capital and surplus |
| Furthermore, such loans and extensions of credit are required to be collateralized |
| Earnings are impacted by business and economic conditions in the United States and abroad |
| These conditions include short-term and long-term interest rates, inflation, monetary supply, fluctuations in both debt and equity capital markets, and the strength of the US economy and the local economies in which Sterling operates |
| Business and economic conditions that negatively impact household or corporate incomes could decrease the demand for Sterling products and increase the number of customers who fail to pay their loans |
| A downturn in the local economies or real estate markets could negatively impact Sterling’s banking business |
| A downturn in the local economies or real estate markets could negatively impact Sterling’s banking business |
| Because Sterling primarily serves individuals and businesses located in the Pacific Northwest, a significant portion of its total loan portfolio is originated in the Pacific Northwest or secured by Pacific Northwest real estate or other assets |
| As a result of this geographic concentration the ability of customers to repay their loans, and consequently Sterling’s results, are impacted by the economic and business conditions in the Pacific Northwest, in particular in the metropolitan areas of Seattle, Washington, Portland, Oregon, Boise, Idaho, Sacramento, California and Phoenix, Arizona |
| Any adverse economic or business developments or natural disasters in these areas could cause uninsured damage and other loss of value to real estate that secures Sterling loans or could negatively affect the ability of borrowers to make payments of principal and interest on the underlying loans |
| In the event of such adverse development or natural disaster, Sterling’s results of operations or financial condition could be adversely affected |
| Furthermore, current uncertain geopolitical trends and negative economic trends, including uncertainty regarding economic growth and increased unemployment, may negatively impact businesses in Sterling’s markets |
| While the short-term and long-term effects of these events remain uncertain, they could adversely affect general economic conditions, consumer confidence, market liquidity or result in changes in interest rates, any of which could have a negative impact on banking business |
| Sterling has shifted its focus to community banking |
| Sterling is increasing its business banking, consumer and construction lending while placing an increased emphasis on attracting greater volumes of retail deposits |
| Business banking, consumer and construction loans generally produce higher yields than residential mortgage loans |
| Such loans, however, generally involve a higher degree of risk than the financing of residential real estate, primarily because the collateral may be difficult to obtain or liquidate in the event of default |
| Construction lending is subject to risks such as construction delays, cost overruns, insufficient collateral and the inability to obtain permanent financing in a timely manner |
| Business banking and construction loans are more expensive to originate than residential mortgage loans |
| As a result, Sterling’s operating expenses are likely to increase as Sterling increases its lending in these areas |
| Additionally, Sterling is likely to experience higher levels of loan losses than it would on residential mortgage loans |
| There can be no assurance that Sterling’s emphasis on community banking will be successful or that any increase in the yields on business banking, consumer and construction loans will offset higher levels of expense and losses on such loans |
| 26 _________________________________________________________________ [109]Table of Contents Sterling’s loan originations are highly concentrated in certain types of loans |
| Sterling’s loans, with limited exceptions, are secured by either, real estate, marketable securities or corporate assets |
| A significant portion of Sterling’s loans are residential construction loans |
| Sterling’s ability to continue to originate such loans may be impaired by adverse changes in local and regional economic conditions in the real estate markets, or by acts of nature |
| Due to the concentration of real estate collateral, these events could have a material adverse impact on the value of the collateral, resulting in losses or delinquencies |
| Sterling’s residential mortgage and home equity loans are primarily secured by residential property in the Pacific Northwest |
| As a result, conditions in the real estate markets specifically, and the Pacific Northwest economy generally, can materially impact the ability of its borrowers to repay their loans and affect the value of the collateral securing these loans |
| Customer demand for loans secured by real estate could be reduced by a weaker economy, an increase in unemployment, a decrease in real estate values or an increase in interest rates |
| At December 31, 2005, approximately 21prca of Sterling Savings Bank’s total loan portfolio consisted of construction loans, approximately 23prca of which were for speculative endeavors |
| A reduction in the demand for new construction could have a negative impact on the Bank and therefore on Sterling |
| Additionally, 23prca of the Bank’s loan portfolio consisted of multifamily residential and commercial property loans at December 31, 2005 |
| Sterling’s earnings are significantly affected by the fiscal and monetary policies of the federal government and the governments of the states in which it operates |
| The Board of Governors of the Federal Reserve System, also known as the Federal Reserve Board, regulates the supply of money and credit in the United States |
| Its policies determine in large part our cost of funds for lending and investing and the return we earn on those loans and investments, both of which impact net interest margin, and can materially affect the value of financial instruments such as debt securities and mortgage servicing rights |
| Its policies also can affect our borrowers, potentially increasing the risk that they may fail to repay their loans |
| Changes in Federal Reserve Board policies are beyond our control and hard to predict or anticipate |
| The amount of income taxes that Sterling is required to pay on its earnings is based on federal and state legislation and regulations |
| Sterling provided for current and deferred taxes in its financial statements, based on its results of operations, business activity, legal structure and interpretation of tax statutes |
| Sterling may take filing positions or follow tax strategies that may be subject to challenge |
| Sterling’s net income and earnings per share may be reduced if a federal, state, or local authority assessed charges for taxes that have not been provided for in its consolidated financial statements |
| There can be no assurance that Sterling will achieve its effective tax rate or that taxing authorities will not change tax legislation, challenge filing positions, or assess taxes and interest charges |
| Changes in market interest rates could adversely affect Sterling’s earnings |
| Sterling’s earnings are impacted by changing market interest rates |
| Changes in market interest rates impact the level of loans, deposits and investments, the credit profile of existing loans and the rates received on loans and investment securities and the rates paid on deposits and borrowings |
| One of Sterling’s primary sources of income from operations is net interest income, which is equal to the difference between the interest income received on interest-earning assets (usually, loans and investment securities) and the interest expense incurred in connection with interest-bearing liabilities (usually, deposits and borrowings) |
| These rates are highly sensitive to many factors beyond our control, including general economic conditions, both domestic and foreign, and the monetary and fiscal policies of various governmental and regulatory authorities |
| Net interest income can be affected significantly by changes in market interest rates |
| Changes in relative interest rates may reduce net interest income as the difference between interest income and interest expenses decreases |
| Interest rates are currently rising and if interest rates continue to rise, the amount of interest Sterling pays on deposits and borrowings could increase more quickly than the amount of interest Sterling receives on its loans, mortgage-related securities and investment securities |
| Rising interest rates would likely reduce the value of Sterling’s mortgage-related securities and investment securities and may decrease demand for loans and make it more difficult for borrowers to repay their loans |
| Increasing market interest rates may also depress property values, which could affect the value of collateral securing Sterling loans |
| 27 _________________________________________________________________ [110]Table of Contents An increase in interest rates could also have a negative impact on Sterling’s results of operations by reducing the ability of borrowers to repay their current loan obligations |
| These circumstances could not only result in increased loan defaults, foreclosures and write-offs, but also necessitate further increases to the allowances for loan losses |
| In addition, fluctuations in interest rates may result in disintermediation, which is the flow of funds away from depository institutions into direct investments that pay a higher rate of return and may affect the value of Sterling investment securities and other interest-earning assets |
| Sterling’s cost of funds may increase as a result of general economic conditions, interest rates or competitive pressures |
| Sterling’s cost of funds may increase because of general economic conditions, unfavorable conditions in the capital markets, interest rates and competitive pressures |
| Sterling has traditionally obtained funds principally through deposits and borrowings |
| As a general matter, deposits are a cheaper source of funds than borrowings, because interest rates paid for deposits are typically less than interest rates charged for borrowings |
| If, as a result of general economic conditions, market interest rates, competitive pressures, or other factors, Sterling’s level of deposits decreases relative to its overall banking operation |
| Sterling may have to rely more heavily on borrowings as a source of funds in the future, which may negatively impact net interest margin |
| Competition may adversely affect Sterling’s ability to attract and retain customers at current levels |
| The banking and financial services businesses in Sterling’s market areas are highly competitive |
| Competition in the banking, mortgage and finance industries may limit Sterling’s ability to attract and retain customers |
| Sterling faces competition from other banking institutions, savings banks, credit unions and other financial institutions |
| Sterling also competes with non-bank financial service companies within the states that it serves and out of state financial intermediaries that have opened loan production offices or that solicit deposits in its market areas |
| There also has been a general consolidation of financial institutions in recent years, which results in new competitors and larger competitors in Sterling’s market areas |
| In particular, Sterling’s competitors include major financial companies whose greater resources may provide them a marketplace advantage |
| Areas of competition include interest rates for loans and deposits, efforts to obtain deposits and the range and quality of services provided |
| Because Sterling has fewer financial and other resources than larger institutions with which it competes, Sterling may be limited in its ability to attract customers |
| In addition, some of the current commercial banking customers may seek alternative banking sources as they develop needs for credit facilities larger than Sterling can accommodate |
| If Sterling is unable to attract and retain customers, it may be unable to continue its loan and deposit growth, and its results of operations and financial condition may otherwise be negatively impacted |
| Sterling may not be able to successfully implement its internal growth strategy |
| Sterling has pursued and intends to continue to pursue an internal growth strategy, the success of which will depend primarily on generating an increasing level of loans and deposits at acceptable risk levels and terms without proportionate increases in non-interest expenses |
| There can be no assurance that Sterling will be successful in implementing its internal growth strategy |
| Furthermore, the success of Sterling’s growth strategy will depend on maintaining sufficient regulatory capital levels and on continued favorable economic conditions in the Pacific Northwest |
| There are risks associated with potential acquisitions |
| Sterling may make opportunistic acquisitions of other banks or financial institutions from time to time that further its business strategy, such as the recently announced pending acquisition of Lynnwood Financial Group, Inc |
| These acquisitions could involve numerous risks including lower than expected performance or higher than expected costs, difficulties in the integration of operations, services, products and personnel, the diversion of management’s attention from other business concerns, changes in relationships with customers and the potential loss of key employees |
| Any acquisitions will be subject to regulatory approval, and there can be no assurance that Sterling will be able to obtain such approvals |
| Sterling may not be successful in identifying further acquisition candidates, integrating acquired institutions or preventing deposit erosion or loan quality deterioration at acquired institutions |
| Competition for acquisitions in Sterling’s market area is highly competitive, and Sterling may not be able to acquire other institutions on attractive terms |
| There can be no assurance that Sterling will be successful in completing future acquisitions, or if such transactions are completed, that Sterling will be successful in integrating acquired businesses into our operations |
| Sterling’s ability to grow may be limited if it is unable to successfully make future acquisitions |
| 28 _________________________________________________________________ [111]Table of Contents Sterling may not be able to replace key members of management or attract and retain qualified relationship managers in the future |
| Sterling depends on the services of existing management to carry out its business and investment strategies |
| As Sterling expands, it will need to continue to attract and retain additional management and other qualified staff |
| In particular, because Sterling plans to continue to expand its locations, products and services, Sterling will need to continue to attract and retain qualified banking personnel and investment advisors |
| Competition for such personnel is significant in Sterling’s geographic market areas |
| The loss of the services of any management personnel, or the inability to recruit and retain qualified personnel in the future, could have an adverse effect on our results of operations, financial conditions and prospects |
| Defaults may negatively impact Sterling’s business |
| Increased delinquencies or loan defaults by Sterling’s customers may negatively impact business |
| A borrower’s default on its obligations under one or more loans may result in lost principal and interest income and increased operating expenses as a result of the allocation of management time and resources to the collection and workout of the loan |
| If collection efforts are unsuccessful or acceptable workout arrangements cannot be reached, Sterling may have to charge-off all or a part of the loan |
| In such situations, Sterling may acquire any real estate or other assets, if any, that secure the loan through foreclosure or other similar available remedies |
| The amount owed under the defaulted loan may exceed the value of the assets acquired |
| The allowance for loan losses may be inadequate |
| Sterling loan customers may not repay their loans according to the terms of the loans, and the collateral securing the payment of these loans may be insufficient to pay any remaining loan balance |
| Sterling therefore may experience significant loan losses, which could have a material adverse effect on its operating results |
| Sterling makes various assumptions and judgments about the collectibility of its loan portfolio, including the creditworthiness of its borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of Sterling’s loans |
| Sterling relies on its loan quality reviews, experience and evaluation of economic conditions, among other factors, in determining the amount of the allowance for loan losses |
| If Sterling’s assumptions prove to be incorrect, its allowance for loan losses may not be sufficient to cover losses inherent in the loan portfolio, resulting in additions to Sterling’s allowance |
| Increases in this allowance result in an expense for the period |
| If, as a result of general economic conditions or a decrease in asset quality, management determines that additional increases in the allowance for loan losses are necessary, Sterling may incur additional expenses |
| Sterling’s loans are primarily secured by real estate, including a concentration of properties located in the Pacific Northwest |
| If an earthquake, volcano eruption or other natural disaster were to occur in one of the major market areas, loan losses could occur that are not incorporated in the existing allowance for loan losses |
| Sterling is expanding its lending activities in riskier areas |
| Sterling has identified commercial real estate, commercial business and consumer loans as areas for increased lending emphasis |
| While increased lending diversification is expected to increase interest income, non-residential loans carry greater risk of payment default than residential real estate loans |
| In the event of substantial borrower defaults, Sterling’s provision for loan losses would increase and therefore, earnings would be reduced |
| Sterling operations could be interrupted if its third-party service providers experience difficulty, terminate their services or fail to comply with banking regulations |
| 29 _________________________________________________________________ [112]Table of Contents Sterling depends, and will continue to depend, to a significant extent, on a number of relationships with third-party service providers |
| Specifically, Sterling receives core systems processing, essential web hosting and other Internet systems and deposit and other processing services from third-party service providers |
| If these third-party service providers experience difficulties or terminate their services and Sterling is unable to replace them with other service providers, its operations could be interrupted |
| If an interruption were to continue for a significant period of time, business, financial condition and results of operations could be materially adversely affected |
| Sterling’s internal control systems could fail to detect certain events |
| Sterling is subject to certain operations risks, including but not limited to data processing system failures and errors and customer or employee fraud |
| Sterling maintains a system of internal controls to mitigate against such occurrences and maintain insurance coverage for such risks, but should such an event occur that is not prevented or detected by Sterling’s internal controls, uninsured or in excess of applicable insurance limits, it could have a significant adverse impact on its business, financial condition or results of operations |
| The network and computer systems on which Sterling depends could fail or experience a security breach |
| Sterling’s computer systems could be vulnerable to unforeseen problems |
| Because Sterling conducts part of its business over the Internet and outsources several critical functions to third parties, operations will depend on the ability, as well as that of third-party service providers, to protect computer systems and network infrastructure against damage from fire, power loss, telecommunications failure, physical break-ins or similar catastrophic events |
| Any damage or failure that causes interruptions in operations could have a material adverse effect on business, financial condition and results of operations |
| In addition, a significant barrier to online financial transactions is the secure transmission of confidential information over public networks |
| Sterling’s Internet banking system relies on encryption and authentication technology to provide the security and authentication necessary to effect secure transmission of confidential information |
| Advances in computer capabilities, new discoveries in the field of cryptography or other developments could result in a compromise or breach of the algorithms its third-party service providers use to protect customer transaction data |
| If any such compromise of security were to occur, it could have a material adverse effect on Sterling’s business, financial condition and results of operations |
| Sterling could be held responsible for environmental liabilities of properties acquired through foreclosure |
| If Sterling is forced to foreclose on a defaulted mortgage loan to recover its investment, it may be subject to environmental liabilities related to the underlying real property |
| Hazardous substances or wastes, contaminants, pollutants or sources thereof may be discovered on properties during its ownership or after a sale to a third party |
| The amount of environmental liability could exceed the value of real property |
| There can be no assurance that Sterling would not be fully liable for the entire cost of any removal and clean-up on an acquired property, that the cost of removal and clean-up would not exceed the value of the property, or that costs could be recovered from any third party |
| In addition, Sterling may find it difficult or impossible to sell the property prior to or following any environmental remediation |
| Sterling’s banking business is highly regulated |
| State-chartered banks operate in a highly regulated environment and are subject to supervision and examination by federal and state regulatory agencies |
| As a Washington State-chartered commercial bank, Sterling’s subsidiary Sterling Savings Bank is subject to regulation and supervision by the FDIC and the Washington Department of Financial Institutions, or DFI Federal and state laws and regulations govern numerous matters, including changes in the ownership or control of banks, maintenance of adequate capital and the financial condition of a financial institution, permissible types, amounts, and terms of extensions of credit and investments, maintenance of permissible non-banking activities, maintenance of deposit insurance, protection of financial privacy the level of reserves against deposits, and restrictions on dividend payments |
| The FDIC, the Federal Reserve Board and the DFI possess cease and desist powers to prevent or remedy unsafe or unsound practices or violations of law by banks subject to their regulations |
| These and other restrictions limit the manner in which Sterling may conduct business and obtain capital or financing |
| Sterling’s stock price can fluctuate widely in response to a variety of factors, including actual or anticipated variations in quarterly operating results; changes in shareholder dividend policy; recommendations by securities analysts; and news reports relating to trends, concerns and other issues in the financial services industry |
| Other factors include new technology used or services offered by Sterling’s competitors; operating and stock price performance of other companies that investors deem comparable to us; and changes in government regulations |
| General market fluctuations, industry factors and general economic and political conditions and events, such as future terrorist attacks and activities, economic slowdowns or recessions, interest rate changes or credit loss trends, also could cause Sterling’s stock price to decrease regardless of its operating results |
| Future legislation could change our competitive position |
| Various legislation, including proposals to change substantially the financial institution regulatory system and to expand or contract the powers of banking institutions and bank holding companies, is from time to time introduced in the Congress |
| This legislation may change banking statutes and Sterling’s operating environment in substantial and unpredictable ways |
| If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions |
| Sterling cannot predict whether any of this potential legislation will be enacted, and if enacted, the effect that it, or any implementing regulations, would have on Sterling’s financial condition or results of operations |