First Financial Northwest, Inc. - Quarter Report: 2007 September (Form 10-Q)

[X]        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
              1934

              For the quarterly period ended September 30, 2007

              or

[   ]        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
              1934

              For the transition period from _____ to _____

Washington                                                                                                                                                                            26-0610707     
(State or other jurisdiction of incorporation                                                                                                                 (I.R.S. Employer
or organization)                                                                                                                                                                     I.D. Number)

201 Wells Avenue South, Renton, Washington                                                                                                                   98057            
(Address of principal executive offices)                                                                                                                             (Zip Code)

Registrant's telephone number, including area code:                                                                                                  (425) 255-4400  

        Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
        Yes [  ] No [ X ]

        Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one):
                        Large accelerated filer [  ]                 Accelerated filer [   ]                     Non-accelerated filer [ X ]

        Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
        Yes [   ] No [X]

        Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: As of September 30, 2007, no shares of the issuer's common stock, $.01 par value per share, were outstanding.

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First Financial Northwest, Inc., a Washington corporation, was formed in connection with the conversion of First Financial Holdings, MHC from the mutual to the stock form of organization. The conversion and First Financial Northwest, Inc.'s initial stock offering was completed on October 9, 2007. As of the quarter ended September 30, 2007 the conversion had not been completed. First Financial Northwest, Inc. had not issued any shares of its common stock, had no assets or liabilities, and had not conducted any business other than that of an organizational nature. Consequently, since the closing of the conversion occurred following the September 30, 2007 quarter end, the information presented in this Form 10-Q is for First Financial Holdings, MHC and its subsidiary, First Financial of Renton, Inc., and First Savings Bank of Renton.

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                    Consolidated Balance Sheets as of
                            September 30, 2007 and December 31, 2006                                                                                            3 
                    Consolidated Statements of Income for the Three and Nine Months
                            ended September 30, 2007 and 2006                                                                                                         4 
                    Consolidated Statements of Equity and Comprehensive Income for the Nine
                            Months ended September 30, 2007 and the Year Ended December 31, 2006                                      5 
                    Consolidated Statements of Cash Flows for the Nine Months
                            ended September 30, 2007 and 2006                                                                                                          6
                    Selected Notes to Unaudited Consolidated Financial Statements                                                               8

Item 2 - Management's Discussion and Analysis of Financial Condition
                    and Results of Operations                                                                                                                                  14

Item 3 - Quantitative and Qualitative Disclosures About Market Risk                                                                            26

Item 4 - Controls and Procedures                                                                                                                                           27

Item 1 - Legal Proceedings                                                                                                                                                       28

Item 1A - Risk Factors                                                                                                                                                              28

Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds                                                                             28

Item 3 - Defaults upon Senior Securities                                                                                                                                28

Item 4 - Submission of Matters to a Vote of Security Holders                                                                                           28

Item 5 - Other Information                                                                                                                                                        28

Item 6 - Exhibits                                                                                                                                                                          29

SIGNATURES                                                                                                                                                                            30

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3

See accompanying notes to unaudited consolidated financial statements.

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See accompanying notes to unaudited consolidated financial statements.

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Continued

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See accompanying notes to unaudited consolidated financial statements.

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FIRST FINANCIAL HOLDINGS, MHC
AND SUBSIDIARY

Notes to the Unaudited Consolidated Financial Statements

        At September 30, 2007, First Financial Holdings, MHC, a mutual holding company incorporated in the State of Washington in June 2002, was primarily engaged in the business of planning, directing and coordinating the business activities of its wholly owned subsidiary First Financial of Renton, Inc., a mid tier bank holding company. Effective October 9, 2007, First Financial Holdings, MHC completed its conversion from the mutual to stock holding company structure. In connection with the conversion, a new stock holding company, First Financial Northwest, Inc. was created and First Financial Holdings, MHC and First Financial of Renton, Inc. ceased to exist.

        First Savings Bank of Renton is a Washington-chartered stock savings bank and at September 30, 2007 was the wholly owned subsidiary of First Financial of Renton, Inc. First Savings Bank is a community-based savings bank primarily serving King and to a lesser extent, Pierce and Snohomish counties, Washington through a full-service banking office and automated teller machine. First Savings Bank's business consists of attracting deposits from the public and utilizing these deposits to fund loans. First Savings Bank, along with its subsidiary, Executive House, Inc., uses these deposits to originate one-to-four family, multifamily, construction/land development, commercial and consumer loans. Effective with the conversion of First Financial Holdings, MHC, First Savings Bank changed its name to "First Savings Bank Northwest" and became the subsidiary of First Financial Northwest.

        The accompanying interim consolidated financial statements have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. These consolidated financial statements should be read with our December 31, 2006 audited consolidated financial statements and its accompanying notes included in our Registration Statement on Form S-1 (333-143549). In our opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of the consolidated financial statements is accordance with accounting principles generally accepted in the United States of America ("GAAP") have been included. Operating results for the three and nine months ended September 30, 2007 are not necessarily indicative of the results that may be expected for the year ended December 31, 2007. In preparing the consolidated financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expense. Actual results could differ from those estimates.

        On November 15, 2006, the Board of Directors of First Financial Holdings, MHC and its subsidiary, First Financial of Renton, Inc., and First Savings Bank, adopted, and on April 18, 2007, July 18, 2007 and July 31, 2007, amended, a Plan of Conversion and Reorganization, pursuant to which First Financial Holdings, MHC would convert from a mutual holding company structure to a stock holding company structure, a new stock holding company, First Financial Northwest, would be created that would own all of the outstanding shares of First Savings Bank, and First Financial Northwest would issue and sell shares of its common stock to depositors of First Savings Bank and others in an initial stock offering. As provided in the Plan of Conversion and Reorganization, First Financial Northwest was incorporated on June 1, 2007 under the laws of the State of Washington. The conversion was approved at a Special Meeting of Members on September 27, 2007 by First Financial Holdings, MHC's members, which consisted of the depositors and borrowers of First Savings Bank. In addition, the conversion and stock offering was approved by the Office of Thrift Supervision, the Washington Department of Financial Institutions and the Securities and Exchange Commission. The conversion and stock offering were completed on October 9, 2007, with First Financial Northwest issuing 22,852,800 shares of its common stock. With the completion of the conversion, First Financial Holdings, MHC, and First Financial of Renton, Inc., ceased to exist as separate legal entities and First Savings Bank changed its corporate title to "First Savings Bank Northwest" and became a wholly-owned subsidiary of First Financial Northwest.

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        First Financial Northwest's common stock offered was priced based upon the estimated pro forma market value of First Financial Holdings, MHC, First Financial of Renton, Inc., and First Savings Bank of Renton as determined by an independent appraisal. In connection with the conversion First Financial Northwest sold 21,160,000 shares of its common stock to the public resulting in $211,600,000 of gross proceeds. An additional 1,692,800 shares of First Financial Northwest's common stock were contributed to the First Financial Northwest Foundation, a charitable foundation established in connection with the conversion, resulting in the issuance of a total of 22,852,800 shares. Costs to complete the stock offering were deducted from the gross proceeds of the offering. First Savings Bank Northwest issued 1,000 shares of its capital stock to First Financial Northwest in exchange for one half of the net proceeds of the offering. At September 30, 2007, approximately $2.0 million of the conversion expenses were included in prepaid expenses and other assets on the balance sheet of First Savings Bank. As part of the conversion and reorganization, First Savings Bank elected to be treated as a savings association under the Home Owners Loan Act. As a result, First Financial Northwest, as a savings and loan holding company, will be subject to the regulations of the Office of Thrift Supervision. First Savings Bank will continue to be regulated by the Federal Deposit Insurance Corporation and the Washington Department of Financial Institutions.

        Additionally, in accordance with Office of Thrift Supervision regulations, at the effective time of the conversion, First Savings Bank amended its charter for the purpose of establishing a liquidation account, which will substantially restrict retained earnings. The liquidation account will be maintained for the benefit of eligible holders and supplemental eligible account holders who continue to maintain their accounts at First Savings Bank after the conversion. The liquidation account will be reduced annually to the extent that eligible account holders have reduced their qualifying deposits. Subsequent increases will not restore an eligible account holder's interest in the liquidation account. In the event of a complete liquidation of the First Savings Bank, and only in such event, each account holder will be entitled to receive a distribution from the liquidation account in an amount proportionate to the adjusted qualifying account balances then held. First Savings Bank may not pay dividends if those dividends would reduce equity capital below the required liquidation account amount.

        Effective January 1, 2007, we adopted Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainties in Income Taxes, an Interpretation of FASB Statement No. 109 (FIN 48). FIN 48 prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. As of September 30, 2007 and January 1, 2007, we had an insignificant amount of unrecognized tax benefits. Our policy is to recognize interest and penalties on unrecognized tax benefits in Federal income tax expense in the Consolidated Statements of Income. The amount of interest and penalties for the three and nine months ended September 30, 2007 was immaterial. The tax years subject to examination by the federal taxing authorities are the years ended December 31, 2006, 2005, 2004, and 2003. The Company is not subject to state income tax.

        On February 15, 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, which allows an entity the irrevocable option to elect fair value for the initial and subsequent measurement for certain financial assets and liabilities on a contract-by-contract basis. Subsequent changes in fair value of these financial assets and liabilities would be recognized in earnings when they occur. This statement further establishes certain additional disclosure requirements. This statement is effective for financial statements issued for the year beginning on January 1, 2008, with earlier adoption permitted. Management is currently evaluating the impact and timing of the adoption of this statement of our financial condition and results of operations.

        On September 15, 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements. This statement defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles and enhances disclosures about fair value measurements. This statement defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. This statement is effective for financial statements issued for the year beginning on January 1, 2008, with earlier adoption permitted. Management is currently evaluating the impact and timing of the adoption of this statement on our financial condition and results of operations.

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        Investment securities available for sale are summarized as follows:

(1) The fund invests primarily in private label securities backed by or representing an interest in mortgages or domestic residential housing or manufactured housing with additional investments in U.S. Government or agency securities.

        The amortized cost and estimated fair value of investment and mortgage-backed and related securities available for sale at September 30, 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.

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        Incorporated within the above maturity schedule are mortgage-backed securities which are allocated using the contractual maturity as a basis.

        There were no sales of investment securities available for sale during the three or nine months ended September 30, 2007 and 2006.

        The amortized cost and estimated fair value of investment securities held to maturity are as follows:

        The amortized cost and fair value of investment securities held to maturity at September 30, 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.

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        There were no sales of investment securities held to maturity during the three or nine months ended September 30, 2007 and 2006.

        The following table summarizes the aggregate fair value and gross unrealized loss by length of time those investment securities have been continuously in an unrealized loss position:

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        This report contains forward-looking statements, which can be identified by the use of words such as "believes," "expects," "anticipates," "estimates" or similar expressions. Forward-looking statements include, but are not limited to:

• statements of our goals, intentions and expectations;

• statements regarding our business plans, prospects, growth and operating strategies;

• statements regarding the quality of our loan and investment portfolios; and

• estimates of our risks and future costs and benefits.

        These forward-looking statements are subject to significant risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:

• general economic conditions, either nationally or in our market area, that are worse than expected;

• changes in the interest rate environment that reduce our interest margins or reduce the fair value of financial instruments;

• increased competitive pressures among financial services companies;

• changes in consumer spending, borrowing and savings habits;

• our ability to successfully manage its growth;

• legislative or regulatory changes that adversely affect our business;

• adverse changes in the securities markets; and

• changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, the Public Company Accounting Oversight Board or the Financial Accounting Standards Board.

        First Savings Bank is a community-based savings bank primarily serving King and to a lesser extent, Pierce and Snohomish counties, Washington through our full-service banking office and automated teller machine. The local economy and housing market has remained relatively strong as compared to other parts of the country. We are in the business of attracting deposits from the public through our office and utilizing those deposits to originate loans. Historically, we have been a traditional fixed rate portfolio lender originating residential home loans. We do not participate in the subprime mortgage market. Our business strategy centers on the continued transition to commercial banking activities in order to expand our net interest margin. Since December 31, 2006 we have increased the amount of our construction/land development loans from 20.09% to 29.44% of our total loan portfolio at September 30, 2007 while reducing our one-to-four-family residential loans from 48.86% to 42.05% over the same period. The commercial real estate portfolio at September 30, 2007 increased $41.3 million or 26.83% to $195.2 million from December 31, 2006. At September 30, 2007 our construction/land development loans totaled $288.1 million, substantially all which are short-term adjustable rate loans. In contrast, our residential mortgage

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loans, commercial real estate and multi-family loans that comprise almost all of the balance of our loan portfolio are generally long term fixed rate loans.

        Our primary source of pre-tax income is net interest income. Net interest income is the difference between interest income, which is the income that we earn on our loans and investments, and interest expense, which is the interest that we pay on our deposits and borrowings. Changes in levels of interest rates affect our net interest income. To offset the impact of the interest rate environment, we continue to seek means of increasing interest income while controlling expenses. Consistent with this strategy, we acquired Executive House and are working to further reduce the percentage of our assets that are lower-yielding residential loans and mortgage-backed securities and to increase the percentage of our assets consisting of construction/land development loans, commercial real estate and multi-family loans that have higher risk-adjusted returns. Although historically our loan losses have been low, we expect to increase our allowance for loan losses and allocate more of our allowance to non-residential loans consistent with any increase in the percentage of our loan portfolio mix of these loans due to their higher risk characteristics..

        Our operating expenses consist primarily of compensation and benefits, occupancy and equipment, data processing, marketing, postage and supplies, professional services and deposit insurance premiums. Compensation and benefits consist primarily of the salaries and wages paid to our employees, payroll taxes and expenses for retirement and other employee benefits. Occupancy and equipment expenses, which are the fixed and variable costs of building and equipment, consist primarily of real estate taxes, depreciation charges, maintenance and costs of utilities.

        Critical accounting policies are those that involve significant judgments and assumptions by management and that have, or could have, a material impact on our income or the carrying value of our assets. Our critical accounting policies are those related to our allowance for loan losses and mortgage servicing rights.

        Allowance for Loan Losses. Management recognizes that loan losses may occur over the life of a loan and that the allowance for loan losses must be maintained at a level necessary to absorb specific losses on impaired loans and probable losses inherent in the loan portfolio on non-impaired loans. Our Asset Liability Management Committee assesses the allowance for loan losses on a quarterly basis. The committee analyzes several different factors, including delinquency, charge-off rates and the changing risk profile of our loan portfolio, as well as local economic conditions such as unemployment rates, bankruptcies and vacancy rates of business and residential properties.

        We believe that the accounting estimate related to the allowance for loan losses is a critical accounting estimate because it is highly susceptible to change from period to period requiring management to make assumptions about probable losses inherent in the loan portfolio; and 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.

        Our methodology for analyzing the allowance for loan losses consists of two components: formulas and specific allowances. The formula allowance is determined by applying an estimated loss percentage to various groups of loans. The loss percentages are generally based on various historical measures such as the amount and type of classified loans, past due ratios and loss experience, which could affect the collectibility of the respective loan types.

        The specific allowance component is created when management believes that the collectibility of a specific large loan, such as a real estate, multi-family or commercial real estate loan, has been impaired and a loss is probable.

        The allowance is increased by the provision for loan losses, which is charged against current period earnings and decreased by the amount of actual loan charge-offs, net of recoveries.

        Mortgage Servicing Rights. Mortgage servicing rights represent the present value of the future servicing fees from the right to service loans in the portfolio. This accounting policy is considered critical as the methodology used to determine the fair value of capitalized mortgage servicing rights requires the development of a number of estimates, the most critical of which is the mortgage loan prepayment speeds assumption. The mortgage loan prepayment speeds assumption is significantly impacted by interest rates. In general, during periods of falling interest rates, mortgage loans prepay faster and the value of our mortgage servicing asset declines. Conversely, during periods of rising rates, the value of mortgage servicing rights generally increases as a result of slower rates of prepayments. Mortgage servicing rights are amortized in proportion to, and over, the estimated period the net servicing income will be collected. At the end of each quarter, the estimated fair value is evaluated for impairment by reviewing events or changes in circumstances which have occurred in the market and specifically

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to the loan portfolio risk characteristics such as loan type, interest rate and loan term. On an annual basis, we also perform an independent valuation review of mortgage servicing rights, which based on the significance of any changes since the preceding independent appraisal, may included an independent appraisal of the fair value of our servicing portfolio.

        General. Our total assets increased $114.3 million, or 11.37% to $1.1 billion at September 30, 2007 from $1.0 billion at December 31, 2006. The asset growth resulted primarily from an increase in loans receivable, net of $152.1 million. This increase, along with a $98.0 million decrease in Federal Home loan Bank advances, were funded by a decrease in cash and cash equivalents of $15.0 million, a decrease in investments available for sale of $23.7 million, an increase in deposits of $201.0 million and net income for the nine month period of $6.4 million.

        Assets. Total assets increased $114.3 million or 11.37% during the nine months ended September 30, 2007. The following table details the changes in the composition of our assets from December 31, 2006 to September 30, 2007.

        Cash and cash equivalents decreased $15.0 million from December 31, 2006, as cash was used to fund loan volume and pay down Federal Home Loan Bank advances.

        Loans receivable, net increased $152.1 million to $852.4 million at September 30, 2007 from $700.3 million at December 31, 2006. During the nine months ended September 30, 2007, we originated $93.6 million in one-to-four-family mortgage loans. We also originated $47.5 million and $9.0 million in commercial real estate and multi-family mortgages, respectively, $218.0 million in construction/land development loans and $4.5 million in consumer loans. The loan growth during the nine months ended September 30, 2007 was partially offset by $152.1 million in principal repayments during the year and an increase in loans in process of $60.7 million.

        Investment securities available for sale decreased $23.7 million or 15.88% to $125.4 million at September 30, 2007 from $149.1 million at December 31, 2006. This decrease was the result of our using the liquidity generated by principal repayments to fund loan originations.

        Deposits. During the nine months ended September 30, 2007, deposits increased $201.0 million to $951.7 million. The increase in deposits was the result of $191.7 million primarily attributable to deposits made in anticipation of participating

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in the Company's stock offering. Increases in certificate accounts of $1.8 million, NOW accounts of $3.8 million and savings accounts of $4.5 million were offset by a decrease in money market accounts of $870,000.

        Advances. Total advances at September 30, 2007 were $49.0 million, a decrease of $98.0 million or 66.67% from December 31, 2006. The liquidity generated from the increase in deposits was used to lower the principal balance of the advances.

        Equity. Total equity increased $6.9 million, or 6.62% to $110.9 million at September 30, 2007 from $104.0 million at December 31, 2006. The increase was primarily a result of $6.4 million in net income for the nine month period ended September 30, 2007, and a decrease of $468,000 in unrealized loss on investment securities available for sale, net of tax.

        General. Our net income for the three months ended September 30, 2007 was $2.7 million, an increase of $860,000 from the comparable period in the prior year. The increase in net income was the result of a $1.7 million increase in net interest income, a $225,000 increase in the provision for loan losses, an increase in noninterest income of $95,000, an increase in noninterest expense of $236,000 and an increase of $469,000 in federal income tax expenses. The increased liquidity of the Company has allowed it to fund loan volume while also reducing borrowings resulted in the increase in net interest income.

        Net Interest Income. Our net interest income increased $1.7 million for the three months ended September 30, 2007 to $5.9 million, compared to $4.2 million for the comparable period in the prior year. Average total interest-earning assets increased $139.1 million for the three months ended September 30, 2007 from $911.0 million for the same quarter in 2006, while average total interest-bearing liabilities increased $111.4 million from the three months ended September 30, 2006. This includes deposits received in anticipation of the stock offering. During the same period our yield on interest-earning assets increased 34 basis points while our cost on interest-bearing liabilities increased 3 basis points increasing our interest rate spread for the quarter ended September 30, 2007 by 31 basis points to 1.88% from 1.57% during the same quarter in 2006.

        Interest Income. Total interest income for the three months ended September 30, 2007 increased $3.1 million to $17.3 million from the quarter ended September 30, 2006. The following table compares detailed average earning asset balances, associated yields and resulting changes in interest income for the three months ended September 30, 2007 and 2006: