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First Financial Northwest, Inc. - Quarter Report: 2011 September (Form 10-Q)

Unassociated Document
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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, 2011

or

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

      For the transition period from _____ to _____

Commission File Number: 001-33652

FIRST FINANCIAL NORTHWEST, INC. 

(Exact name of registrant as specified in its charter)
 
Washington                                                                                    
 
                        26-0610707                      
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification Number)
     
201 Wells Avenue South, Renton, Washington
 
     98057    
(Address of principal executive offices)
  (Zip Code) 
     
Registrant’s telephone number, including area code:     

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 [ X ]    No [  ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes [X ]    No [  ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
   Large accelerated filer [  ]    Accelerated filer [X]  Non-accelerated filer [  ]  Smaller reporting company [  ]
 
       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 November 4, 2011, 18,805,168 shares of the issuer’s common stock, $0.01 par value per share, were outstanding.

 
1

 




 
FIRST FINANCIAL NORTHWEST, INC. 
FORM 10-Q
TABLE OF CONTENTS
     
PART 1 - FINANCIAL INFORMATION    
     
Item 1 - Financial Statements 3  
     
Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations
32  
     
Item 3 - Quantitative and Qualitative Disclosures About Market Risk 51  
     
Item 4 - Controls and Procedures 53  
     
PART II - OTHER INFORMATION    
     
Item 1 - Legal Proceedings 55  
     
Item 1A - Risk Factors 55  
     
Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds 55  
     
Item 3 - Defaults upon Senior Securities 55  
     
Item 4 - [Removed and Reserved]  55  
     
Item 5 - Other Information  55  
     
Item 6 - Exhibits  55  
     
SIGNATURES 57  
     
 
 

 
2

 

Item 1. Financial Statements
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(Dollars in thousands, except share data)
(Unaudited)

 
September 30,
   
December 31,
           
                            Assets
2011
   
2010
 
             
Cash on hand and in banks
  $ 5,159     $ 7,466  
Interest-bearing deposits
    207,040       90,961  
Investments available for sale
    140,273       164,603  
Loans receivable, net of allowance of $16,634 and $22,534
    727,226       856,456  
Premises and equipment, net
    19,092       19,829  
Federal Home Loan Bank stock, at cost
    7,413       7,413  
Accrued interest receivable
    3,972       4,686  
Federal income tax receivable
    -       5,916  
Other real estate owned ("OREO")
    25,201       30,102  
Prepaid expenses and other assets
    5,004       6,226  
Total assets
  $ 1,140,380     $ 1,193,658  
                 
Liabilities and Stockholders' Equity
               
                 
Interest-bearing deposits
  $ 844,702     $ 911,526  
Noninterest-bearing deposits
    5,843       8,700  
Advances from the Federal Home Loan Bank
    93,066       93,066  
Advance payments from borrowers for taxes and insurance
    3,623       2,256  
Accrued interest payable
    228       214  
Investment transactions payable
    10,000       -  
Other liabilities
    3,931       3,418  
Total liabilities
    961,393       1,019,180  
                 
Commitments and contingencies
               
                 
Stockholders' Equity
               
     Preferred stock, $0.01 par value; authorized 10,000,000
         
shares, no shares issued or outstanding
  $ -     $ -  
Common stock, $0.01 par value; authorized 90,000,000
               
shares; issued and outstanding 18,805,168 shares
               
at September 30, 2011 and December 31, 2010
    188       188  
Additional paid-in capital
    188,460       187,371  
Retained earnings (accumulated deficit), substantially restricted
    3,010       (305 )
Accumulated other comprehensive income (loss), net of tax
    (257 )     484  
Unearned Employee Stock Ownership Plan ("ESOP") shares
    (12,414 )     (13,260 )
Total stockholders' equity
    178,987       174,478  
Total liabilities and stockholders' equity
  $ 1,140,380     $ 1,193,658  
                 
See accompanying notes to consolidated financial statements.
         

 
3

 
 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Income Statements
(Dollars in thousands, except share data)
(Unaudited)

                                   
             
Three Months Ended
 
 Nine Months Ended
             
September 30,
 
 September 30,
             
2011
 
2010
 
2011
 
2010
Interest income
                     
 
Loans, including fees
$
             11,397
 
 $
            13,677
 
 $
             35,716
 
 $
            42,516
 
Investments available for sale
 
                  926
   
              1,254
   
               3,393
   
              3,367
 
Interest-bearing deposits with banks
 
                  127
   
                   80
   
                  297
   
                 214
       Total interest income
$
             12,450
 
 $
            15,011
 
 $
             39,406
 
 $
            46,097
Interest expense
                     
 
Deposits
     
               3,981
   
              5,563
   
             12,714
   
            18,456
 
Federal Home Loan Bank advances
 
                  589
   
              1,057
   
               1,748
   
              3,115
       Total interest expense
$
               4,570
 
 $
              6,620
 
 $
             14,462
 
 $
            21,571
       Net interest income
 
               7,880
   
              8,391
   
             24,944
   
            24,526
Provision for loan losses
 
               1,300
   
            12,000
   
               4,100
   
            51,000
       Net interest income (loss) after
                     
         provision for loan losses
$
               6,580
 
 $
            (3,609)
 
 $
             20,844
 
 $
           (26,474)
Noninterest income
                     
 
Net gain on sale of investments
 
                  479
   
                     -
   
               1,741
   
                      -
 
Other
       
                    77
   
                   38
   
                  237
   
                 146
       Total noninterest income
$
                  556
 
 $
                   38
 
 $
               1,978
 
 $
                 146
                                   
Noninterest expense
                     
 
Compensation and employee benefits
 
               3,544
   
              3,258
   
             10,047
   
              9,339
 
Occupancy and equipment
 
                  370
   
                 411
   
               1,167
   
              1,260
 
Professional fees
 
                  449
   
                 664
   
               1,431
   
              1,610
 
Data processing
 
                  181
   
                 191
   
                  573
   
                 533
 
(Gain) loss on sale of OREO property, net
 
                (293)
   
               (205)
   
             (1,427)
   
                 218
 
OREO market value adjustments
 
                  515
   
              2,016
   
               1,432
   
              5,184
 
OREO related expenses, net
 
                  540
   
                 962
   
               2,376
   
              2,372
 
FDIC/OTS assessments
 
                  578
   
                 910
   
               1,900
   
              2,005
 
Insurance and bond premiums
 
                  248
   
                 150
   
                  743
   
                 449
 
Marketing
     
                    43
   
                   49
   
                  154
   
                 170
 
Other general and administrative
 
                  338
   
                   94
   
               1,111
   
              1,237
            Total noninterest expense
$
               6,513
 
 $
              8,500
 
 $
             19,507
 
 $
            24,377
            Income (loss) before provision
                     
               for federal income taxes
 
                  623
   
          (12,071)
   
               3,315
   
           (50,705)
Provision for federal income taxes
 
                      -
   
                     -
   
                      -
   
              3,999
            Net income (loss)
$
                  623
 
 $
          (12,071)
 
 $
               3,315
 
 $
           (54,704)
                       
            Basic income (loss) per share
$
                 0.04
 
 $
              (0.69)
 
 $
                 0.19
 
 $
               (3.14)
            Diluted income (loss) per share
$
                 0.04
 
 $
              (0.69)
 
 $
                 0.19
 
 $
               (3.14)
                                   
                   
 
See accompanying notes to consolidated financial statements.

 
4

 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Statements of Stockholders' Equity and Comprehensive Income
(Dollars in thousands, except share data)
(Unaudited)

 
Shares
 
Common
Stock
 
Additional
Paid-in
Capital
 
Retained
Earnings
(Accumulated
Deficit)
  Accumulated
Other
Comprehensive
Income (Loss),
net of tax
 
Unearned
ESOP
Shares
   
Total
Stockholders'
Equity
 
                               
Balances at December 31, 2010
  18,805,168   $ 188   $ 187,371   $ (305 ) $ 484   $ (13,260 )   $ 174,478  
Comprehensive income:
                                           
     Net income
  -     -     -     3,315     -     -       3,315  
     Change in fair value of investments
                                             
        available for sale
  -     -     -     -     (741 )   -       (741 )
     Total comprehensive income
                                        2,574  
Compensation related to stock options
                                       
   and restricted stock awards
  -     -     1,489     -     -     -       1,489  
Allocation of 84,640 ESOP shares
  -     -     (400 )   -     -     846       446  
Balances at September 30, 2011
  18,805,168   $ 188   $ 188,460   $ 3,010   $ (257 ) $ (12,414 )   $ 178,987  
                                             
See accompanying notes to consolidated financial statements.
 

 
 
5

 
 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
             
 
Nine Months Ended
September 30,
 
 
2011
   
2010
 
Cash flows from operating activities:
           
Net income (loss)
  $ 3,315     $ (54,704 )
Adjustments to reconcile net income (loss) to net cash provided by
               
 operating activities:
               
Provision for loan losses
    4,100       51,000  
OREO market value adjustments
    1,432       5,184  
(Gain) loss on sale of OREO property, net
    (1,427 )     218  
Depreciation of premises and equipment
    792       829  
Net amortization of premiums and discounts on investments
    1,835       1,119  
ESOP expense
    446       461  
Compensation expense related to stock options and restricted stock awards
    1,489       1,441  
Net realized gain on investments available for sale
    (1,741 )     -  
Deferred federal income taxes
    (1,061 )     11,878  
Changes in operating assets and liabilities:
               
Prepaid expenses and other assets
    1,222       1,713  
Accrued interest receivable
    714       169  
Accrued interest payable
    14       (62 )
Other liabilities
    513       413  
Investment transactions payable
    10,000       -  
Federal income taxes, net
    5,916       3,779  
Net cash provided by operating activities
  $ 27,559     $ 23,438  
                 
Cash flows from investing activities:
               
Proceeds from sales of investments
    74,633       -  
Capitalized improvements in OREO
    (181 )     (488 )
Proceeds from sales of OREO properties
    25,814       18,837  
Principal repayments on investments
    24,602       23,851  
Purchases of investments
    (74,679 )     (84,408 )
Net decrease in loans receivable
    104,393       37,895  
Purchases of premises and equipment
    (55 )     (1,321 )
Net cash provided (used) by investing activities
  $ 154,527     $ (5,634 )
                 
Balance, carried forward
  $ 182,086     $ 17,804  

 
6

 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)

     
Nine Months Ended September 30,
 
     
2011
     
2010
 
Balance, brought forward
  $ 182,086     $ 17,804  
Cash flows from financing activities:
               
Net increase (decrease) in deposits
    (69,681 )     13,325  
Advances from the Federal Home Loan Bank
    -       53,173  
Repayments of advances from the Federal Home Loan Bank
    -       (50,007
Net increase in advance payments from borrowers for taxes and insurance
     1,367        2,129  
Repurchase and retirement of common stock
    -       (106
Dividends paid
    -       (1,421
Net cash provided (used) by financing activities
  $ (68,314 )   $ 17,093  
                 
Net increase in cash
    113,772       34,897  
Cash and cash equivalents:
               
Beginning of period
    98,427       104,970  
End of period
  $ 212,199     $ 139,867  
                 
Supplemental disclosures of cash flow information:
               
Cash paid during the period for:
               
Interest
  $ 14,448     $ 21,633  
Noncash transactions:
               
Loans, net of deferred loan fees and allowance for loan losses transferred to OREO
  20,737     $ 34,843  
                 
                 
See accompanying notes to consolidated financial statements.

 
7

 

FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)


Note 1 – Description of Business

First Financial Northwest, Inc. (“First Financial Northwest” or the “Company”), a Washington corporation, was formed on June 1, 2007 for the purpose of becoming the holding company for First Savings Bank Northwest (“First Savings Bank” or “the Bank”) in connection with the conversion from a mutual holding company structure to a stock holding company structure. First Financial Northwest’s business activities generally are limited to passive investment activities and oversight of its investment in First Savings Bank. Accordingly, the information presented in the consolidated financial statements and related data, relates primarily to First Savings Bank. First Financial Northwest is a savings and loan holding company and is subject to regulation by the Federal Reserve Board (“FRB”), as successor on July 24, 2011 to the powers and responsibilities of the Office of Thrift Supervision (“OTS”). First Savings Bank is regulated by the Federal Deposit Insurance Corporation (“FDIC”) and the Washington State Department of Financial Institutions (“DFI”).

First Savings Bank is a community-based savings bank primarily serving King and to a lesser extent, Pierce, Snohomish and Kitsap counties, through our full-service banking office located in Renton, Washington. First Savings Bank’s business consists of attracting deposits from the public and utilizing these deposits to originate one-to-four family, multifamily, commercial real estate, business, consumer and construction/land development loans.
 
As used throughout this report, the terms “we”, “our”, “us”, or the “Company” refer to First Financial Northwest, Inc. and its consolidated subsidiary First Savings Bank Northwest, unless the context otherwise requires.

Note 2 – Regulatory Items

On April 14, 2010, the OTS and members of the Board of Directors of First Financial Northwest entered into an informal supervisory agreement or Memorandum of Understanding (“MOU”) which is now enforced by the FRB as the successor to the OTS. Under the terms of the MOU, the Company agreed, among other things, to provide notice to and obtain a written non-objection from the FRB prior to the Company (a) declaring a dividend or redeeming any capital stock and (b) incurring, issuing, renewing or repurchasing any new debt. Further, in connection with a prior examination of the Bank by the FDIC and DFI, we must obtain a written non-objection from the FDIC before engaging in any transaction that would materially change the balance sheet composition (including growth in total assets of five percent or more), significantly change funding sources (including brokered deposits) or declare or pay cash dividends. In addition, both the Company and the Bank must obtain prior regulatory approval before adding any new director or senior executive officer or changing the responsibilities of any current senior executive officer or pay pursuant to or by entering into certain severance and other forms of compensation agreements.

The Bank entered into a Stipulation to the Issuance of a Consent Order (“Order”) with the FDIC and the DFI which became effective on September 24, 2010. Under the terms of the Order, the Bank cannot declare dividends or repurchase stock without the prior written approval of the FDIC. Other material provisions of the Order require the Bank to:

·  
Maintain and preserve qualified management;
·  
Increase the Board of Directors’ participation in the Bank’s affairs;
·  
Obtain an independent study of management and the personnel structure of the Bank;
·  
Maintain specified Capital levels;
·  
Eliminate loans classified as “Loss” at its regulatory examination, and reduce the loans classified as “Doubtful” and “Substandard” as a percent of capital;
·  
Revise its policy with respect to the allowance for loan losses;
·  
Not extend additional credit to borrowers whose loan had been classified as “Loss” and is uncollected;
 
 
 
 
8

 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)

 
·  
Revise its lending and collection policies and practices;
·  
Develop a plan to reduce the amount of commercial real estate loans;
·  
Enhance its written funds management and liquidity policy;
·  
Develop a three-year strategic plan;
·  
Not solicit brokered deposits and comply with certain deposit rate restrictions;
·  
Eliminate and correct all violations of laws; and
·  
Prepare and submit progress reports to the FDIC and DFI.

The Bank has implemented a comprehensive plan to achieve full compliance with the Order. The Order contains target dates to achieve the items listed above, including that the Bank’s Tier 1 capital ratio and total risk-based capital ratio be at least 10% and 12%, respectively. At September 30, 2011, the Bank’s Tier 1 capital ratio was 12.76% and its total risk-based capital ratio was 23.87%, which exceeded the requirements of the Order.

Adversely classified assets as a percent of Tier 1 capital plus the allowance for loan and lease losses (“ALLL”) was 128% at the beginning of 2010. The Order required this ratio to be below 65% by March 2011 for the adversely classified assets identified at that exam. We achieved this target as of September 30, 2010 and remained in compliance with this requirement at September 30, 2011.

The Order also required that the Bank develop a written plan to systematically reduce the amount of loans to borrowers in the commercial real estate loan category, including its construction/land development loans which are considered commercial real estate for purposes of this calculation. At September 30, 2010, the Bank’s commercial real estate loans, excluding owner-occupied properties, represented 314% of its total risk-based capital including construction/land development loans which equaled 84% of its total risk-based capital. As of September 30, 2011, the Bank’s concentration in commercial real estate loans was reduced to 238% of its risk-based capital and its construction/land development loan portfolio was reduced to 34% of total risk-based capital.

The Order also required the Bank to obtain an independent management study and adopt a plan to implement the recommendations from the study, satisfactory to its regulators. The Bank has obtained the independent management study and continues to work on implementing the study’s recommendations, including the addition of new Board members and the evaluation of senior management. We are in discussions with potential new Board members for the Bank and the Company who would further enhance the knowledge and expertise of our Boards of Directors. Senior management is also being evaluated in connection with the independent management study and efforts are being made to identify outside individuals who would augment the leadership of our organization and who possess the experience and qualifications to strengthen and establish the foundation for our future growth.

A copy of the Order is attached to the Form 8-K that we filed with the Securities and Exchange Commission (“SEC”) on September 27, 2010. The Order will remain in effect until modified or terminated by the FDIC and the DFI.

Note 3 – Basis of Presentation

The accompanying unaudited interim consolidated financial statements have been prepared pursuant to the rules and regulations of the SEC. Accordingly, they do not include all of the information and footnotes required by U.S. Generally Accepted Accounting Principles (“GAAP”) for complete financial statements. These unaudited consolidated financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, as filed with the SEC. In our opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of the consolidated financial statements in accordance with GAAP have been included. All significant intercompany balances and transactions between the Company and its subsidiaries have been eliminated in consolidation. Operating results for the three and nine months ended September 30, 2011 are not necessarily indicative of the results that may be expected for the year ended December 31, 2011. In preparing the unaudited consolidated financial statements, we are required to make
 
 
 
9

 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)
 
estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the ALLL, the valuation of other real estate owned (“OREO”) and the underlying collateral of loans in the process of foreclosure, deferred tax assets and the fair value of financial instruments.

Certain amounts in the unaudited consolidated financial statements for prior periods have been reclassified to conform to the current unaudited financial statement presentation.

Note 4 – Recently Issued Accounting Pronouncements

In January 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-01, Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20. This ASU temporarily delays the effective date of the disclosures about troubled debt restructurings in Update 2010-20 for public entities. The delay is intended to allow the FASB time to complete its deliberations on what constitutes a troubled debt restructuring. The effective date of the new disclosures about troubled debt restructurings for public entities and the guidance for determining what constitutes a troubled debt restructuring will then be coordinated. The guidance is effective for interim and annual periods ending after September 15, 2011. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In April 2011, the FASB issued ASU No. 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring. The update provides additional guidance relating to when creditors should classify loan modifications as troubled debt restructurings. The ASU also ends the deferral issued in January 2011 of the disclosures about troubled debt restructurings required by ASU No. 2010-20.  The provisions of ASU No. 2011-02 and the disclosure requirements of ASU No. 2010-20 are effective for the Company’s interim reporting period ending September 30, 2011. The guidance applies retrospectively to restructurings occurring on or after January 1, 2011. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In April 2011, the FASB issued ASU No. 2011-03, Reconsideration of Effective Control for Repurchase Agreements. The update amends existing guidance to remove from the assessment of effective control, the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee and, as well, the collateral maintenance implementation guidance related to that criterion. ASU No. 2011-03 is effective for the Company’s reporting period beginning on or after December 15, 2011. The guidance applies prospectively to transactions or modification of existing transactions that occur on or after the effective date and early adoption is not permitted. The adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.

In April 2011, the FASB issued ASU No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The update amends existing guidance regarding the highest and best use and valuation premise by clarifying these concepts are only applicable to measuring the fair value of nonfinancial assets.  The Update also clarifies that the fair value measurement of financial assets and financial liabilities which have offsetting market risks or counterparty credit risks that are managed on a portfolio basis, when several criteria are met, can be measured at the net risk position. Additional disclosures about Level 3 fair value measurements are required including a quantitative disclosure of the unobservable inputs and assumptions used in the measurement, a description of the valuation process in place, and discussion of the sensitivity of fair value changes in unobservable inputs and interrelationships about those inputs as well as disclosure of the level of the fair value of items that are not measured at fair value in the financial statements but disclosure of fair value is required. The provisions of ASU No. 2011-04 are effective for the Company’s reporting period beginning after December 15, 2011 and should be applied prospectively. The Company is currently evaluating the impact of this ASU and does not expect it to have a material impact on the Company’s consolidated financial statements.
 
 
 
10

 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)


In June 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income. The update amends current guidance to allow a company the option of presenting the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The provisions do not change the items that must be reported in other comprehensive income or when an item of other comprehensive must be reclassified to net income. The amendments do not change the option for a company to present components of other comprehensive income either net of related tax effects or before related tax effects, with one amount shown for the aggregate income tax expense (benefit) related to the total of other comprehensive income items. The amendments do not affect how earnings per share is calculated or presented.  The provisions of ASU No. 2011-05 are effective for the Company’s reporting periods beginning after December 15, 2011 and should be applied retrospectively. Early adoption is permitted and there are no required transition disclosures.  The adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.

Note 5 – Investments

Investment securities available for sale are summarized as follows:
 
 
September 30, 2011
 
       
Gross
 
Gross
       
 
Amortized
 
Unrealized
 
Unrealized
       
 
Cost
 
Gains
 
Losses
    Fair Value  
 
(In thousands)
 
Mortgage-backed investments:
                       
Fannie Mae
  $ 56,562     $ 1,285     $ (8 )   $ 57,839  
Freddie Mac
    21,974       632       -       22,606  
Ginnie Mae
    7,959       37       (19 )     7,977  
Municipal bonds
    2,391       49       (306 )     2,134  
U.S. Government agencies
    49,794       290       (367 )     49,717  
    $ 138,680     $ 2,293     $ (700 )   $ 140,273  
                                 
 
December 31, 2010
 
         
Gross
 
Gross
         
 
Amortized
 
Unrealized
 
Unrealized
         
 
Cost
 
Gains
 
Losses
    Fair Value  
 
(In thousands)
 
Mortgage-backed investments:
                               
Fannie Mae
  $ 109,134     $ 1,291     $ (281 )   $ 110,144  
Freddie Mac
    40,454       860       (165 )     41,149  
Ginnie Mae
    9,542       -       (98 )     9,444  
Municipal bonds
    2,395       -       (473 )     1,922  
U.S. Government agencies
    1,805       139       -       1,944  
    $ 163,330     $ 2,290     $ (1,017 )   $ 164,603  

 
11

 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)

 
The following table summarizes the aggregate fair value and gross unrealized loss by length of time those investments have been continuously in an unrealized loss position:
 
   
September 30, 2011
 
   
Less Than 12 Months
   
12 Months or Longer
    Total  
   
Fair Value
   
Unrealized
Loss
   
Fair Value
   
Unrealized
Loss
   
Fair Value
   
Unrealized
Loss
 
Mortgage-backed investments:
 
(In thousands)
 
   Fannie Mae
  $ 1,515     $ (8 )   $ -     $ -     $ 1,515     $ (8 )
   Ginnie Mae
    4,374       (19 )     -       -       4,374       (19 )
Municipal bonds
    -       -       1,403       (306 )     1,403       (306 )
U.S. Government agencies
    35,060       (367 )     -       -       35,060       (367 )
    $ 40,949     $ (394 )   $ 1,403     $ (306 )   $ 42,352     $ (700 )
                                                 
   
December 31, 2010
 
   
Less Than 12 Months
   
12 Months or Longer
   
Total
 
   
Fair Value
   
Unrealized
Loss
   
Fair Value
   
Unrealized
Loss
   
Fair Value
   
Unrealized
Loss
 
Mortgage-backed investments:  
(In thousands)
 
   Fannie Mae
  $ 39,801     $ (281 )   $ -     $ -     $ 39,801     $ (281 )
   Freddie Mac
    15,232       (165 )     -       -       15,232       (165 )
   Ginnie Mae
    5,193       (98 )     -       -       5,193       (98 )
Municipal bonds
    -       -       1,885       (473 )     1,885       (473 )
    $ 60,226     $ (544 )   $ 1,885     $ (473 )   $ 62,111     $ (1,017 )

On a quarterly basis, management makes an assessment to determine whether there have been any events or economic circumstances to indicate that a security on which there is an unrealized loss is impaired on an other-than-temporary basis. We consider many factors including the severity and duration of the impairment, recent events specific to the issuer or industry, and for debt securities, external credit ratings and recent downgrades. Securities on which there is an unrealized loss that is deemed to be an other-than-temporary impairment (“OTTI”) are written down to fair value. For equity securities, the write-down is recorded as a realized loss in noninterest income on our Consolidated Income Statements. For debt securities, if we intend to sell the security or it is likely that we will be required to sell the security before recovering its cost basis, the entire impairment loss would be recognized in earnings as an OTTI. If we do not intend to sell the security and it is not likely that we will be required to sell the security but we do not expect to recover the entire amortized cost basis of the security, only the portion of the impairment loss representing credit losses would be recognized in earnings. The credit loss on a security is measured as the difference between the amortized cost basis and the present value of the cash flows expected to be collected. Projected cash flows are discounted by the original or current effective interest rate depending on the nature of the security being measured for potential OTTI. The remaining impairment related to all other factors, the difference between the present value of the cash flows expected to be collected and fair value, is recognized as a charge to other comprehensive income (“OCI”). Impairment losses related to all other factors are presented as separate categories within OCI. For the nine months ended September 30, 2011, we did not have any OTTI losses on investments.

The amortized cost and estimated fair value of investments available for sale at September 30, 2011, 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. Investments not due at a single maturity date, primarily mortgage-backed investments, are shown separately.
 
 
 
12

 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)
 
   
September 30, 2011
 
   
Amortized Cost
   
Fair Value
 
   
(In thousands)
 
                 
Due within one year
  $ -     $ -  
Due after one year through five years
    30,494       30,239  
Due after five years through ten years
    10,827       10,862  
Due after ten years
    10,864       10,750  
      52,185       51,851  
Mortgage-backed investments
    86,495       88,422  
    $ 138,680     $ 140,273  

We sold $43.1 million of investments during the three months ended September 30, 2011, resulting in gross gains of $487,000 and gross losses of $8,000. For the nine months ended September 30, 2011, we sold $72.9 million of investments resulting in gross gains of $1.7 million and gross losses of $8,000.

Note 6 - Loans Receivable

Loans receivable are summarized as follows:             
 
               
September 30, 2011
   
December 31, 2010
 
                 
 Amount
 
Percent
     
Amount
 
Percent
 
               
(Dollars in thousands)
 
One-to-four family residential: (1)
                       
 
Permanent
       
$
         346,258
 
          46.3
%
 
$
393,334  
 
                 44.1
%
 
Construction
       
                     -
 
              -
     
5,356  
 
                  0.6
 
                 
         346,258
 
          46.3
     
398,690  
 
                44.7
 
Multifamily:
                               
 
Permanent
         
           113,759
 
          15.2
     
140,762  
 
                 15.8
 
 
Construction
       
             3,526
 
            0.5
     
4,114  
 
                  0.5
 
                 
           117,285
 
          15.7
     
144,876  
 
                 16.3
 
Commercial real estate:
                         
 
Permanent
         
           221,817
 
          29.6
     
237,708  
 
                26.6
 
 
Construction
       
            12,500
 
            1.7
     
28,362  
 
                  3.2
 
 
Land
           
               3,131
 
            0.4
     
6,643  
 
                  0.7
 
                 
         237,448
 
          31.7
     
272,713  
 
                30.5
 
Construction/land development:
                       
 
One-to-four family residential
   
            10,034
 
            1.3
     
26,848  
 
                  3.0
 
 
Multifamily
         
                882
 
            0.1
     
1,283  
 
                   0.1
 
 
Commercial
         
               1,104
 
            0.1
     
1,108  
 
                   0.1
 
 
Land development
     
            17,859
 
            2.4
     
27,262  
 
                   3.1
 
                 
           29,879
 
            3.9
     
56,501  
 
                  6.3
 
                                     
Business
           
              3,531
 
            0.5
     
479  
 
                   0.1
 
Consumer
           
            13,898
 
            1.9
     
19,127  
 
                   2.1
 
Total loans
           
         748,299
 
        100.0
%
   
892,386  
 
               100.0
%
Less:
                                 
 
Loans in process ("LIP")
   
              2,591
         
            10,975
     
 
Deferred loan fees, net
   
              1,848
         
              2,421
     
 
ALLL
           
            16,634
         
           22,534
     
Loans receivable, net
   
$
         727,226
       
$
         856,456
     
                                     
(1)   Includes $151.3 million and $173.4 million of non-owner occupied loans at September 30, 2011 and December 31, 2010, respectively.     

At September 30, 2011 and December 31, 2010, there were no loans classified as held for sale.
 
 
 
13

 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)

A summary of changes in the ALLL for the three and nine months ended September 30, 2011 and 2010 are as follows:
 
 
   
Three  Months Ended September 30,
   
Nine Months Ended September 30,
 
     
2011
     
2010
     
2011
     
2010
 
     
(In thousands)
 
Balance at the beginning of the period
  $ 16,989     $ 29,858     $ 22,534     $ 33,039  
   Provision for loan losses
    1,300       12,000       4,100       51,000   
   Charge-offs
    (1,686 )     (14,121 )     (10,337 )     (56,506 )
   Recoveries
    31       663       337       867  
Balance at the end of the period
  $ 16,634     $ 28,400     $ 16,634     $ 28,400  

 
14

 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)
 
 
    The following tables represent a summary of our ALLL and loan portfolio by loan type and impairment method:


   
At or For the Three Months Ended September 30, 2011
 
   
One-to-Four
Family
Residential
   
Multifamily
   
Commercial
Real Estate
   
Construction/
Land
Development
   
Business
   
Consumer
   
Total
 
ALLL:
 
(In thousands)
 
  Beginning balance
  $ 5,499     $ 984     $ 7,279     $ 2,893     $ 14     $ 320     $ 16,989  
     Charge-offs
    (371 )     -       (590 )     (633 )     -       (92 )     (1,686 )
     Recoveries
    12       -       -       18       -       1       31  
     Provision
    164       5       429       457       127       118       1,300  
  Ending balance
  $ 5,304     $ 989     $ 7,118     $ 2,735     $ 141     $ 347     $ 16,634  
     General reserve
  $ 4,739     $ 989     $ 7,074     $ 2,735     $ 141     $ 347     $ 16,025  
     Specific reserve
  $ 565     $ -     $ 44     $ -     $ -     $ -     $ 609  
                                                         
Loans (1):
                                                       
  Total Loans
  $ 346,222     $ 116,461     $ 236,775     $ 28,821     $ 3,531     $ 13,898     $ 745,708  
     General reserve (2)
  $ 280,334     $ 113,311     $ 220,966     $ 16,930     $ 3,531     $ 13,784     $ 648,856  
     Specific reserve (3)
  $ 65,888     $ 3,150     $ 15,809     $ 11,891     $ -     $ 114     $ 96,852  
__________                                                         
(1) Net of undisbursed funds.
(2) Loans collectively evaluated for impairment.
(3) Loans individually evaluated for impairment.
 
 
   
At or For the Nine Months Ended September 30, 2011
 
   
One-to-Four
Family
 Residential
   
Multifamily
   
Commercial
Real Estate
   
Construction/
Land
Development
   
Business
   
Consumer
   
Total
 
ALLL:
 
(In thousands)
 
  Beginning balance
  $ 8,302     $ 1,893     $ 6,742     $ 5,151     $ 7     $ 439     $ 22,534  
     Charge-offs
    (1,987 )     (88 )     (4,184 )     (3,815 )     -       (263 )     (10,337 )
     Recoveries
    31       -       -       304       -       2       337  
     Provision
    (1,042 )     (816 )     4,560       1,095       134       169       4,100  
  Ending balance
  $ 5,304     $ 989     $ 7,118     $ 2,735     $ 141     $ 347     $ 16,634  
     General reserve
  $ 4,739     $ 989     $ 7,074     $ 2,735     $ 141     $ 347     $ 16,025  
     Specific reserve
  $ 565     $ -     $ 44     $ -     $ -     $ -     $ 609  
                                                         
Loans (1):
                                                       
  Total Loans
  $ 346,222     $ 116,461     $ 236,775     $ 28,821     $ 3,531     $ 13,898     $ 745,708  
     General reserve (2)
  $ 280,334     $ 113,311     $ 220,966     $ 16,930     $ 3,531     $ 13,784     $ 648,856  
     Specific reserve (3)
  $ 65,888     $ 3,150     $ 15,809     $ 11,891     $ -     $ 114     $ 96,852  
__________                                                         
(1) Net of undisbursed funds.
 
(2) Loans collectively evaluated for impairment.
(3) Loans individually evaluated for impairment.

 
15

 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)

   
 At or For the Year Ended December 31, 2010
 
   
One-to-Four
Family
Residential
   
Multifamily
   
Commercial
Real Estate
   
Construction/ Land
Development
   
Business
   
Consumer
   
Total
 
ALLL:
    (In thousands)
  Beginning balance
  $ 11,130     $ 1,896     $ 6,422     $ 13,255     $ 6     $ 330     $ 33,039  
     Charge-offs
    (24,594 )     -       (8,012 )     (32,080 )     -       (790 )     (65,476 )
     Recoveries
    176       -       823       778       -       94       1,871  
     Provision
    21,590       (3 )     7,509       23,198       1       805       53,100  
  Ending balance
  $ 8,302     $ 1,893     $ 6,742     $ 5,151     $ 7     $ 439     $ 22,534  
     General reserve
  $ 7,137     $ 1,893     $ 5,499     $ 1,819     $ 7     $ 337     $ 16,692  
     Specific reserve
  $ 1,165     $ -     $ 1,243     $ 3,332     $ -     $ 102     $ 5,842  
                                                         
Loans (1):
                                                       
  Total Loans
  $ 398,583     $ 143,513     $ 266,297     $ 53,412     $ 479     $ 19,127     $ 881,411  
     General reserve (2)
  $ 330,651     $ 140,998     $ 248,578     $ 20,394     $ 479     $ 19,000     $ 760,100  
     Specific reserve (3)
  $ 67,932     $ 2,515     $ 17,719     $ 33,018     $ -     $ 127     $ 121,311  
__________                                                         
(1) Net of undisbursed funds.
(2) Loans collectively evaluated for impairment.
(3) Loans individually evaluated for impairment.


Nonperforming loans, net of undisbursed funds, were $30.8 million and $62.9 million at September 30, 2011 and December 31, 2010, respectively. Foregone interest on nonaccrual loans for the three and nine months ended September 30, 2011 was $527,000 and $2.1 million, respectively. Foregone interest for the same periods in 2010 was $1.5 million and $5.1 million, respectively.

Loans committed to be advanced in connection with impaired loans at September 30, 2011 and December 31, 2010 were $43,000 and $1.1 million, respectively.




 
16

 

FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)


The following tables represent a summary of loans individually evaluated for impairment by the type of loan:
 
   
At  or for the Three Months Ended September 30, 2011
         
 Unpaid
       
 Average
 
 Interest
   
Recorded
 
 Principal
 
 Related
 
 Recorded
 
 Income
   
Investment (1)
 
 Balance (2)
 
 Allowance
 
 Investment
 
 Recognized
   
(In thousands)
                               
Loans with no related allowance:
                           
 
One-to-four family residential:
                           
 
       Owner occupied
$
        7,438
 
 $
        8,679
 
 $
               -
 
 $
        7,618
 
 $
             40
 
       Non-owner occupied
 
      43,290
   
      46,422
   
               -
   
      44,759
   
           552
 
Multifamily
 
        3,150
   
        3,238
   
               -
   
        3,154
   
             42
 
Commercial real estate
 
      12,068
   
      16,763
   
               -
   
      13,311
   
           112
 
Construction/land development
 
      11,891
   
      26,836
   
               -
   
      13,786
   
               -
 
Consumer
 
           114
   
           117
   
               -
   
           114
   
               1
Total
 
      77,951
   
    102,055
   
               -
   
      82,742
   
           747
                               
Loans with an allowance:
                           
 
One-to-four family residential:
                           
 
       Owner occupied
 
        5,120
   
        5,219
   
           190
   
        5,207
   
             57
 
       Non-owner occupied
 
      10,040
   
      10,141
   
           375
   
        8,683
   
           194
 
Commercial real estate
 
        3,741
   
        3,741
   
             44
   
        3,742
   
             47
Total
 
      18,901
   
      19,101
   
           609
   
      17,632
   
           298
                               
Total impaired loans:
                           
 
One-to-four family residential:
                           
 
       Owner occupied
 
      12,558
   
      13,898
   
           190
   
      12,825
   
             97
 
       Non-owner occupied
 
      53,330
   
      56,563
   
           375
   
      53,442
   
           746
 
Multifamily
 
        3,150
   
        3,238
   
               -
   
        3,154
   
             42
 
Commercial real estate
 
      15,809
   
      20,504
   
             44
   
      17,053
   
           159
 
Construction/land development
 
      11,891
   
      26,836
   
               -
   
      13,786
   
               -
 
Consumer
 
           114
   
           117
   
               -
   
           114
   
               1
Total
$
      96,852
 
 $
    121,156
 
 $
           609
 
 $
    100,374
 
 $
        1,045
_______________                             
(1)
Represents the loan balance less charge-offs.
 
(2)
Contractual loan principal balance.
                               

 
17

 


FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)
 
     
At or For the Nine Months Ended September 30, 2011
 
           
Unpaid
         
Average
   
Interest
 
     
Recorded
   
Principal
   
Related
   
Recorded
   
Income
 
     
Investment (1)
   
Balance (2)
   
Allowance
   
Investment
   
Recognized
 
     
(In thousands)
 
                                 
Loans with no related allowance:
                             
 
One-to-four family residential:
                             
 
     Owner occupied
  $ 7,438     $ 8,679     $ -     $ 7,747     $ 126  
 
     Non-owner occupied
    43,290       46,422       -       44,858       1,683  
 
Multifamily
    3,150       3,238       -       2,833       126  
 
Commercial real estate
    12,068       16,763       -       11,744       329  
 
Construction/land development
    11,891       26,836       -       11,687       -  
 
Consumer
    114       117       -       123       2  
Total
    77,951       102,055       -       78,992       2,266  
                                           
Loans with an allowance:
                                       
 
One-to-four family residential:
                                       
 
     Owner occupied
    5,120       5,219       190       5,216       193  
 
     Non-owner occupied
    10,040       10,141       375       9,410       384  
 
Multifamily
    -       -       -       175       -  
 
Commercial real estate
    3,741       3,741       44       6,594       151  
 
Construction/land development
    -       -       -       9,332       -  
 
Consumer
    -       -       -       20       -  
Total
    18,901       19,101       609       30,747       728  
                                           
Total impaired loans:
                                       
 
One-to-four family residential:
                                       
 
     Owner occupied
    12,558       13,898       190       12,963       319  
 
     Non-owner occupied
    53,330       56,563       375       54,268       2,067  
 
Multifamily
    3,150       3,238       -       3,008       126  
 
Commercial real estate
    15,809       20,504       44       18,338       480  
 
Construction/land development
    11,891       26,836       -       21,019       -  
 
Consumer
    114       117       -       143       2  
Total
  $ 96,852     $ 121,156     $ 609     $ 109,739     $ 2,994     
_______________                                         
(1)
Represents the loan balance less charge-offs.
                                 
(2)
Contractual loan principal balance.
                                       
 

 
 
18

 
 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)

 
   
At  or For the Year Ended December 31, 2010
         
Unpaid
         
Interest
 
Recorded
   
Principal
   
Related
   
Income
 
Investment (1)(3)
   
Balance (2)(3)
   
Allowance
   
Recognized (3)
         
(In thousands)
     
Loans with no related allowance:
                     
     One-to-four family residential:
                     
        Owner occupied
$
             5,663
 
$
           5,997
 
$
               -
 
$
            178
        Non-owner occupied
 
           42,584
   
         42,947
   
               -
   
         2,920
     Multifamily
   
             2,515
   
           2,515
   
               -
   
            169
     Commercial real estate
 
             7,236
   
           7,753
   
               -
   
            350
     Construction/land development
 
             6,565
   
           8,607
   
               -
   
                8
     Consumer
   
                  48
   
              547
   
               -
   
               -
Total
   
           64,611
   
         68,366
   
               -
   
         3,625
                         
Loans with an allowance:
                     
     One-to-four family residential:
                     
        Owner occupied
 
             7,333
   
           8,570
   
            276
   
              95
        Non-owner occupied
 
           12,352
   
         16,722
   
            889
   
            130
     Commercial real estate
 
           10,483
   
         14,713
   
         1,243
   
            281
     Construction/land development
 
           26,453
   
         46,026
   
         3,332
   
               -
     Consumer
   
                  79
   
              298
   
            102
   
                3
Total
   
           56,700
   
         86,329
   
         5,842
   
            509
                         
Total impaired loans:
                     
     One-to-four family residential:
                     
        Owner occupied
 
           12,996
   
         14,567
   
            276
   
            273
        Non-owner occupied
 
           54,936
   
         59,669
   
            889
   
         3,050
     Multifamily
   
             2,515
   
           2,515
   
               -
   
            169
     Commercial real estate
 
           17,719
   
         22,466
   
         1,243
   
            631
     Construction/land development
 
           33,018
   
         54,633
   
         3,332
   
                8
     Consumer
   
                127
   
              845
   
            102
   
                3
Total
 
$
         121,311
 
$
       154,695
 
$
         5,842
 
$
         4,134
_________________                         
(1) Represents the loan balance less charge-offs.
                 
(2) Contractual loan principal balance.
                 
(3) Certain amounts in the table have been reclassified to conform to the current presentation.
 
 
 
19

 
 
 
 

FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)

The following is a summary of information pertaining to impaired loans, nonperforming assets and troubled debt restructured loans (“TDRs”):
 
   
September 30,
   
December 31,
 
   
2011
   
2010
 
   
(In thousands)
 
             
Impaired loans without a valuation allowance
  $ 77,951     $ 64,611  
Impaired loans with a valuation allowance
    18,901       56,700   
    Total impaired loans
  $ 96,852     $ 121,311  
Valuation allowance related to impaired loans
  $ 609     $ 5,842  
Nonperforming assets (1):
               
    Nonaccrual loans
  $ 23,644     $ 46,637  
    Nonaccrual troubled debt restructured loans
    7,188       16,299   
Total nonperforming loans
    30,832       62,936   
    Other real estate owned
    25,201       30,102   
Total nonperforming assets
  $ 56,033     $ 93,038  
                 
Performing troubled debt restructured loans
  $ 66,020     $ 58,375  
Nonaccrual troubled debt restructured loans
    7,188       16,299   
Total troubled debt restructured loans (2)
  $ 73,208     $ 74,674  
______________________________                 
(1) There were no loans 90 days or more past due and still accruing interest at September 30, 2011 and December 31, 2010.
 
(2) Troubled debt restructured loans are also considered impaired loans and are included in "Total impaired loans."
 

Nonacrrual and Past Due Loans. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual when they are 90 days delinquent or when, in management’s opinion, the borrower is unable to meet scheduled payment obligations.

A loan is considered impaired when we have determined that we may be unable to collect payments of principal or interest when due under the terms of the loan. In the process of identifying loans as impaired, management takes into consideration factors which include payment history and status, collateral value, financial condition of the borrower and the probability of collecting scheduled payments in the future. Minor payment delays and insignificant payment shortfalls typically do not result in a loan being classified as impaired. The significance of payment delays and shortfalls is considered by management on a case-by-case basis, after taking into consideration the circumstances surrounding the loan and the borrower, including payment history and the amounts of any payment shortfall, length and reason for delay and the likelihood of a return to stable performance. Impairment is measured on a loan-by-loan basis for all loans in the portfolio.




 
20

 
 

 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)

The following table is a summary of nonaccrual loans by loan type:
 
   
September 30,
   
December 31,
 
   
2011
   
2010
 
   
(In thousands)
 
One-to-four family residential
  $ 12,859     $ 22,688  
Multifamily
    638       -  
Commercial real estate
    5,400       7,306  
Construction/land development
    11,891       32,885  
Consumer
    44       57  
Total nonaccrual loans
  $ 30,832     $ 62,936  

The following tables represent a summary of the aging of loans by type:
 
 
Loans Past Due as of September 30, 2011
             
    30-59 Days     60-89 Days  
  90 Days and
Greater
    Total     Current  
  Total Loans
(1) (2)
 
  (In thousands)  
Real estate:
                                   
  One-to-four family residential:
                                   
     Owner occupied
  $ 676     $ 674     $ 4,043     $ 5,393     $ 189,566     $ 194,959  
     Non-owner occupied
    1,177       576       5,620       7,373       143,890       151,263  
  Multifamily
    349       -       638       987       115,474       116,461  
  Commercial real estate
    1,383       -       4,226       5,609       231,166       236,775  
  Construction/land development
    1,104       -       11,891       12,995       15,826       28,821  
Total real estate
    4,689       1,250       26,418       32,357       695,922       728,279  
Business
    -       -       -       -       3,531       3,531  
Consumer
    644       -       -       644       13,254       13,898  
Total
  $ 5,333     $ 1,250     $ 26,418     $ 33,001     $ 712,707     $ 745,708  
                                                 
(1) There were no loans 90 days past due and still accruing interest at September 30, 2011.
 
(2) Net of undisbursed funds.
                                               
                                                 
                                                 
 
Loans Past Due as of December 31, 2010
                 
 
30-59 Days
 
60-89 Days
   
  90 Days and
      Greater
 
Total
 
Current
 
Total Loans
(1) (2)
 
 
(In thousands)
 
Real estate:
                                               
  One-to-four family residential:
                                                
    Owner occupied
  $ 2,178     $ 780     $ 5,863     $ 8,821     $ 216,392     $ 225,213   
    Non-owner occupied
    800       1,996       11,801       14,597       158,773       173,370  
  Multifamily
    -       -       -       -       143,513       143,513  
  Commercial real estate
    2,141       836       6,948       9,925       256,372       266,297  
  Construction/land development
    133       265       32,620       33,018       20,394       53,412  
Total real estate
    5,252       3,877       57,232       66,361       795,444       861,805  
Business
    -       -       -       -       479       479  
Consumer
    -       55       57       112       19,015       19,127  
Total
  $ 5,252     $ 3,932     $ 57,289     $ 66,473     $ 814,938     $ 881,411  
                                                 
(1) There were no loans 90 days past due and still accruing interest at December 31, 2010.
 
(2) Net of undisbursed funds.
                                               

 
21

 
 
 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)

Credit Quality Indicators.  We utilize a nine-point risk rating system and assign a risk rating for all credit exposures. The risk rating system is designed to define the basic characteristics and identify risk elements of each credit extension. Credits risk rated 1 through 5 are considered to be “pass” credits. Pass credits can be assets where there is virtually no credit risk, such as cash secured loans with funds on deposit with the Bank. Pass credits also include credits that are on our watch list, where the borrower exhibits potential weaknesses, which may, if not checked or corrected, negatively affect the borrower’s financial capacity and threaten their ability to fulfill debt obligations in the future. Credits classified as special mention are risk rated 6 and possess weaknesses that deserve management’s close attention. Special mention assets are not adversely classified and do not expose the Bank to sufficient risk to warrant adverse classification. Substandard credits are risk rated 7. An asset is considered substandard if it is inadequately protected by the current net worth and payment capacity of the borrower or of any collateral pledged. Substandard assets include those characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. Assets classified as doubtful are risk rated 8 and have all the weaknesses inherent in those credits classified as substandard with the added characteristic that the weaknesses present make collection or liquidation in full highly questionable and improbable, on the basis of currently existing facts, conditions and values. Assets classified as loss are risk rated 9 and are considered uncollectible and cannot be justified as a viable asset for the Bank.
 
    The following tables represent a summary of loans by type and risk category:
 
 
September 30, 2011
 
   
One-to-Four
Family
Residential
   
Multifamily
   
Commercial
Real Estate
   
Construction/ 
Land Development
   
Business
   
Consumer
   
Total (1)
 
 
 
               
(In thousands)
                   
Risk Rating:
                                         
      Pass
  $ 303,798     $ 110,392     $ 206,855     $ 16,506     $ 3,531     $ 13,632     $ 654,714  
      Special mention
    24,308       5,431       13,980       424       -       222       44,365   
      Substandard
    18,116       638       15,940       11,891       -       44       46,629  
      Doubtful
    -       -       -       -       -       -       -  
      Total
  $ 346,222     $ 116,461     $ 236,775     $ 28,821     $ 3,531     $ 13,898     $ 745,708  
______________                                                         
(1) Net of undisbursed funds.
                                                 
 
 
December 31, 2010
 
   
One-to-Four
Family
Residential
   
Multifamily
   
Commercial
Real Estate
   
Construction/ 
Land Development
   
Business
   
Consumer
   
Total (1)
 
 
 
               
(In thousands)
                   
Risk Rating:
                                         
      Pass
  $ 360,239     $ 141,224     $ 249,576     $ 17,589     $ 479     $ 18,792     $ 787,899  
      Special mention
    10,261       1,936       5,805       -       -       189       18,191  
      Substandard
    28,083       353       10,916       35,484       -       140       74,976   
      Doubtful
    -       -       -       339       -       6       345  
Total
  $ 398,583     $ 143,513     $ 266,297     $ 53,412     $ 479     $ 19,127     $ 881,411  
______________                                                         
(1) Net of undisbursed funds.
                                                 

 
22

 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)


The following tables summarize the loan portfolio by type and payment activity:
 
 
September 30, 2011
 
   
   One-to-Four Family
Residential
   
Multifamily
   
Commercial
Real Estate
 
Construction/ 
Land
Development
 
Business
   
Consumer
   
Total (3)
 
 
(In thousands)
 
Performing (1)
  $ 333,363     $ 115,823     $ 231,375     $ 16,930     $ 3,531     $ 13,854     $ 714,876  
Nonperforming (2)
    12,859       638       5,400       11,891       -       44       30,832  
Total
  $ 346,222     $ 116,461     $ 236,775     $ 28,821     $ 3,531     $ 13,898     $ 745,708  
                                                         
(1)  There were $189.9 million of owner-occupied one-to-four family loans and $143.5 million of non-owner occupied one-to-four family loans classified
        as performing.
 
(2)  There were $5.1 million of owner-occupied one-to-four family loans and $7.8 million of non-owner occupied one-to-four family loans classified
        as nonperforming.
 
(3)  Net of undisbursed funds.
                                                 
 

 
 
December 31, 2010
 
     
One-to-Four
Family
Residential
 
Multifamily
   
Commercial
Real Estate
 
Construction/ 
Land
Development
 
Business
   
Consumer
   
Total (3)
 
 
(In thousands)
 
Performing (1)
  $ 375,895     $ 143,513     $ 258,991     $ 20,527     $ 479     $ 19,070     $ 818,475  
Nonperforming (2)
    22,688       -       7,306       32,885       -       57       62,936  
Total
  $ 398,583     $ 143,513     $ 266,297     $ 53,412     $ 479     $ 19,127     $ 881,411  
                                                         
(1)  There were $217.3 million of owner-occupied one-to-four family loans and $158.6 million of non-owner occupied one-to-four family loans classified
        as performing.
(2)  There were $8.0 million of owner-occupied one-to-four family loans and $14.7 million of non-owner occupied one-to-four family loans classified
        as nonperforming.
 
(3)  Net of undisbursed funds.
                             
 
The following table presents our TDRs recorded investment prior to the modification and after the modification:
 
   
Three Months Ended September 30, 2011
   
Nine Months Ended September 30, 2011
 
   
Number of
Loans
   
Pre-
Modification Outstanding
Recorded
 Investment
   
Post-
Modification Outstanding
Recorded
Investment
   
Number of
Loans
   
Pre-
Modification Outstanding
Recorded
Investment
   
Post-
Modification Outstanding
Recorded
Investment
 
   
(Dollars in thousands)     
 
TDRs that Occurred During the Period:
                                   
  One-to-four family residential:
                                   
     A/B Note restructure
    -     $ -     $ -       6     $ 1,130     $ 635  
     Interest only payments with interest rate
       concession
  1       1,019       1,017       12       4,459       4,451  
     Principal and interest with interest rate
       concession
  14       2,471       2,464       23       6,190       6,069  
     Interest only payments with no interest rate
       concession
  -       -       -       2       527       510  
Total
    15     $ 3,490     $ 3,481       43     $ 12,306     $ 11,665  

    At September 30, 2011, the Company had $36,000 in commitments to extend additional credit to borrowers whose loan terms have been modified in TDRs. All TDRs are also classified as impaired loans and are included in the loans individually evaluated for impairment in the calculation of the ALLL.

The TDRs that occurred during the three and nine months ended September 30, 2011 were primarily a result of granting the borrower interest rate concessions for a period of time ranging from one to three years. The impaired portion of the loan with an interest rate concession for a specific period of time is calculated based on the present value of expected future cash flows discounted at the loan’s effective interest rate. The effective interest rate is the rate of return implicit on the original loan. This impaired amount reduces the ALLL and a valuation allowance
 
 
 
 
 
23

 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)

is established to reduce the loan balance. As loan payments are received in future periods, the ALLL entry is reversed and the valuation allowance is reduced utilizing the level yield method over the modification period. TDRs resulted in a charge to the ALLL of $148,000 and $396,000 for the three and nine months ended September 30, 2011, respectively.

The following is a summary of loans that were modified as TDRs within the previous 12 months and for which there was a payment default during the period.
 
   
Types of Modifications
 
   
Number of
Loans
 
Interest
Only
Payments
 
Interest
Rate
Concession
 
   
(Dollars in thousands)
 
TDRs that Subsequently Defaulted:
                 
     One-to-four family residential
    4     $ 391     $ 2,233  
 

TDRs that default after they have been modified are typically evaluated individually on a collateral basis. Any additional impairment further reduces the ALLL.
 
Note 7 – Other Real Estate Owned

The following table is a summary of OREO:
 
   
Three Months Ended 
September 30,
   
Nine Months Ended
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
   
(In thousands)
 
Beginning Balance
  $ 25,979     $ 16,493     $ 30,102     $ 11,835  
   Loans transferred to OREO
    4,787       17,177       20,737       34,843  
   Capitalized improvements
    91       202       181       488  
   Dispositions of OREO
    (5,141 )     (2,016 )     (24,387 )     (19,055 )
   Market value adjustments
    (515 )     (8,929 )     (1,432 )     (5,184 )
Ending Balance
  $ 25,201     $ 22,927     $ 25,201     $ 22,927  

OREO includes properties acquired by the Bank through foreclosure or deed in lieu of foreclosure. OREO at September 30, 2011 consisted of $9.2 million in one-to-four family residential homes, $7.3 million in construction/land development projects and $8.7 million in commercial real estate buildings.

Note 8 – Fair Value

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

We determined the fair values of our financial instruments based on the fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair values. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our estimates for market assumptions.

Valuation inputs refer to the assumptions market participants would use in pricing a given asset or liability using one of the three valuation techniques. Inputs can be observable or unobservable. Observable inputs are those
 
 
 
 
24

 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)
 
assumptions that market participants would use in pricing the particular asset or liability. These inputs are based on market data and are obtained from an independent source. Unobservable inputs are assumptions based on our own information or estimate of assumptions used by market participants in pricing the asset or liability. Unobservable inputs are based on the best and most current information available on the measurement date.

All inputs, whether observable or unobservable, are ranked in accordance with a prescribed fair value hierarchy:

·  
Level 1 – Quoted prices for identical instruments in active markets.
·  
Level 2 – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived
                   valuations whose inputs are observable.
·  
Level 3 – Instruments whose significant value drivers are unobservable.

The tables below present the balances of assets and liabilities measured at fair value on a recurring basis (there were no transfers between Level 1, Level 2 and Level 3 recurring measurements during the periods presented):
 
   
Fair Value Measurements at September 30, 2011
         
Quoted Prices in
 
Significant
     
         
Active Markets
 
Other
 
Significant
   
Fair Value
 
for Identical
 
Observable
 
Unobservable
   
Measurements
 
Assets (Level 1)
 
Inputs (Level 2)
 
Inputs (Level 3)
   
(In thousands)
Available for sale investments:                           
    Mortgage-backed investments:
                     
        Fannie Mae
 
$
                   57,839
 
$
                               -
 
$
              57,839
 
$
                      -
        Freddie Mac
   
                   22,606
   
                               -
   
              22,606
   
                      -
        Ginnie Mae
   
                    7,977
   
                               -
   
               7,977
   
                      -
    Municipal bonds
   
                    2,134
   
                               -
   
               2,134
   
                      -
    U.S. Government agencies
   
                   49,717
   
                               -
   
              49,717
   
                      -
   
$
                 140,273
 
$
                               -
 
$
            140,273
 
$
                      -
                         
   
Fair Value Measurements at December 31, 2010
           
Quoted Prices in
   
Significant
     
           
Active Markets
   
Other
   
Significant
   
Fair Value
   
for Identical
   
Observable
   
Unobservable
   
Measurements
   
Assets (Level 1)
     Inputs (Level 2)    
Inputs (Level 3)
   
(In thousands)
Available for sale investments:                          
    Mortgage-backed investments:                        
        Fannie Mae  
$
                 110,144
 
 $
                               -
 
 $
            110,144
 
 $
                      -
        Freddie Mac    
                   41,149
   
                               -
   
              41,149
   
                      -
       Ginnie Mae    
                    9,444
   
                               -
   
               9,444
   
                      -
    Municipal bonds    
                    1,922
   
                               -
   
               1,922
   
                      -
    U.S. Government agencies    
                    1,944
   
                               -
   
               1,944
   
                      -
   
$
                 164,603
 
$
                               -
 
$
            164,603
 
$
                      -

The estimated fair value of Level 2 investments is based on quoted prices for similar investments in active markets, identical or similar investments in markets that are not active and model-derived valuations whose inputs are observable.

The tables below present the balances of assets and liabilities measured at fair value on a nonrecurring basis:
 
 
 
25

 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)
 
   
Fair Value Measurements at September 30, 2011
         
Quoted Prices in
 
Significant
           
         
Active Markets
 
Other
 
Significant
     
   
Fair Value
 
for Identical
 
Observable
 
Unobservable
 
Total
   
Measurements
 
Assets (Level 1)
 
Inputs (Level 2)
 
Inputs (Level 3)
 
Losses
   
(In thousands)
Impaired loans including undisbursed but committed funds                               
    of $43,000 (included in loans receivable, net)(1)  
$
                   96,286
 
$
                                    -
 
$
                                 -
 
$
                     96,286
 
$
                       609
OREO (2)     
                    25,201
   
                                    -
   
                                 -
   
                      25,201
   
                        515
   
$
                   121,487
 
$
                                    -
 
$
                                 -
 
$
                    121,487
 
$
                      1,124
                               
 (1) The loss represents the specific reserve against loans that were considered impaired at September 30, 2011 
 (2) The loss represents OREO market value adjustments for the quarter ended September 30, 2011
 
   
Fair Value Measurements at December 31, 2010
           
Quoted Prices in
   
Significant
           
           
Active Markets
   
Other
   
Significant
     
   
Fair Value
   
for Identical
   
Observable
   
Unobservable
 
Total
   
Measurements
   
Assets (Level 1)
   
Inputs (Level 2)
   
Inputs (Level 3)
 
Losses
   
(In thousands)
Impaired loans including undisbursed but committed funds                               
    of $1.1 million (included in loans receivable, net) (1)   
$
116,543
 
$
                                    -
 
$
                                 -
 
$
116,543
 
$
                    5,842
OREO (2)     
30,102
   
                                    -
   
                                 -
   
30,102
   
                    5,624
   
$
146,645
 
$
                                    -
 
$
                                 -
 
$
146,645
 
$
                   11,466
                               
(1) The loss represents the specific reserve against loans that were considered impaired at December 31, 2010.
(2) The loss represents OREO market value adjustments for the year ended December 31, 2010.
 
                       

The fair value of impaired loans is calculated using the collateral value method or on a discounted cash flow basis. Inputs used in the collateral value method include appraised values, estimates of certain completion costs and closing and selling costs. Some of these inputs may not be observable in the marketplace.

OREO properties are measured at the lower of their carrying amount or fair value, less costs to sell. Fair values are generally based on third party appraisals of the property, resulting in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.

 
26

 

FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)



The carrying amounts and estimated fair values of financial instruments were as follows:
 
               
September 30, 2011
 
December 31, 2010
               
Carrying
 
Estimated
 
Carrying
 
Estimated
               
Value
 
Fair Value
 
Value
 
Fair Value
             
(In thousands)
Assets:
                               
 
Cash on hand and in banks
 
$
            5,159
 
$
            5,159
 
$
            7,466
 
$
            7,466
 
Interest-bearing deposits
   
        207,040
   
        207,040
   
          90,961
   
          90,961
 
Investments available for sale
   
        140,273
   
        140,273
   
        164,603
   
        164,603
 
Loans receivable, net
   
        727,226
   
        763,147
   
        856,456
   
        878,737
 
Federal Home Loan Bank stock
   
            7,413
   
            7,413
   
            7,413
   
            7,413
 
Accrued interest receivable
   
            3,972
   
            3,972
   
            4,686
   
            4,686
Liabilities:
                             
 
Deposits
       
        212,257
   
        212,257
   
        231,527
   
        231,527
 
Certificates of deposit
   
        638,288
   
        645,085
   
        688,699
   
        701,976
 
Advances from the Federal Home
                       
   
Loan Bank
     
          93,066
   
          95,522
   
          93,066
   
          95,972
 
Accrued interest payable
   
               228
   
               228
   
               214
   
               214


Fair value estimates, methods, and assumptions are set forth below for our financial instruments.

·  
Financial instruments with book value equal to fair value: The fair value of financial instruments that are short-term or reprice frequently and that have little or no risk are considered to have a fair value equal to book value. These instruments include cash on hand and in banks, interest-bearing deposits, investments available for sale, Federal Home Loan Bank of Seattle (“FHLB”) stock, accrued interest receivable and accrued interest payable. FHLB stock is not publicly-traded, however, it may be redeemed on a dollar-for-dollar basis, for any amount the Bank is not required to hold, subject to the FHLB’s discretion.

·  
Investments: The fair value of all investments, excluding FHLB stock, was based upon quoted market prices for similar investments in active markets, identical or similar investments in markets that are not active and model-derived valuations whose inputs are observable.

·  
Loans receivable: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair value of fixed-rate loans is estimated using discounted cash flow analysis, utilizing interest rates that would be offered for loans with similar terms to borrowers of similar credit quality. As a result of current market conditions, cash flow estimates have been further discounted to include a credit factor. The fair value of nonperforming loans is estimated using the fair value of the underlying collateral.
 
·  
Liabilities: The fair value of deposits with no stated maturity, such as statement, NOW, and money market accounts, is equal to the amount payable on demand. The fair value of certificates of deposit is based on the discounted value of contractual cash flows using current interest rates for certificates of deposit with similar remaining maturities. The fair value of FHLB advances is estimated based on discounting the future cash flows using current interest rates for debt with similar remaining maturities.
 
·  
Off balance sheet commitments: No fair value adjustment is necessary for commitments made to extend credit, which represents commitments for loan originations or for outstanding commitments to purchase loans. These commitments are at variable rates, are for loans with terms
 
 
 
27

 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)
 
 
 of less than one year and have interest rates which approximate prevailing market rates, or are set at the time of loan closing.
 
Fair value estimates are based on existing balance sheet financial instruments without attempting to estimate the value of anticipated future business. The fair value has not been estimated for assets and liabilities that are not considered financial instruments.

Note 9 – Federal Home Loan Bank Stock

At September 30, 2011, we held $7.4 million of FHLB stock. FHLB stock is carried at par ($100 per share) and does not have a readily determinable fair value. Ownership of FHLB stock is restricted to the FHLB and member institutions, and can only be purchased and redeemed at par. As a result of ongoing turmoil in the capital and mortgage markets, the FHLB has a risk-based capital deficiency largely as a result of write-downs on its private label mortgage-backed securities portfolio.

Management evaluates FHLB stock for impairment. The determination of whether this investment is impaired is based on our assessment of the ultimate recoverability of cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of cost is influenced by criteria such as: (1) the significance of any decline in net assets of the FHLB as compared to the capital stock amount for the FHLB and the length of time this situation has persisted; (2) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB; (3) the impact of legislative and regulatory changes on institutions and, accordingly, the customer base of the FHLB; and (4) the liquidity position of the FHLB.

On October 25, 2010, the FHLB agreed to the stipulation and issuance of a Consent Order by its primary regulator, the Federal Housing Finance Agency (“FHFA”). The Consent Order sets forth requirements for capital management, asset composition, and other operational and risk management improvements. The FHLB may not repurchase member stock or pay dividends, until they achieve and maintain financial thresholds established by the FHFA as part of the agency’s supervisory process, subject to FHFA approval.

This restriction is not expected to have a material effect on our financial position, liquidity or results of operations. We have determined there is no OTTI on the FHLB stock investment as of September 30, 2011.

Note 10 - Stock-Based Compensation

In June 2008, our shareholders approved the First Financial Northwest, Inc. 2008 Equity Incentive Plan (“Plan”). The Plan provides for the grant of stock options, awards of restricted stock and stock appreciation rights.
 
Total compensation expense for the Plan was $540,000 and $464,000 for the three months ended September 30, 2011 and 2010, respectively, and the related income tax benefit was $189,000 and $162,000 for the nine months ended September 30, 2011 and 2010, respectively.

Total compensation expense for the Plan was $1.5 million and $1.4 million for the nine months ended September 30, 2011 and 2010, respectively, and the related income tax benefit was $521,000 and $504,000 for the nine months ended September 30, 2011 and 2010, respectively.

Stock Options

The Plan authorized the grant of stock options totaling 2,285,280 shares to our directors, advisory directors, officers and employees. Option awards are granted with an exercise price equal to the market price of our common stock at the date of grant. These option awards have a vesting period of five years, with 20% vesting on the anniversary date of each grant date and a contractual life of ten years. Any unexercised stock options will expire ten years after the grant date or sooner in the event of the award recipient’s death, disability or termination of service
 
 
 
 
28

 
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)
  
with the Company or the Bank. We have a policy of issuing new shares from authorized but unissued common stock upon the exercise of stock options. At September 30, 2011, remaining options for 911,756 shares of common stock were available for grant under the Plan.

The fair value of each option award is estimated on the date of grant using a Black-Scholes model that uses the following assumptions. The dividend yield is based on the current quarterly dividend in effect at the time of the grant. Historical employment data is used to estimate the forfeiture rate. In previous periods, we elected to use a weighted-average of our peers’ historical stock price information in conjunction with our own stock price history due to the limited amount of history available regarding our stock price. Now that sufficient historical stock price information is available regarding our stock, we will utilize in future periods the historical volatility of our stock price over a specified period of time for the expected volatility assumption. We base the risk-free interest rate on the U.S. Treasury Constant Maturity Indices in effect on the date of the grant. We elected to use the “Share-Based Payments” method permitted by the SEC to calculate the expected term. This method uses the vesting term of an option along with the contractual term, setting the expected life at the midpoint. There were no options granted during the third quarter ended September 30, 2011.
 
 
The following is a summary of our stock option plan awards for the nine months ended September 30, 2011:
 
             
Weighted-Average
 
 
   
Weighted-
         
Weighted-Average
Remaining Contractual
Aggregate
Intrinsic
   
Average
Grant Date
   
Shares
   
Exercise Price
Term in Years
 
Value
   
Fair Value
   
(Dollars in thousands, except share data)
Outstanding at January 1, 2011
     1,383,524
 
$
  9.52
 
         7.60
 
 $
                -
 
 $
                 1.91
 
Granted
                  -
   
     -
 
            -
   
                -
   
                    -
 
Exercised
                  -
   
     -
 
            -
   
                -
   
                    -
 
Forfeited or expired
        (10,000)
   
  9.78
 
            -
   
                -
   
                    -
Outstanding at September 30, 2011
     1,373,524
   
  9.52
 
         6.85
   
              80
   
                 1.91
                           
Expected to vest assuming a 3% forfeiture
                       
 
rate over the vesting term
        562,022
   
  9.31
 
         6.92
   
              62
   
                    -
                           
Exercisable at September 30, 2011
        794,114
   
  9.67
 
         6.80
   
              16
   
                    -
 
As of September 30, 2011, there was $929,000 of total unrecognized compensation cost related to non-vested stock options granted under the Plan. The cost is expected to be recognized over the remaining weighted-average vesting period of 1.9 years.
 
Restricted Stock Awards

The Plan authorized the grant of restricted stock awards amounting to 914,112 shares to our directors, advisory directors, officers and employees. Compensation expense is recognized over the vesting period of the awards based on the fair value of the stock at the date of grant. The restricted stock awards’ fair value is equal to the value on the date of grant. Shares awarded as restricted stock vest ratably over a five-year period beginning at the grant date with 20% vesting on the anniversary date of each grant date. At September 30, 2011, remaining restricted awards for 167,078 shares were available to be issued. Shares that have been repurchased totaled 310,494 and are held in trust until they are issued in connection with the agreement.


 
29

 

FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)

 
The following is a summary of changes in non-vested restricted stock awards for the nine months ended September 30, 2011: 
 
Non-vested Shares
 
Shares
 
 Fair Value Per Share
               
Non-vested at January 1, 2011
 
     456,140
   
 $    9.75
 
Granted
   
               -
   
                            -
 
Vested
   
   (145,646)
   
                       9.93
 
Forfeited
   
               -
   
                            -
Non-vested at September 30, 2011
 
     310,494
   
                       9.66
               
Expected to vest assuming a 3% forfeiture
         
 
rate over the vesting term
 
     301,178
     

As of September 30, 2011, there was $2.8 million of total unrecognized compensation costs related to non-vested shares granted as restricted stock awards. The cost is expected to be recognized over the remaining weighted-average vesting period of 2.1 years. The total fair value of shares that vested during both of the quarters ended September 30, 2011 and 2010 was $1.4 million.

Note 11 – Federal Taxes on Income

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. These calculations are based on many complex factors including estimates of the timing of reversals of temporary differences, the interpretation of federal income tax laws and a determination of the differences between the tax and the financial reporting basis of assets and liabilities. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax assets and liabilities.

Our primary deferred tax assets relate to our ALLL, our contribution to the First Financial Northwest Foundation and an impairment charge relating to a past investment in the AMF Ultra Short Mortgage Fund.

Under GAAP, a valuation allowance is required to be recognized if it is “more likely than not” that a portion of the deferred tax asset will not be realized.  Our policy is to evaluate our deferred tax assets on a quarterly basis and record a valuation allowance for our deferred tax asset if we do not have sufficient positive evidence indicating that it is more likely than not that some or all of the deferred tax asset will be realized.  At September 30, 2011, we considered positive and negative evidence, which includes cumulative losses in the most recent three year period and uncertainty regarding short-term future earnings.  We further considered that GAAP places heavy emphasis on prior earnings in determining the realizable deferred tax asset.  After reviewing and weighing these various factors, in 2010 we recorded a valuation allowance for the balance of the deferred tax asset in excess of the tax carryback refund potential, resulting in no deferred tax asset at September 30, 2011.

 
 
30

 

FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)


Note 12 – Earnings/(Loss) Per Share

The following table presents a reconciliation of the components used to compute basic and diluted earnings (loss) per share:
 
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2011
   
2010
   
2011
   
2010
 
   
(Dollars in thousands, except share data)
 
Net income (loss)
  $ 623     $ (12,071 )   $ 3,315     $ (54,704 )
                                 
Basic weighted-average common shares outstanding
    17,545,157       17,432,309       17,519,016       17,411,169  
   Plus common stock options considered outstanding
                               
   for dilutive purposes (excludes antidilutive options)
    -       -       -       -  
Diluted weighted-average common shares outstanding
    17,545,157       17,432,309       17,519,016       17,411,169  
                                 
Basic income (loss) per share
  $ 0.04     $ (0.69 )   $ 0.19     $ (3.14 )
Diluted income (loss) per share
  $ 0.04     $ (0.69 )   $ 0.19     $ (3.14 )

For the three and nine months ended September 30, 2011 and 2010, there were no stock options included in calculating the dilutive earnings per share because they were antidilutive.

Note 13 – Segment Information

Our activities are considered to be a single industry segment for financial reporting purposes. We are engaged in the business of attracting deposits from the general public and originating loans for our portfolio in our primary market area. Substantially all income is derived from a diverse base of commercial and residential real estate loans, consumer lending activities and investments.


Note 14 – Subsequent Events

In October, 2011, we prepaid a $10.0 million fixed-rate advance due to mature in March 2012, at an interest rate of 2.82%. The prepayment penalty was $118,000. We prepaid this in advance in order to utilize some of our excess liquidity and to reduce our cost of funds.


 
31

 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-looking statements:

Certain matters discussed in this Quarterly Report on Form 10-Q constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to our financial condition, results of operations, plans, objectives, future performance or business. Forward-looking statements are not statements of historical fact, are based on certain assumptions and are generally identified by use of the words “believe,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions or future or conditional verbs such as “may,” “will,” “should,” “would,” and “could.” Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, assumptions and statements about, among other things, expectations of the business environment in which we operate, projections of future performance or financial items, perceived opportunities in the market, potential future credit experience, and statements regarding our mission and vision. These forward-looking statements are based upon current management expectations and may, therefore, involve risks and uncertainties. Our actual results, performance, or achievements may differ materially from those suggested, expressed, or implied by forward-looking statements as a result of a wide variety or range of factors including, but not limited to: the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs, and deterioration in the housing and commercial real estate markets, which may lead to increased losses and nonperforming assets in our loan portfolio, and may result in our allowance for loan losses not being adequate to cover actual losses, and require us to materially increase our reserves; changes in general economic conditions, either nationally or in our market areas; changes in the levels of general interest rates, and the relative differences between short and long term interest rates, deposit interest rates, our net interest margin and funding sources; fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas; results of examinations of us by the FRB and our bank subsidiary by the FDIC, the DFI or other regulatory authorities, including the possibility that any such regulatory authority may initiate additional enforcement actions against the Company or the Bank to take additional corrective action and refrain from unsafe and unsound practices which also may require us, among other things, to increase our reserve for loan losses, write-down assets, change our regulatory capital position or affect our ability to borrow funds or maintain or increase deposits, which could adversely affect our liquidity and earnings; our compliance with regulatory enforcement actions, including the requirements and restrictions that have been imposed upon the Company under the memoranda of understanding with the FRB and the consent order the Bank entered into with the FDIC and the DFI and the possibility that the Company and the Bank will be unable to fully comply with these enforcement actions which could result in the imposition of additional requirements or restrictions; our ability to pay dividends on our common stock; our ability to attract and retain deposits; further increases in premiums for deposit insurance; our ability to control operating costs and expenses; the use of estimates in determining the fair values of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation; difficulties in reducing risk associated with the loans on our balance sheet; staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our work force and potential associated charges; computer systems on which we depend could fail or experience a security breach; our ability to retain key members of our senior management team; costs and effects of litigation, including settlements and judgments; our ability to implement our branch expansion strategy; our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we have acquired or may in the future acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames and any goodwill charges related thereto; our ability to manage loan delinquency rates; increased competitive pressures among financial services companies; changes in consumer spending, borrowing and savings habits; legislative or regulatory changes that adversely affect our business including changes in regulatory policies and principles, including the interpretation of regulatory capital or other rules; the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the implementing regulations; the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions; adverse changes in the securities markets; inability of key third-party providers to perform their obligations to us; changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the Financial Accounting Standards Board, including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods; the economic impact of war or any terrorist activities; other economic, competitive, governmental, regulatory, and technological factors affecting our operations; pricing, products and services; and other risks
 
 
 
32

 
detailed in our reports filed with the Securities and Exchange Commission, including our Annual Report on Form 10-K for the year ended December 31, 2010 (“2010 Form 10-K”). Any of the forward-looking statements that we make in this Form 10-Q and in the other public reports and statements we make may turn out to be wrong because of the inaccurate assumptions we might make, because of the factors illustrated above or because of other factors that we cannot foresee. Because of these and other uncertainties, our actual future results may be materially different from those expressed in any forward-looking statements made by or on our behalf. Therefore, these factors should be considered in evaluating the forward-looking statements, and undue reliance should not be placed on such statements. We undertake no responsibility to update or revise any forward-looking statements.

Regulatory Items

On April 14, 2010, the OTS and members of the Board of Directors of First Financial Northwest entered into an informal supervisory agreement or Memorandum of Understanding (“MOU”) which is now enforced by the FRB as the successor to the OTS. Under the terms of the MOU, the Company agreed, among other things, to provide notice to and obtain a written non-objection from the FRB prior to the Company (a) declaring a dividend or redeeming any capital stock and (b) incurring, issuing, renewing or repurchasing any new debt. Further, in connection with a prior examination of the Bank by the FDIC and DFI, we must obtain a written non-objection from the FDIC before engaging in any transaction that would materially change the balance sheet composition (including growth in total assets of five percent or more), significantly change funding sources (including brokered deposits) or declare or pay cash dividends. In addition, both the Company and the Bank must obtain prior regulatory approval before adding any new director or senior executive officer or changing the responsibilities of any current senior executive officer or pay pursuant to or by entering into certain severance and other forms of compensation agreements.

The Bank entered into a Stipulation to the Issuance of a Consent Order (“Order”) with the FDIC and the DFI which became effective on September 24, 2010. Under the terms of the Order, the Bank cannot declare dividends or repurchase stock without the prior written approval of the FDIC. Other material provisions of the Order require the Bank to:

·    
Maintain and preserve qualified management;
·    
Increase the Board of Directors’ participation in the Bank’s affairs;
·    
Obtain an independent study of management and the personnel structure of the Bank;
·    
Maintain specified Capital levels;
·    
Eliminate loans classified as “Loss” at its regulatory examination, and reduce the loans classified as “Doubtful” and “Substandard” as a percent of capital;
·    
Revise its policy with respect to the allowance for loan losses;
·    
Not extend additional credit to borrowers whose loan had been classified as “Loss” and is uncollected;
·    
Revise its lending and collection policies and practices;
·    
Develop a plan to reduce the amount of commercial real estate loans;
·    
Enhance its written funds management and liquidity policy;
·    
Develop a three-year strategic plan;
·    
Not solicit brokered deposits and comply with certain deposit rate restrictions;
·    
Eliminate and correct all violations of laws; and
·    
Prepare and submit progress reports to the FDIC and DFI.

The Bank has implemented a comprehensive plan to achieve full compliance with the Order. The Order contains target dates to achieve the items listed above, including that the Bank’s Tier 1 capital ratio and total risk-based capital ratio be at least 10% and 12%, respectively. At September 30, 2011, the Bank’s Tier 1 capital ratio was 12.76% and its total risk-based capital ratio was 23.87%, which exceeded the requirements of the Order.

Adversely classified assets as a percent of Tier 1 capital plus the allowance for loan and lease losses (“ALLL”) was 128% at the beginning of 2010. The Order required this ratio to be below 65% by March 2011 for the adversely classified assets identified at that exam. We achieved this target as of September 30, 2010 and remained in compliance with this requirement at September 30, 2011.
 
 
 
33

 
The Order also required that the Bank develop a written plan to systematically reduce the amount of loans to borrowers in the commercial real estate loan category, including its construction/land development loans which are considered commercial real estate for purposes of this calculation. At September 30, 2010, the Bank’s commercial real estate loans, excluding owner-occupied properties, represented 314% of its total risk-based capital including construction/land development loans which equaled 84% of its total risk-based capital. As of September 30, 2011, the Bank’s concentration in commercial real estate loans was reduced to 238% of its risk-based capital and its construction/land development loan portfolio was reduced to 34% of total risk-based capital.

The Order also required the Bank to obtain an independent management study and adopt a plan to implement the recommendations from the study, satisfactory to its regulators. The Bank has obtained the independent management study and continues to work on implementing the study’s recommendations, including the addition of new Board members and the evaluation of senior management. We are in discussions with potential new Board members for the Bank and the Company who would further enhance the knowledge and expertise of our Boards of Directors. Senior management is also being evaluated in connection with the independent management study and efforts are being made to identify outside individuals who would augment the leadership of our organization and who possess the experience and qualifications to strengthen and establish the foundation for our future growth.

A copy of the Order is attached to the Form 8-K that we filed with the SEC on September 27, 2010. The Order will remain in effect until modified or terminated by the FDIC and the DFI.

Overview

First Savings Bank is a community-based savings bank primarily serving King and, to a lesser extent, Pierce, Snohomish and Kitsap counties, through our full-service banking office located in Renton, Washington. First Savings Bank’s business consists of attracting deposits from the public and utilizing these funds to originate one-to-four family, multifamily, commercial real estate, business, consumer and construction/land development loans.

Our primary source of revenue 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.

An offset to net interest income is the provision for loan losses which represents the quarterly charge to operations which is required to adequately provide for probable losses inherent in our loan portfolio.

Noninterest expense consists primarily of compensation and employee benefits, occupancy and equipment, data processing, marketing, postage and supplies, professional services, expenses associated with OREO and deposit insurance premiums. Compensation and employee benefits consist primarily of the salaries paid to our employees, payroll taxes, expenses for retirement benefits, the equity incentive plan and other employee benefits. Occupancy and equipment expenses consist primarily of real estate taxes, depreciation charges, maintenance and costs of utilities. OREO expenses consist of market value adjustments related to real estate that we own as well as maintenance costs, taxes, insurance and gains/losses resulting from the sale of these properties.

Net income for the third quarter ended September 30, 2011 was $623,000, or $0.04 per diluted share, as compared to a net loss of $12.1 million, or $0.69 per diluted share for the quarter ended September 30, 2010. The change in operating results in the third quarter of 2011 as compared to the third quarter of 2010 was primarily the result of a $10.7 million decrease in the provision for loan losses to $1.3 million, a $518,000 increase in noninterest income primarily the result of $479,000 in net gains on sales of investments with no comparable sales activity during the quarter ended September 30, 2010, and decreases of $2.0 million in noninterest expense primarily due to decreases in OREO related expenses and FDIC insurance premiums during the quarter.

For the nine months ended September 30, 2011, the Company had net income of $3.3 million, or $0.19 per diluted share as compared to a net loss of $54.7 million, or $3.14 per diluted share for the comparable period in 2010. The change in operating results for the nine months ended September 30, 2011 as compared to the same
 
 
 
34

 
period last year was primarily the result of a $46.9 million decrease in the provision for loan losses, a $1.8 million increase in noninterest income primarily the result of $1.7 million in net gains on sales of investments with no comparable sales activity during the nine months ended September 30, 2010, a $4.9 million decrease in noninterest expense primarily due to a $5.4 million decrease in net OREO related expenses (including a $1.6 million increase in net gain on sales of OREO) and a $4.0 million decrease in the provision for federal income taxes as the Company utilized tax loss carry-forwards to offset net income. As a result, we did not recognize any tax expense in our Consolidated Income Statements during the current quarter and nine months ended September 30, 2011.

During the nine months ended September 30, 2011, our total loan portfolio decreased $144.1 million, or 16.1% from December 31, 2010, including a $26.6 million, or 47.1% decrease in construction/land development loans. In addition, our one-to-four family residential loans decreased $52.4 million, or 13.2%, multifamily loans decreased $27.6 million, or 19.0% and commercial real estate loans decreased $35.3 million, or 12.9%, all contributing to the overall decrease in our total loan portfolio.

The five largest borrowing relationships, as of September 30, 2011, in descending order were:
 
   
 
Borrower (1)
 
  Aggregate Amount of Loans
at September 30, 2011 (2)
 
Number of
Loans
   
(Dollars in thousands)
   
Real estate builder
 
$     26,528 
 
                100
Real estate builder
 
20,194 
 (3)
                101
Real estate investor
 
18,197 
 
                   3
Real estate builder
 
17,331 
 (4)
                 84
Real estate investor
 
16,625 
 
                 40
Total
 
$     98,875 
 
                328
 
           
(1)   The composition of borrowers represented in the table may change from one period to the next.
(2)   Net of undisbursed funds.
       
(3)   Of this amount, $18.8 million are considered impaired loans of which $ 13.3 million are performing
        and $5.5 million are nonperforming.
(4)   Of this amount, $16.5 million are considered impaired loans of which $13.0 million are performing
        and $3.5 million are nonperforming.

The following table details the breakdown of the types of loans to our five largest borrowing relationships at September 30, 2011:
 
   
One-to-Four Family
                       
   
Residential
 
Multifamily
 
Commercial
 
Construction/
 
Aggregate Balance
Borrower
 
(Rental Properties)
 
(Rental Properties)
 
(Rental Properties)
 
Land Development (1)
 
of Loans (1)
   
(In thousands)
Real estate builder
 
$
                16,826
 
 $
                        -
 
 $
                104
 
 $
                      9,598
 
 $
              26,528
Real estate builder (2)
   
                15,249
   
                        -
   
                244
   
                      4,701
   
              20,194
Real estate investor
   
                        -
   
                        -
   
            18,197
   
                            -
   
              18,197
Real estate builder (3)
   
                16,063
   
                        -
   
                823
   
                        445
   
              17,331
Real estate investor
   
                10,641
   
                  5,037
   
                947
   
                            -
   
              16,625
Total
 
$
                58,779
 
 $
                  5,037
 
 $
            20,315
 
 $
                    14,744
 
 $
              98,875
                               
(1) Net of undisbursed funds.
                 
(2) Of the $18.8 million loans considered impaired, $13.9 million are one-to-four family residential loans, $4.7 million are
     
     construction/land development loans and $200,000 are commercial loans.
(3) Of the $16.5 million loans considered impaired, $15.2 million are one-to-four family residential loans, $500,000 are
     
     construction/land development loans and $800,000 are commercial loans.
 
 
 
35

 
Some of the builders listed in the above tables, as part of their previous business strategy, retained a certain percentage of their finished homes in their own inventory of permanent investment properties (i.e. one-to-four family rental properties). In the past, these properties were used to enhance the builders’ liquidity through rental income and improve their long-term equity position through the appreciation in market value of the properties. Due to the continued, prolonged depressed housing market and the challenging local economy, this business strategy was not sustainable for these builders. As a result, we have incurred losses related to these builders and have significantly reduced our exposure to these builders by $26.3 million at September 30, 2011 as compared to September 30, 2010. We are continuing to work with these builders to further reduce our exposure through workout plans established in 2010. For the three builders included in the previous table, the total one-to-four family rental properties decreased $8.7 million, or 15.3% to $48.1 million at September 30, 2011 from $56.8 million at September 30, 2010.

The following table includes construction/land development loans, net of undisbursed funds, by the five counties that contain our largest loan concentrations at September 30, 2011.
 
 
 
 
County
     
Loan Balance (1)
   
Percent of
Loan Balance
       Nonperforming
Loans
 
Nonperforming
Loans as a
Percent of Loan
Balance (2)
   
       (Dollars in thousands)  
King
 
$
        9,210
   
32.0
%
 
$
          1,568
 
    17.0 %
 
 
Pierce
   
        5,345
   
18.5
     
          1,758
 
32.9
   
Thurston
   
        4,676
   
16.2
     
          1,436
 
30.7
   
Whatcom (3)
   
        3,635
   
12.6
     
          3,635
 
100.0
   
Kitsap
   
        2,681
   
9.3
     
          2,612
 
97.4
   
All other counties
 
        3,274
   
11.4
     
              882
 
26.9
   
Total
 
$
      28,821
   
100.0
%
 
$
        11,891
 
    41.3 %
 
                             
(1) Net of undisbursed funds.
                     
(2) Represents the percent of the loan balance by county that is nonperforming.
   
(3) Represents one loan.
                     

Critical Accounting Policies

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. The following are our critical accounting policies.
 
Allowance for Loan and Lease Losses. Management recognizes that loan losses may occur over the life of a loan and that the ALLL must be maintained at a level necessary to absorb specific losses on impaired loans and probable losses inherent in the loan portfolio. Our methodology for analyzing the ALLL consists of two components: general and specific allowances. The general allowance is determined by applying factors to our various groups of loans. Management considers factors such as charge-off history, current economic conditions in our market areas, borrowers’ ability to repay, the regulatory environment, competition, geographic and loan type concentrations, policy and underwriting standards, nature and volume of the loan portfolio, management’s experience level, our loan review and grading systems, the value of underlying collateral and the level of problem loans in assessing the ALLL. The specific allowance component is created when management believes that the collectability of a specific loan has been impaired and a loss is probable. The specific reserves are computed using current appraisals, listed sales prices and other available information less costs to complete (if any) and costs to sell the property. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available or as future events differ from predictions.

Our Board of Directors approves the provision for loan losses on a quarterly basis. 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.
 
 
 
36

 

We believe that the accounting estimate related to the ALLL 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. 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. In addition, various regulatory agencies, as an integral part of their examination process, periodically review a financial institution’s ALLL and carrying amounts of OREO. Such agencies may require the financial institution to recognize additions to the allowance based on their judgment and information available to them at the time of their examination. For additional information see  Item 1A-Risk Factors: “Our provision for loan losses has increased substantially and we may be required to make further increases in our provision for loan losses and to charge-off additional loans in the future, which could adversely affect our results of operations,” in our 2010 Form 10-K.

Valuation of OREO and Foreclosed Assets. Real estate properties acquired through foreclosure or by deed-in-lieu of foreclosure are recorded at the lower of cost or fair value less estimated costs to sell. Fair value is generally determined by management based on a number of factors, including third-party appraisals of fair value in an orderly sale. Accordingly the valuation of OREO is subject to significant external and internal judgment. Any differences between management’s assessment of fair value, less estimated costs to sell, and the carrying value of the loan at the date a particular property is transferred into OREO are charged to the ALLL. Management periodically reviews OREO values to determine whether the property continues to be carried at the lower of its recorded book value or fair value, net of estimated costs to sell. Any further decreases in the value of OREO are considered valuation adjustments and trigger a corresponding charge to noninterest expense in the Consolidated Income Statement. Expenses from the maintenance and operations and any gains or losses from the sales of OREO are included in noninterest expense.

Deferred Taxes. Deferred taxes arise from a variety of sources, the most significant being: a) expenses, such as our charitable contribution to the First Financial Northwest Foundation, that can be carried forward to be utilized against profits in future years; b) expenses recognized in our financial statements but disallowed in our tax return until the associated cash flow occurs; and c) write-downs in the value of assets for financial statement purposes that are not deductible for tax purposes until the asset is sold or deemed worthless.

We record a valuation allowance to reduce our deferred tax assets to the amount which can be recognized in line with the relevant accounting standards. The level of deferred tax asset recognition is influenced by management’s assessment of our historic and future profitability profile. At each balance sheet date, existing assessments are reviewed and, if necessary, revised to reflect changed circumstances. In a situation where income is less than projected or recent losses have been incurred, the relevant accounting standards require convincing evidence that there will be sufficient future tax capacity.

Other-Than-Temporary Impairments In the Market Value of Investments. Declines in the fair value of any available for sale or held to maturity investment below their cost that is deemed to be other-than-temporary results in a reduction in the carrying amount of the investment to that of fair value. A charge to earnings and an establishment of a new cost basis for the investment is made. Unrealized investment losses are evaluated at least quarterly to determine whether such declines should be considered other-than-temporary and therefore be subject to immediate loss recognition. Although these evaluations involve significant judgment, an unrealized loss in the fair value of a debt security is generally deemed to be temporary when the fair value of the investment security is below the carrying value primarily due to changes in interest rates and where there has not been significant deterioration in the financial condition of the issuer. An unrealized loss in the value of an equity security is generally considered temporary when the fair value of the security is below the carrying value primarily due to current market conditions and not deterioration in the financial condition of the issuer. Other factors that may be considered in determining whether a decline in the value of either a debt or an equity security is other-than-temporary include ratings by recognized rating agencies; the extent and duration of an unrealized loss position; actions of commercial banks or other lenders relative to the continued extension of credit facilities to the issuer of the security; the financial condition, capital strength and near-term prospects of the issuer and recommendations of investment advisors or market analysts. Therefore continued deterioration of market conditions could result in additional impairment losses recognized within the investment portfolio.
 
 
 
37

 
Comparison of Financial Condition at September 30, 2011 and December 31, 2010

General. Total assets were $1.1 billion at September 30, 2011, a decrease of $53.3 million, or 4.5% from December 31, 2010. Increases in interest-bearing deposits of $116.1 million were offset by decreases in cash on hand and in banks of $2.3 million, net loans receivable of $129.2 million, investment securities of $24.3 million, OREO of $4.9 million and the federal income tax receivable of $5.9 million. Total liabilities were $961.4 million at September 30, 2011, a decrease of $57.8 million, or 5.7% from December 31, 2010. The decline in total liabilities was primarily the result of a decrease of $66.8 million in interest-bearing deposits and $2.9 million in noninterest-bearing deposits, partially offset by a $10.0 million increase in investment transactions payable. Stockholders’ equity increased $4.5 million, primarily due to the net income of $3.3 million for the nine months ended September 30, 2011.

Assets. Total assets were $1.1 billion at September 30, 2011, a decrease of $53.3 million, or 4.5% from $1.2 billion at December 31, 2010. The following table details the changes in the composition of our assets.
 


         
Increase /
       
         
(Decrease)
   
Percentage
 
   
Balance at
   
from
   
Increase /
 
   
September 30, 2011
   
December 31, 2010
   
(Decrease)
 
   
(Dollars in thousands)
 
                   
Cash on hand and in banks
  $ 5,159     $ (2,307 )     (30.9 ) %
Interest-bearing deposits
    207,040       116,079       127.6  
Investments available for sale
    140,273       (24,330 )     (14.8 )
Loans receivable, net
    727,226       (129,230 )     (15.1 )
Premises and equipment, net
    19,092       (737 )     (3.7 )
FHLB stock, at cost
    7,413       -       -  
Accrued interest receivable
    3,972       (714 )     (15.2 )
Federal income tax receivable
    -       (5,916 )     (100.0 )
OREO
    25,201       (4,901 )     (16.3 )
Prepaid expenses and other assets
    5,004       (1,222 )     (19.6 )
    Total assets
  $ 1,140,380     $ (53,278 )     (4.5 ) %
 
    Interest-bearing deposits increased $116.1 million to $207.0 million at September 30, 2011 from $91.0 million at December 31, 2010, as a result of $136.8 million in loan repayments, $74.6 million in proceeds from sales of investments and $25.8 million in OREO dispositions. Investments available for sale decreased $24.3 million, or 14.8% to $140.3 million at September 30, 2011 from $164.6 million at December 31, 2010. During the nine months ended September 30, 2011, we sold $72.9 million of investments, primarily fixed-rate, mortgage-backed securities issued by Freddie Mac and Fannie Mae, to recognize $1.7 million in net gains on these securities to support the Bank’s profitability in this low interest rate environment. In addition, we received $24.6 million in principal repayments on our investment portfolio. We purchased $47.7 million of variable rate U.S. Government agency securities and $27.0 million of Freddie Mac and Fannie Mae mortgage-backed investments during the nine months ended September 30, 2011 to maintain our liquidity position, improve the Bank’s interest rate risk profile and to position our securities portfolio to be more responsive to rising interest rates. Net loans receivable decreased $129.2 million, or 15.1% to $727.2 million at September 30, 2011 from $856.5 million at December 31, 2010. This decrease in net loans resulted from loan repayments of $136.8 million, charge-offs of $10.3 million and transfers of loans into OREO of $20.7 million during the nine months ended September 30, 2011. All of our loan categories decreased during the nine months ended September 30, 2011 except for business loans which increased $3.1 million. OREO decreased $4.9 million, or 16.3% to $25.2 million at September 30, 2011 from $30.1 million at December 31, 2010 as we continue to sell our inventory of foreclosed real estate.

Loan originations for the nine months ended September 30, 2011, totaled $22.2 million and included the following loan breakdown: $7.1 million in one-to-four family residential; $4.2 million in consumer; $2.5 million in
 
 
 
38

 
 commercial real estate; $1.4 million in construction/land development; $5.3 million in multifamily and $1.7 million in business loans.

Deposits. During the first nine months of 2011, deposits decreased $69.7 million to $850.5 million at September 30, 2011. The following table details the changes in our deposits:
 
         
Increase /
       
         
(Decrease)
   
Percentage
 
   
Balance at
   
from
   
Increase /
 
   
September 30, 2011
   
December 31, 2010
   
(Decrease)
 
   
(Dollars in thousands)
             
Noninterest-bearing
  $ 5,843     $ (2,857 )     (32.8 ) %
NOW
    12,427       (1,031 )     (7.7 )
Statement savings
    17,601       2,214       14.4  
Money market
    176,386       (17,596 )     (9.1 )
Certificates of deposit
    638,288       (50,411 )     (7.3 )
    $ 850,545     $ (69,681 )     (7.6 ) %
 
 
All of our deposit categories decreased except for statement savings as compared to December 31, 2010. The decreases in certificates of deposit of $50.4 million, money market accounts of $17.6 million and noninterest-bearing deposit accounts of $2.9 million comprised the majority of the decrease. The decrease in certificates of deposit was primarily the result of our strategic plan to continue to reduce our cost of funds through our pricing decisions designed to allow higher rate certificates of deposit to run-off. We also chose not to renew our public funds at maturity as they are more expensive to maintain due to additional state collateralization requirements. The decline in public funds represented $27.6 million, or 54.8% of the total decrease in certificates of deposit for the nine months ended September 30, 2011. In addition, customers that were more rate sensitive chose other investment options which contributed to the decline in our deposit balances. We did not have any brokered deposits at September 30, 2011 or December 31, 2010. Public funds totaled $31.1 million at September 30, 2011.

Advances from the FHLB. Total FHLB advances were $93.1 million at September 30, 2011, unchanged from December 31, 2010. During October 2011, we prepaid a $10.0 million fixed-rate advance due to mature in March 2012, at an interest rate of 2.82%. The prepayment penalty was $118,000. The early repayment of this advance was executed in order to utilize some of our excess liquidity and to reduce our cost of funds.

Investment Transactions Payable. During the quarter ended September 30, 2011, we purchased a $10.0 million U.S. Government agency security which settled in October 2011. We were required to record the transaction on the trade date even though the cash payment for the purchase will not be transferred until October 2011.

Stockholders’ Equity. Total stockholders’ equity increased $4.5 million, or 2.6%, to $179.0 million at September 30, 2011 from $174.5 million at December 31, 2010. The increase was primarily the result of our net income for the nine months ended September 30, 2011 of $3.3 million.

Comparison of Operating Results for the Three and Nine Months Ended September 30, 2011 and 2010.

General. Net income was $623,000 for the third quarter of 2011, an increase of $12.7 million from the $12.1 million loss in the comparable quarter in the prior year. Net interest income was $7.9 million and noninterest income was $556,000 for the third quarter of 2011, partially offset by the provision for loan losses of $1.3 million and noninterest expense of $6.5 million. For the nine months ended September 30, 2011, net income was $3.3 million, an increase of $58.0 million from a net loss of $54.7 million for the same period in 2010. The change was primarily the result of decreases in the provision for loan losses of $46.9 million, noninterest expense of $4.9 million and provision for federal income taxes of $4.0 million for the nine months ended September 30, 2011 compared to the first nine months of 2010.

Net Interest Income. Our net interest income for the quarter ended September 30, 2011, decreased $511,000 to $7.9 million, as compared to $8.4 million for the same quarter in 2010. A decrease of $2.0 million in
 
 
 
39

 
 
interest expense was offset by a $2.6 million reduction in interest income. Average interest-earning assets decreased $153.7 million to $1.1 billion for the three months ended September 30, 2011, from the same quarter in 2010. Average interest-bearing liabilities decreased $145.5 million to $950.9 million for the third quarter of 2011 compared to the third quarter of 2010. During the same period, our yield on interest-earning assets decreased 26 basis points while our cost of funds decreased 50 basis points. Our interest rate spread for the quarter ended September 30, 2011 increased 24 basis points to 2.67% from 2.43% during the same quarter in 2010. Our net interest margin for the third quarter of 2011 increased 20 basis points to 2.91% from 2.71% for the same quarter last year.

Our net interest income for the nine months ended September 30, 2011 increased $418,000 to $24.9 million, as compared to $24.5 million for the same period in 2010. A decrease of $7.1 million in interest expense was partially offset by a $6.7 million reduction in interest income. Average interest-earning assets decreased $144.0 million for the nine months ended September 30, 2011, from $1.2 billion for the same period in 2010. Average interest-bearing liabilities decreased $117.5 million to $975.1 million for the nine months ended September 30, 2011 from the same nine month period in 2010. The yield on interest-earning assets decreased 16 basis points to 4.78% while our cost of funds decreased 65 basis points increasing our interest rate spread for the first nine months of 2011 by 49 basis points to 2.80% from 2.31% for the same period last year. Our net interest margin for the first nine months of 2011 increased 39 basis points to 3.02% as compared to 2.63% for the same period last year.

The following table sets forth the effects of changes in rates and volumes on our net interest income:
 
 
   
Three Months Ended September 30, 2011
   
Nine Months Ended September 30, 2011
 
   
Compared to September 30, 2010 Increase/(Decrease)
   
Compared to September 30, 2010 Increase/(Decrease)
 
   
Rate
   
Volume
   
Total
   
Rate
   
Volume
   
Total
 
   
(In thousands)
 
Interest-earning assets:
                                   
   Loans receivable, net
  $ 782     $ (3,062 )   $ (2,280 )   $ 2,367     $ (9,167 )   $ (6,800 )
   Investments available for sale
    (207 )     (121 )     (328 )     (814 )     840       26  
   Interest-bearing deposits
    (5 )     52       47       -       83       83  
Total net change in income on
                                               
   interest-earning assets
    570       (3,131 )     (2,561 )     1,553       (8,244 )     (6,691 )
                                                 
Interest-bearing liabilities:
                                               
   NOW
    (7 )     (1 )     (8 )     (25 )     (1 )     (26 )
   Statement savings
    (32 )     1       (31 )     (97 )     6       (91 )
   Money market
    (262 )     (54 )     (316 )     (1,010 )     (137 )     (1,147 )
   Certificates of deposit
    (715 )     (512 )     (1,227 )     (3,214 )     (1,264 )     (4,478 )
   Advances from the FHLB
    (104 )     (364 )     (468 )     (314 )     (1,053 )     (1,367 )
Total net change in expense on
                                               
   interest-bearing liabilities
    (1,120 )     (930 )     (2,050 )     (4,660 )     (2,449 )     (7,109 )
                                                 
Change in net interest income
  $ 1,690     $ (2,201 )   $ (511 )   $ 6,213     $ (5,795 )   $ 418  
                                                 

Interest Income. Total interest income for the third quarter of 2011 decreased $2.6 million, or 17.1%, to $12.4 million from $15.0 million as compared to the third quarter of 2010. Total interest income for the nine months ended September 30, 2011 decreased $6.7 million, or 14.5% to $39.4 million from $46.1 million as compared to the nine months ended September 30, 2010.





 
40

 
The following table compares detailed average interest-earning asset balances, associated yields and resulting changes in interest income for the three months ended September 30, 2011 and 2010:
 
                         
Increase /
 
Three Months Ended September 30,
 
(Decrease) in
 
2011
 
2010
 
Interest and
 
Average
       
Average
       
Dividend
 
Balance
 
Yield
   
Balance
 
Yield
   
Income
   
(Dollars in thousands)
     
                             
Loans receivable, net
$
       743,439
 
   6.13
%
 
$
         957,529
 
      5.71
%
 
$
        (2,280)
Investments available for sale
 
       133,001
 
   2.78
     
         147,304
 
      3.41
     
           (328)
Interest-bearing deposits
 
       200,039
 
   0.25
     
         125,367
 
      0.26
     
               47
FHLB stock
 
           7,413
 
       -
     
             7,413
 
          -
     
                 -
Total interest-earning assets
$
    1,083,892
 
   4.59
%
 
$
      1,237,613
 
      4.85
%
 
$
        (2,561)

Interest income from loans decreased $2.3 million during the third quarter of 2011 as compared to the same quarter in 2010. The decrease in loan interest income was primarily the result of a decrease in the average loan balance of $214.1 million resulting in a $3.1 million decrease in interest income for the quarter as compared to the third quarter of 2010. This decrease was partially offset by an increase in the average yield on the loan portfolio of 42 basis points, resulting in an increase of $782,000 in interest income. The decrease in the average loan portfolio was due to weaker loan demand, paydowns due to normal borrower activity, short sales, charge-offs and transfers of nonperforming loans to OREO. Interest income on investments available for sale decreased $328,000 to $926,000 for the quarter ended September 30, 2011, compared to $1.3 million for the comparable quarter in 2010. The decrease in interest income from investments available for sale was due to the decrease in the average balance of investments available for sale of $14.3 million, resulting in a decrease of $121,000 in interest income. In addition, the yield earned on investments declined to 2.78% during the third quarter of 2011 from 3.41% for the same quarter in 2010, resulting in a $207,000 decrease in interest income.

The following table compares detailed average interest-earning asset balances, associated yields and resulting changes in interest income for the nine months ended September 30, 2011 and 2010:
 
                             
 
Nine Months Ended September 30,
 
Increase /
 
2011
 
2010
 
(Decrease) in
 
Average
       
Average
       
 Interest and
 
Balance
 
Yield
   
Balance
 
Yield
   
Dividend Income
 
(Dollars in thousands)
     
Loans receivable, net
$
     784,956
 
     6.07
%
 
$
       999,414
 
    5.67
%
 
$
         (6,800)
Investments available for sale
 
     149,596
 
     3.02
     
       123,654
 
    3.63
     
                26
Interest-bearing deposits
 
     158,077
 
     0.25
     
       113,533
 
    0.25
     
                83
FHLB stock
 
         7,413
 
        -
     
           7,413
 
       -
     
                  -
Total interest-earning assets
$
  1,100,042
 
     4.78
%
 
$
    1,244,014
 
    4.94
%
 
$
         (6,691)
 
 
Interest income from loans decreased $6.8 million during the first nine months of 2011 compared to the same period in 2010. The decrease in interest income was due to a decrease in average loan balances of $214.5 million resulting in a decrease in interest income of $9.2 million, partially offset by an increase in the average yield of 40 basis points, or $2.4 million. Interest income on investments available for sale remained relatively unchanged at $3.4 million for the nine months ended September 30, 2011 and 2010. The average balance of investments available for sale increased $25.9 million for the nine months ended September 30, 2011 from the same period in 2010 which resulted in an $840,000 increase in interest income. The yield on investments available for sale decreased 61 basis points resulting in an $814,000 decline in interest income.

Interest Expense. Total interest expense for the three months ended September 30, 2011 was $4.6 million, a decrease of $2.0 million compared to $6.6 million for the third quarter of 2010.
 
 
 
41

 

The following table details average balances, cost of funds and the resulting decrease in interest expense for the nine months ended September 30, 2011 and 2010:
 
 
Three Months Ended September 30,
 
Increase /
 
2011
 
2010
 
(Decrease) in
 
Average
       
Average
       
Interest
 
Balance
 
Cost
   
Balance
 
Cost
   
Expense
   
(Dollars in thousands)
     
                             
NOW
$
         12,690
 
      0.16
%
 
$
          13,578
 
        0.38
%
 
$
                  (8)
Statement savings
 
         16,827
 
      0.26
     
          16,523
 
        1.02
     
                (31)
Money market
 
       175,814
 
      0.43
     
        196,945
 
        1.03
     
               (316)
Certificates of deposit
 
       652,549
 
      2.31
     
        727,314
 
        2.75
     
            (1,227)
Advances from the FHLB
 
         93,066
 
      2.53
     
        142,069
 
        2.98
     
               (468)
Total interest-bearing liabilities
$
       950,946
 
      1.92
%
 
$
      1,096,429
 
        2.42
%
 
$
            (2,050)

Interest expense on our money market accounts decreased $316,000, primarily as a result of a decrease in the average cost of these funds of 60 basis points or $262,000 to 0.43% from 1.03% for the third quarter of 2011 compared to the same quarter in 2010. The average cost of our certificates of deposit decreased 44 basis points, or $715,000 as compared to the third quarter of 2010 due to maturing certificates repricing to lower rates. The decline in interest expense was also the result of a $74.8 million decrease in the average balance of certificates of deposit, resulting in a $512,000 reduction in interest expense. Interest expense related to our FHLB advances decreased $468,000 primarily as a result of the decrease in the average balance of our advances to $93.1 million as compared to $142.1 million at September 30, 2010, resulting in a $364,000 reduction in interest expense. In addition, our cost of funds for these advances decreased 45 basis points to 2.53% from 2.98% for the third quarter of 2011 compared to the same quarter in 2010, decreasing interest expense by $104,000.

The following table details average balances, cost of funds and the resulting decrease in interest expense for the nine months ended September 30, 2010 and 2011:
 
 
 
Nine Months Ended September 30,
 
Increase /
 
2011
 
2010
 
(Decrease) in
 
Average
       
Average
       
Interest
 
Balance
 
Cost
   
Balance
 
Cost
   
Expense
   
(Dollars in thousands)
     
                             
NOW
$
       12,818
 
    0.18
%
 
$
        13,175
 
    0.44
%
 
$
            (26)
Statement savings
 
       16,343
 
    0.38
     
        15,711
 
    1.16
     
            (91)
Money market
 
     182,800
 
    0.57
     
      196,787
 
    1.31
     
       (1,147)
Certificates of deposit
 
     670,116
 
    2.36
     
      726,313
 
    3.00
     
       (4,478)
Advances from the FHLB
 
       93,066
 
    2.50
     
      140,631
 
    2.95
     
       (1,367)
Total interest-bearing liabilities
$
     975,143
 
    1.98
%
 
$
   1,092,617
 
    2.63
%
 
$
       (7,109)

Our interest expense for the nine months ended September 30, 2011 decreased $7.1 million to $14.5 million from $21.6 million for the same period in 2010. The average cost of funds for the money market accounts decreased 74 basis points resulting in a $1.0 million reduction in interest expense for the first nine months of 2011 as compared to the same period in 2010. The average balance of our money market accounts decreased $14.0 million, resulting in a further decrease of $137,000 in interest expense as compared to the same period last year. The average cost of our certificates of deposit for the nine months ended September 30, 2011 decreased 64 basis points compared to the first nine months of 2010 resulting in a decline in interest expense of $3.2 million. This decline in interest expense was also affected by a decrease in the average balance of certificates of deposit of $56.2 million, which resulted in an additional $1.3 million decline in interest expense. Interest expense related to advances from the FHLB decreased $1.4 million for the nine months ended September 30, 2011 from the same
 
 
 
 
42

 
 
period in 2010 primarily due to the $47.6 million decline in the average balance of advances. The average cost of funds for our advances decreased 45 basis points during this same period.

Provision for Loan Losses. We establish the ALLL for loan losses at a level we believe is necessary to absorb known and inherent losses that are both probable and reasonably estimable at the date of the financial statements. Our methodology in assessing the ALLL places greater emphasis on factors such as charge-off history, the economy, the regulatory environment, competition, geographic and loan type concentrations, policy and underwriting standards, nature and volume of the loan portfolio, management experience levels, our loan review and grading system and the value of underlying collateral. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available or as future events differ from predictions.

During the quarter ended September 30, 2011, management evaluated the adequacy of the ALLL and concluded that a provision of $1.3 million was required for the quarter, a decrease of $10.7 million compared to the same quarter in 2010. This decline was a result of the significant improvement in our nonperforming loans over the past year. Nonperforming loans decreased $62.6 million, or 67.0% to $30.8 million at September 30, 2011 from $93.4 million at September 30, 2010. We have been very proactive in identifying our problem loans and implementing workout strategies. The $1.3 million provision for loan losses represents a $300,000 decrease from the second quarter of 2011. This decrease was primarily the result of the reduction in the amount of charge-offs, a decrease in nonperforming loans of $7.1 million and the relatively unchanged amount of delinquent loans less than 90 days past due which totaled $6.6 million at September 30, 2011.

We believe that the ALLL as of September 30, 2011 was adequate to absorb the probable and inherent risks of loss in the loan portfolio at that date. While we believe the estimates and assumptions used in our determination of the adequacy of the allowance are reasonable, there can be no assurance that such estimates and assumptions will be proven correct in the future, or that the actual amount of future provisions will not exceed the amount of past provisions or that any increased provisions that may be required will not adversely impact our financial condition and results of operations. Future changes to the allowance may become necessary based upon changing economic conditions, the level of loan balances or changes in the underlying collateral of the loan portfolio. In addition, the determination of the amount of our ALLL is subject to review by the Bank’s regulators as part of their routine examination process, which may result in the establishment of additional reserves or charge-offs, based upon their judgment of information available to them at the time of their examination.

For the nine months ended September 30, 2011, the provision for loan losses was $4.1 million compared to $51.0 million for the same period in 2010. The provision for loan losses and net charge-offs of $10.0 million during the nine months ended September 30, 2011 resulted in a decrease in the ALLL to $16.6 million from $22.5 million at December 31, 2010. The ALLL as a percent of nonperforming loans increased to 54.0% at September 30, 2011 compared to the following at the dates indicated:
 
June 30, 2011
 
March 31, 2011
 
December 31, 2010
 
September 30, 2010
44.8%
 
39.6%
 
35.8%
 
30.4%

 
 
 
 
43

 

The following table presents a breakdown of our nonperforming assets and as a percent of total assets at the dates indicated:
 
   
September 30,
2011
   
December 31,
2010
   
September 30,
2010
   
Nine Month Increase /
(Decrease)
   
One Year
Increase /
(Decrease)
 
   
(Dollars in thousands)
 
One-to-four family residential (1)
  $ 12,859     $ 22,688     $ 37,420     $ (9,829 )   $ (24,561 )
Multifamily
    638       -       -       638       638  
Commercial real estate
    5,400       7,306       8,170       (1,906 )     (2,770 )
Construction/land development
    11,891       32,885       47,672       (20,994 )     (35,781 )
Consumer
    44       57       181       (13 )     (137 )
Total nonperforming loans
    30,832       62,936       93,443       (32,104 )     (62,611 )
OREO
    25,201       30,102       22,927       (4,901 )     2,274  
Total nonperforming assets
  $ 56,033     $ 93,038     $ 116,370     $ (37,005 )   $ (60,337 )
Nonperforming assets as a percent of total assets
    4.9 %     7.8 %     9.1 %                
_____________________                                         
(1) The majority of these loans are related to investor rental properties.

Nonperforming loans include loans to borrowers who are experiencing deteriorating financial conditions and there is doubt as to the ultimate recoverability of the full principal and interest due the Bank in accordance with the terms of the loan agreement. Nonperforming loans decreased $32.1 million to $30.8 million at September 30, 2011, from $62.9 million at December 31, 2010. This decrease was the result of $16.5 million of loans becoming nonperforming during the nine months ended September 30, 2011 offset by $10.3 million in charge-offs, $17.6 million in short sales and $20.7 million of loans transferred to OREO.

The three largest nonperforming loans in the commercial real estate portfolio at September 30, 2011, consisted of a $943,000 loan secured by four individual rooming/dormitory style houses located in Snohomish County, a $692,000 loan secured by a gas station/convenience store located in Thurston County and a $570,000 loan secured by a warehouse/office building located in King County.

The three largest nonperforming, construction/land development loans included a $3.6 million loan secured by 34 acres intended for a 251-unit development located in Whatcom County. The project consists of 77 detached condominium lots (single-family residences) and vacant land for 174 attached units (multifamily). The second largest nonperforming construction/land development loan is a $1.3 million loan secured by 55 finished lots for residential development, of which, 15 lots have been sold, located in Thurston County.  The third largest nonperforming, construction/land development loan is a $1.1 million loan secured by 43 finished lots for residential development, of which, 18 lots have been sold, located in Kitsap County.

Nonperforming assets decreased for the sixth consecutive quarter. At their peak, nonperforming assets reached $166.4 million at March 31, 2010 decreasing to $56.0 million at September 30, 2011, representing a $110.4 million, or 66.3% decrease.



 
44

 


The following table presents a breakdown of our TDRs:
 
   
September 30,
   
December 31,
   
September 30,
   
Nine Month
   
One Year
 
   
2011
   
2010
   
2010
   
$ Change
   
$ Change
 
   
(In thousands)
 
Performing TDRs:
                             
   One-to-four family residential
  $ 53,029     $ 45,244     $ 34,227     $ 7,785     $ 18,802  
   Multifamily
    2,512       2,515       2,523       (3 )     (11 )
   Commercial real estate
    10,409       10,413       6,071       (4 )     4,338  
   Construction/land development
    -       133       -       (133 )     -  
   Consumer
    70       70       70       -       -  
Total performing TDRs
    66,020       58,375       42,891       7,645     $ 23,129  
                                         
Nonaccrual TDRs:
                                       
   One-to-four family residential
    5,185       7,510       14,290       (2,325 )     (9,105 )
   Commercial real estate
    1,531       3,428       3,581       (1,897 )     (2,050 )
   Construction/land development
    472       5,361       10,516       (4,889 )     (10,044 )
Total nonaccrual TDRs
    7,188       16,299       28,387       (9,111 )     (21,199 )
Total TDRs
  $ 73,208     $ 74,674     $ 71,278     $ (1,466 )   $ 1,930  


Our TDRs decreased $1.5 million, or 2.0% to $73.2 million at September 30, 2011 as compared to $74.7 million at December 31, 2010. During the first nine months of 2011, we added $10.8 million of new performing TDRs and transferred $8.6 million of nonperforming TDRs to OREO while $2.1 million of nonperforming TDRs were paid-off with the remaining activity relating to principal payments and charge-offs.

As we work with our borrowers to help them through this difficult economic cycle, we explore all options available to minimize our risk of loss. At times, the best option for our customers and the Bank is to modify the loan for a period of time, usually one year or less. These modifications have included lowering the interest rate on the loan for a period of time and/or extending the maturity date of the loan or allowing interest only payments for a period of time. These modifications are granted only when there is a reasonable and attainable workout plan that has been agreed to by the borrower and is in the Bank’s best interest. Of the $73.2 million in TDRs at September 30, 2011, $66.0 million were classified as performing and $7.2 million were not performing according to their restructured terms. Of the $66.0 million of performing TDRs, $33.9 million were related to an “A” note as a result of an “A/B” note workout strategy where the “A” note amount was the current loan balance charged down to result in an acceptable loan to value ratio and positive debt service coverage and the “B” note was charged-off at the time of the restructure.

The largest TDR relationship at September 30, 2011 was $13.8 million (which included both construction/land development loans as well as one-to-four family residential rental properties located in King, Kitsap, Pierce and Thurston Counties). At September 30, 2011, there were no undisbursed funds to that builder in connection with these TDRs.






 
45

 
The following table presents a breakdown of our OREO at September 30, 2011:
 
 
   
King
County
   
Pierce
County
   
Kitsap
County
   
All other
 counties
   
Total OREO
   
Percent of Total
OREO
 
   
(Dollars in thousands)
 
One-to-four family residential
  $ 2,874     $ 4,065     $ 1,515     $ 776     $ 9,230       36.6 %
Commercial real estate
    2,643       4,375       1,201       450       8,669       34.4  
Construction/land development
    1,763       3,982       203       1,354       7,302       29.0  
Total OREO
  $ 7,280     $ 12,422     $ 2,919     $ 2,580     $ 25,201       100.0 %


The following table represents a breakdown of our OREO activity:
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
   
(In thousands)
 
Beginning Balance
  $ 25,979       16,493     $ 30,102       11,835  
   Loans transferred to OREO
    4,787       17,177       20,737       34,843  
   Capitalized improvements
    91       202       181       488  
   Dispositions of OREO
    (5,141 )     (2,016 )     (24,387 )     (19,055 )
   Market value adjustments
    (515 )     (8,929 )     (1,432 )     (5,184 )
Ending Balance
  $ 25,201     $ 22,927     $ 25,201     $ 22,927  


We sold $5.1 million of OREO during the third quarter of 2011 which was comprised of 24 properties and generated a net gain of $293,000. For the first nine months of 2011 we sold $24.4 million of OREO and generated a net gain of $1.4 million. The three largest OREO properties in terms of market value at September 30, 2011 were a residential development with 45 completed lots valued at $1.5 million, an office/retail building valued at $1.4 million, with both properties located in Pierce County, and an office/retail building valued at $1.3 million located in King County.

During the remainder of 2011, we will focus our efforts on converting nonperforming loans to OREO through foreclosure or deeds in lieu of foreclosure and selling the properties. These properties consist primarily of non-owner occupied and completed one-to-four family residential homes. By taking ownership of these properties, we can convert nonearning assets into earning assets on a more timely basis.





 
46

 
The following table summarizes selected financial data related to our ALLL:
 
 
 
At or For the Nine Months Ended September 30,
 
2011
 
2010
 
(Dollars in thousands)
 
                 
Provision for loan losses
$
       4,100
   
$
        51,000
 
Charge-offs
$
     10,337
   
$
        56,506
 
Recoveries
$
          337
   
$
            867
 
ALLL
$
     16,634
   
$
        28,400
 
ALLL as a percent of total loans outstanding
             
   at the end of the period, net of undisbursed funds
 
2.23
%
   
           3.00
%
ALLL as a percent of nonperforming loans
             
   at the end of the period, net of undisbursed funds
 
53.95
%
   
         30.39
%
Total nonaccrual and 90 days or more past due loans,
             
   net of undisbursed funds
$
30,832
   
$
        93,443
 
Nonaccrual and 90 days or more past due loans as a
             
   percent of total loans, net of undisbursed funds
 
         4.13
%
   
           9.87
%
Total loans receivable, net of undisbursed funds
$
    745,708
   
$
      946,649
 
Total loans originated, net of undisbursed funds
$
     22,203
   
$
        55,339
 

Noninterest Income. Noninterest income increased $518,000 to $556,000 for the three months ended September 30, 2011 from $38,000 in the comparable quarter in 2010. For the nine months ended September 30, 2011, noninterest income increased $1.8 million to $2.0 million from $146,000 for the same period in 2010.

The following tables provide a detailed analysis of the changes in the components of noninterest income:
 
 
Three Months
Ended
September 30,
2011
   
Increase/
(Decrease) from
September 30, 2010
   
Percentage
Increase/
(Decrease)
 
 
(Dollars in thousands)
 
                   
Service fees on deposit accounts
  $ 17     $ (5 )     (22.7 ) %
Loan service fees
    59       30       103.5  
Net gain on sale of investments
    479       479       100.0  
Amortization of servicing rights
    (24 )     13       35.1  
Other
    25       1       4.2  
Total noninterest income
  $ 556     $ 518       1,363.2 %

The increase in noninterest income was primarily due to a $479,000 net gain on the sale of $43.1 million of long-term, fixed-rate, mortgage-backed securities during the third quarter of 2011 with no comparable sales in the third quarter of 2010.
 
 
 
47

 
 
 
   
Nine Months
Ended
September 30,
2011
   
Increase/
(Decrease)
from
September 30, 2010
   
Percentage
Increase/
(Decrease)
 
   
(Dollars in thousands)
 
                   
Service fees on deposit accounts
  $ 65     $ (10 )     (13.3 ) %
Loan service fees
    153       35       29.7  
Net gain on sale of investments
    1,741       1,741       100.0  
Amortization of servicing rights
    (60 )     49       45.0  
Other
    79       17       27.4  
Total noninterest income
  $ 1,978     $ 1,832       1,254.8 %
                         

 
The increase in noninterest income for the nine months ended September 30, 2011 from the comparable period in 2010 was the result of $1.7 million in net gains on the sales of $72.9 million of investments with no comparable sales during the first nine months of 2010.

Noninterest Expense. Noninterest expense decreased $2.0 million during the quarter ended September 30, 2011 to $6.5 million as compared to $8.5 million for the same quarter in 2010. For the nine months ended September 30, 2011 noninterest expense decreased $4.9 million to $19.5 million from $24.4 million for the same nine month period in 2010.

The following tables provide the detail of the changes in noninterest expense:
 
   
Three Months
Ended
September 30,
2011
   
Increase/
(Decrease)
from
September 30, 2010
   
Percentage
Increase/
(Decrease)
 
   
(Dollars in thousands)
 
                   
Compensation and benefits
  $ 3,544     $ 286       8.8 %
Occupancy and equipment
    370       (41 )     (10.0 )
Professional fees
    449       (215 )     (32.4 )
Data processing
    181       (10 )     (5.2 )
(Gain) loss on sale of OREO property, net
    (293 )     (88 )     42.9  
OREO market value adjustments
    515       (1,501 )     (74.5 )
OREO related expenses, net
    540       (422 )     (43.9 )
FDIC/OTS assessments
    578       (332 )     (36.5 )
Insurance and bond premiums
    248       98       65.3  
Marketing
    43       (6 )     (12.2 )
Other general and administrative
    338       244       259.6  
Total noninterest expense
  $ 6,513     $ (1,987 )     (23.4 ) %

The decrease in noninterest expense for the third quarter of 2011 as compared to the same period in 2010 was primarily a result of the $2.0 million decrease in OREO related expenses (net of gain on sales of OREO property) incurred during the third quarter of 2011 to $762,000 as compared to $2.8 million in the comparable period in 2010. This decrease was attributable to the stabilization of real estate market values in 2011 and the addition, during the second half of 2010, of experienced personnel knowledgeable in evaluating market trends. The combination of these two factors contributed to the increase in the net gain on sales of OREO properties during the quarter ended September 30, 2011 from the same period in 2010. Compensation and benefits expense increased $286,000 as compared to the same quarter last year due predominately to pension expense as a result of a lower than expected yield earned on the underlying investments in the plan and the vesting of new employees into the plan.
 

 
 
48

 
 
 
   
Nine Months
Ended
September 30,
2011
   
Increase/
(Decrease)
from
September 30,
2010
   
Percentage
Increase/
(Decrease)
 
   
(Dollars in thousands)
 
                   
Compensation and benefits
  $ 10,047     $ 708       7.6 %
Occupancy and equipment
    1,167       (93 )     (7.4 )
Professional fees
    1,431       (179 )     (11.1 )
Data processing
    573       40       7.5  
(Gain) loss on sale of OREO property, net
    (1,427 )     (1,645 )     (754.6 )
OREO market value adjustments
    1,432       (3,752 )     (72.4 )
OREO related expenses, net
    2,376       4       0.2  
FDIC/OTS assessments
    1,900       (105 )     (5.2 )
Insurance and bond premiums
    743       294       65.5  
Marketing
    154       (16 )     (9.4 )
Other general and administrative
    1,111       (126 )     (10.2 )
Total noninterest expense
  $ 19,507     $ (4,870 )     (20.0 ) %
 
The decrease in noninterest expense for the nine months ended September 30, 2011 from the comparable period in 2010 was primarily the result of the decrease in net OREO related expenses of $5.4 million to $2.4 million from $7.8 million. The decrease was partially offset by a $708,000 increase in compensation and benefits expenses. Both the decrease in OREO related expenses and the increase in compensation and benefits expenses resulted from the same events as previously described above for the third quarter of 2011.

Federal Income Tax Expense. We did not record any federal income tax expense for the third quarter or the nine months ended September 30, 2011, as we utilized our tax loss carryforward.

Liquidity

We are required to have enough cash flow in order to maintain sufficient liquidity to ensure a safe and sound operation. We maintain cash balances above the minimum level believed to be adequate to meet the requirements of normal operations, including potential deposit outflows. On a daily basis, we review and update cash flow projections to ensure that adequate liquidity is maintained.

Our primary sources of funds are from customer deposits, loan repayments, maturing investment securities and advances from the FHLB. These funds, together with equity, are used to make loans, acquire investment securities and other assets and fund continuing operations. While maturities and the scheduled amortization of loans are a predictable source of funds, deposit flows and loan prepayments are greatly influenced by the level of interest rates, economic conditions and competition. At September 30, 2011, certificates of deposit scheduled to mature in one year or less totaled $363.3 million. Historically, we have been able to retain a significant amount of the deposits as they mature. We believe that our current liquidity position and our forecasted operating results are sufficient to fund all of our existing commitments.

While our primary source of funds is our deposits, when deposits are not available to provide the funds for our assets, we use alternative funding sources. These sources include, but are not limited to advances from the FHLB, wholesale funding, federal funds purchased, dealer repurchase agreements and other short-term alternatives as permissible by regulation. At September 30, 2011, the Bank maintained credit facilities with the FHLB totaling $117.4 million with an outstanding balance of $93.1 million. Effective September 30, 2011, we also have a $10.0 million credit facility with another financial institution with no balance outstanding. For additional information see the Consolidated Statements of Cash Flows in Item 1 of this Form 10-Q.

Commitments and Off-Balance Sheet Arrangements

We are a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and the
 
 
 
 
49

 
 
unused portions of lines of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated financial statements. Commitments to extend credit and lines of credit are not recorded as an asset or liability until the instrument is exercised. At September 30, 2011, we had no commitments to originate loans for sale.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the loan agreement. 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. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of the collateral obtained, if deemed necessary by us upon extension of credit, is based on our credit evaluation of the customer. The amount and type of collateral required varies, but may include real estate and income-producing commercial properties.

The following table summarizes our outstanding commitments to originate loans, to advance additional amounts pursuant to outstanding lines of credit and to disburse funds related to our construction loans at September 30, 2011.
 
       
Amount of Commitment Expiration - Per Period
       
             
After
 
After
       
             
One
 
Three
       
 
Total
       
Through
 
Through
 
After
 
 
Amounts
 
Through
 
Three
 
Five
 
Five
 
 
Committed
 
One Year
 
Years
 
Years
 
Years
 
 
(In thousands)
 
                               
Commitments to originate loans
  $ 1,192     $ 1,192     $ -     $ -     $ -  
Unused portion of lines of credit
    8,579       810       2,803       216       4,750  
Undisbursed portion of construction loans
    2,591       1,821       270       500       -  
       Total commitments
  $ 12,362     $ 3,823     $ 3,073     $ 716     $ 4,750  

We are from time to time involved in various claims and legal actions arising in the ordinary course of business. There are currently no matters that in the opinion of management would have a material adverse effect on our financial position, results of operations or liquidity.

Among our contingent liabilities are exposures to limited recourse arrangements with respect to sales of whole loans and participation interests.

We anticipate that we will continue to have sufficient funds and alternative funding sources to meet our current commitments.

Capital

At September 30, 2011, stockholders’ equity totaled $179.0 million, or 15.70% of total assets. Our book value per share of common stock was $9.52 as of September 30, 2011, as compared to $9.28 as of December 31, 2010. Consistent with our goal to operate a sound and profitable financial organization, we actively seek to maintain a “well-capitalized” institution in accordance with regulatory standards. As of September 30, 2011, the Bank exceeded all regulatory capital requirements. Regulatory capital ratios for the Bank only were as follows at September 30, 2011: Tier 1 leverage capital 12.76% (as compared to 10% required under the Order); Tier 1 risk-based capital 22.60%; and Total risk-based capital 23.87% (as compared to 12% required under the Order). The regulatory capital requirements to be considered well capitalized are 10%, 6% and 5%, respectively. The Bank met the financial ratios for “well-capitalized” status at September 30, 2011, however, the Bank is no longer regarded as “well-capitalized” for federal regulatory purposes as a result of the deficiencies cited in the Order. In addition, at September 30, 2011, First Financial Northwest, the parent company of the Bank, had $18.4 million of available cash to increase its investment in the Bank.


 
50

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Market risk is defined as the sensitivity of income and capital to changes in interest rates and other relevant market rates or prices. Our profitability is largely dependent on our net interest income. Consequently, our primary exposure to market risk arises from the interest rate risk inherent in our lending, investment, deposit and borrowing activities. Interest rate risk is the risk to earnings and capital resulting from adverse movements in interest rates. We actively monitor and manage our exposure to interest rate risk.

A number of measures are utilized to monitor and manage interest rate risk, including net interest income and economic value of equity simulation models. We prepare these models on a quarterly basis for review by our Asset Liability Committee (“ALCO”), senior management and Board of Directors. The use of these models requires us to formulate and apply assumptions to various balance sheet items. Assumptions regarding interest rate risk are inherent in all financial institutions and may include, but are not limited to, prepayment speeds on loans and mortgage-backed securities, cash flows and maturities of financial instruments held for purposes other than trading, changes in market conditions, loan volumes and pricing, deposit sensitivities, consumer preferences and management’s capital plans. We believe that the data and assumptions used for our models are reasonable representations of our portfolio and possible outcomes under the various interest rate scenarios. Nonetheless, these assumptions are inherently uncertain; therefore, the models cannot precisely estimate net interest income or predict the impact of higher or lower interest rates on net interest income. Actual results may differ significantly from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and specific strategies, among other factors.
 
Our primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on our net interest income and capital, while structuring the asset and liability components to maximize net interest margin, utilize capital effectively and provide adequate liquidity. We rely primarily on our asset/liability structure to control interest rate risk. We assume a high level of interest rate risk as a result of our business model which calls for us to originate and hold fixed-rate, single-family loans, which by their nature are longer-term than the short-term liabilities of customer deposits and borrowed funds.

Net Interest Income

Our primary source of income is net interest income, which is the difference between interest earned on loans and investments and the interest paid on deposits and borrowings. Like other financial institutions, we are subject to interest rate risk and expect periodic imbalances in the interest rate sensitivities of our assets and liabilities. Over any defined period of time, our interest-earning assets may be more sensitive to changes in market interest rates than our interest-bearing liabilities or vice versa. We principally manage interest rate risk by managing the volume and mix of our interest-earning assets and interest-bearing liabilities.

Our income simulation model examines changes in net interest income in which interest rates are assumed to remain at their base level, gradually increase by 100, 200 and 300 basis points over a 12-month period, or decline assuming a gradual 100 basis point reduction in rates. Reductions of rates by 200 and 300 basis points were not reported due to the very low current rate environment and the unlikely nature of rates declining further. Based on information as of September 30, 2011, our model indicated that net interest income over the next 12 months would grow in the increasing rate scenarios of 100, 200 and 300 basis points as well as in the declining 100 basis points scenario.

Our net interest income increases in all three rising rate scenarios. Interest income increases due to our current level of liquidity, which is mainly interest-bearing deposits we hold in other banks and variable rate investment securities. As interest rates rise these investments reprice to reflect higher yields and higher interest income. Our loan portfolio is comprised predominately of fixed-rate products so changing interest rates have minimal affect on the change in interest income earned from our loan portfolio. Interest expense in the rising rate scenario decreases primarily due to higher costing certificates of deposits continuing to reprice to lower rates. If rates were to gradually increase 100 basis points over the next 12 months the weighted-average cost for renewed certificates of deposit would be approximately 1.35%. The current cost of these maturing certificates of deposit is 2.09%. We also receive a benefit from the sensitivity of our interest-bearing deposit liabilities, as the cost of these products does not increase at the same rate that prevailing interest rates increase.
 
 
 
51

 

In a declining interest rate environment of 100 basis points, net interest income increases as reductions in interest expense outweigh declines in interest income. In this rate environment our interest-bearing deposits in other banks reprice to lower yields from the current yield of 25 basis points and interest earned on our investment portfolio declines due to prepayments. Interest income from our loan portfolio does not change significantly because of its fixed-rate nature. Our interest expense declines as core deposits and maturing certificates of deposit reprice downwards. The weighted-average cost for renewed certificates of deposit declines to approximately 0.51%, a decrease of 158 basis points compared to the current cost of 2.09%.

During the third quarter of 2011, we completed several transactions to improve the Bank’s interest rate risk profile. We sold $43.1 million of fixed-rate, mortgaged-backed securities, purchased $47.7 million of variable rate investment securities and added $22.6 million of interest-bearing deposits primarily from principal and interest payments from out investment and loan portfolios. Together these actions resulted in a significant increase in the level of interest sensitive assets on our balance sheet. Model results reflecting these shifts in interest sensitive assets are included in the table below:
 
September 30, 2011
 
Net Interest Income Change
 
Basis Point
Change in Rates
 
% Change
 
  +300       17.0%  
  +200       14.7  
  +100       12.2  
 
Base
      8.4   
  (100)       6.1  
(1)  (200)       N/A  
(1) (300)       N/A  
             
(1) The current federal funds rate is 0.25% making a 200 and 300 basis point drop impossible.

The changes indicated by the simulation model represent anticipated changes in net interest income over a 12 month period if rates were to gradually increase or decrease by the specified amount. The simulation assumes that the size of the balance sheet remains stable with no growth or contraction regardless of interest rate movements. Additionally, the tendency for loan and investment prepayments to accelerate in falling interest rate scenarios and slow when interest rates rise are incorporated in the model assumptions.

The rising and falling interest rate scenarios indicate that, if customer loan and deposit preferences do not change in response to further movements of the yield curve, a parallel 300, 200 or 100 basis points increase in rates and a 100 basis points decline in rates over a 12-month period will result in a positive change in our net interest income.

Economic Value of Equity (EVE) Simulation Model Results

The following table illustrates the change in the net portfolio value at September 30, 2011 that would occur in the event of an immediate change in interest rates equally across all maturities. The simulation model results are reported quarterly and are predicated upon a stable balance sheet, with no growth or change in asset or liability mix. Although the net portfolio value measurement provides an indication of our interest rate risk exposure at a particular point in time, such measurement is not intended to and does not provide, a precise forecast.

The EVE analysis goes beyond simulating net interest income for a specified period to estimating the present value of all financial instruments in our portfolio and analyzing how the economic value of the portfolio would be affected by various alternative interest rate scenarios. The portfolio’s economic value is calculated by generating principal and interest cash flows for the entire life of all assets and liabilities and discounting these cash
 
 
 
 
52

 
flows back to their present values. The assumed discount rate used for each projected cash flow is based on a current market rate, such as a FHLB or Treasury curve and from alternative instruments of comparable risk and duration.
 
September 30, 2011
                     
Net Portfolio as % of
       
Basis Point
 
Net Portfolio Value (2)
 
Portfolio Value of Assets
   
Market Value
Change in Rates
   
Amount
 
$ Change
 
% Change
 
NPV Ratio (3)
 
% Change (4)
 
of Assets (5)
(Dollars in thousands)
                                   
+300
 
$
        147,737
 
$
    (50,913)
 
       (25.6)
 %
        13.6
 %
         (4.4)
%
 
$
       1,083,008
+200
   
        165,242
   
    (33,408)
 
       (16.8)
   
        14.9
   
         (2.9)
     
       1,111,255
+100
   
        183,408
   
    (15,242)
 
         (7.7)
   
        16.1
   
         (1.3)
     
       1,141,113
Base
   
        198,650
   
             -
 
           -
   
        17.0
   
           -
     
       1,169,160
(100)
   
        207,767
   
       9,117
 
          4.6
   
        17.5
   
          0.8
     
       1,187,404
(200)
(1)
 
N/A
   
N/A
 
N/A
   
N/A
   
         N/A
     
N/A
(300)
(1)
 
N/A
   
N/A
 
N/A
   
N/A
   
         N/A
     
N/A
                                     
(1)  The current federal funds rate is 0.25%, making a 200 or 300 basis point decrease in rates impossible.
       
(2) The difference between the present value of discounted cash flows for assets and liabilities represents the net portfolio value or the market value of equity.
(3) Net portfolio value divided by the market value of assets.
(4) The increase or decrease in the net portfolio value divided by the market value of assets (base case).
(5) Calculated based on the present value of the discounted cash flows from assets.


In the simulated upward rate shift of the yield curve, the discount rates used to calculate the present value of assets and liabilities will increase, causing the present values of fixed-rate assets to decline and fixed-rate liabilities to increase. Our EVE simulation model results as of September 30, 2011 indicated that if rates increased 100, 200 or 300 basis points the market value of our assets would decrease. This decrease is largely because of the fixed-rate nature of our loan and investment portfolios. The fair value of our equity would also decrease under all three rising rate shift scenarios. The opposite occurs if rates were to decline. The discount rates used to calculate the present value of assets and liabilities will decrease, causing the present value of fixed-rate assets to increase and fixed-rate liabilities to decrease. If rates were to decrease by 100 basis points, the market value of our assets would increase and the fair value of equity would increase.

If interest rates change in the designated amounts, there can be no assurance that our assets and liabilities would perform as set forth previously. Changes in U.S. Treasury rates in the designated amounts accompanied by changes in the shape of the Treasury yield curve could cause changes to the net portfolio value and net interest income other than those indicated previously.

At September 30, 2011, we had no derivative financial instruments or trading accounts for any class of financial instruments, nor have we engaged in hedging activities or purchased off-balance sheet derivative instruments. Interest rate risk continues to be one of our primary risks as other types of risks, such as foreign currency exchange risk and commodity pricing risk do not arise in the normal course of our business activities and operations.

Item 4. Controls and Procedures

The management of First Financial Northwest, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) of the Securities Exchange Act of 1934 (“Exchange Act”). A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that its objectives are met. Also, 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 Company have been detected. Additionally, in designing disclosure controls and procedures, our management was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures is also 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. As a result of these inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Further,
 
 
 
53

 
 
projections of any evaluation of effectiveness to future periods are subject to risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.

(a)  
Evaluation of Disclosure Controls and Procedures: An evaluation of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Exchange Act) was carried out under the supervision and with the participation of our Chief Executive Officer, Chief Financial Officer (Principal Financial and Accounting Officer) and several other members of our senior management as of the end of the period covered by this report. Our Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2011, our disclosure controls and procedures were effective in ensuring that the information required to be disclosed by us in the reports we file or submit under the Exchange Act is (i) accumulated and communicated to our 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: In the quarter ended September 30, 2011, there was no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.


 
54

 

PART II

Item 1. Legal Proceedings

From time to time, we are engaged in legal proceedings in the ordinary course of business, none of which are currently considered to have a material impact on our financial position or results of operations.

Item 1A. Risk Factors

There have been no material changes to the risk factors previously disclosed in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2010.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

There were no repurchases of equity securities in the third quarter of 2011.

On February 18, 2009, the Board of Directors approved a second stock repurchase plan for the purchase of up to 2,056,752 shares, or approximately 10% of our outstanding shares of common stock. There are 294,400 shares remaining to be repurchased under this plan at September 30, 2011. Any future repurchases of stock would require regulatory approval as required by the Order and the MOU.

Under the terms of the MOU entered into with the OTS on April 14, 2010, the Company agreed, among other things, to provide notice to and obtain a written non-objection from the OTS prior to the Company declaring a dividend or redeeming any capital stock which is now enforced by the FRB as the successor to the OTS. Effective July 21, 2011 the FRB replaced the OTS as the Company’s primary regulator.

Item 3. Defaults Upon Senior Securities

Not applicable.

Item 4. [Removed and Reserved]

Item 5. Other Information

Not applicable.

Item 6. Exhibits

3.1            Articles of Incorporation of First Financial Northwest (1)
3.2            Bylaws of First Financial Northwest (1)
4                Form of stock certificate of First Financial Northwest (1)
10.1           Form of Employment Agreement for President and Chief Executive Officer (1)
10.2           Form of Change in Control Severance Agreement for Executive Officers (1)
10.3           Form of First Savings Bank Employee Severance Compensation Plan (1)
10.4           Form of Supplemental Executive Retirement Agreement entered into by First Savings Bank with Victor Karpiak, Harry A. Blencoe
                     and Robert H. Gagnier (1)
10.5           Form of Financial Institutions Retirement Fund (1)
10.6           Form of 401(k) Retirement Plan (2)
10.7           2008 Equity Incentive Plan (3)
10.8           Forms of incentive and non-qualified stock option award agreements (4)
10.9           Form of restricted stock award agreement (4)
14              Code of Business Conduct and Ethics (5)
21              Subsidiaries of the Registrant
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
 
 
 
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101
The following materials from First Financial Northwest’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2011, formatted in Extensible Business Reporting Language (XBRL): (1) Consolidated Balance Sheets; (2) Consolidated Income Statements; (3) Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income; (4) Consolidated Statements of Cash Flows; and (5) Selected Notes to Consolidated Financial Statements.

________________________________________
(1)  Filed as an exhibit to First Financial Northwest’s Registration Statement on Form S-1 (333-143549). 
(2)
Filed as an exhibit to First Financial Northwest’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007 and incorporated herein by reference.
(3)  Filed as Appendix A to First Financial Northwest’s definitive proxy statement dated April 15, 2008. 
(4)  Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated July 1, 2008. 
(5)
 Registrant elects to satisfy Regulation S-K §229.406 (c) by posting its code of ethics on its website at www.fsbnw.com.
 
           
           
          

 
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SIGNATURES

Pursuant to the requirements 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.
 
  First Financial Northwest, Inc. 
   
   
Date: November 7, 2011  /s/Victor Karpiak                                                
 
Victor Karpiak
 
Chairman of the Board, President and
Chief Executive Officer
(Principal Executive Officer)
   
   
Date: November 7, 2011  /s/Kari Stenslie                                                  
  Kari Stenslie 
 
Chief Financial Officer
 
(Principal Financial and Accounting Officer)

 


 
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EXHIBIT INDEX
 
 
 
31.1
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act
31.2
Certification of Chief Financial Officer and Principal Financial and Accounting 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
101 The following materials from First Financial Northwest’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2011, formatted in Extensible Business Reporting Language (XBRL): (1) Consolidated Balance Sheets; (2) Consolidated Income Statements; (3) Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income; (4) Consolidated Statements of Cash Flows; and (5) Selected Notes to Consolidated Financial Statements.

 
 

 
 
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