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First Financial Northwest, Inc. - Quarter Report: 2018 September (Form 10-Q)


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, 2018
 
 
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:
 
(425) 255-4400
 
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES    X   NO      

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files).

YES    X   NO      

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer”, “smaller reporting company”, and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer _____
Accelerated filer    X    
  Non-accelerated filer _____
Smaller reporting company _____
Emerging growth company _____
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. _____

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 5, 2018, 10,914,556 shares of the issuer’s common stock, $0.01 par value per share, were outstanding.



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


2

FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(Dollars in thousands, except share data)


Part 1. Financial Information

Item 1. Financial Statements
 
September 30, 2018
 
December 31, 2017
Assets
 
(Unaudited)
 
 
Cash on hand and in banks
$
7,167

 
$
9,189

Interest-earning deposits with banks
19,094

 
6,942

Investments available-for-sale, at fair value
140,868

 
132,242

Loans receivable, net of allowance of $13,116 and $12,882
995,557

 
988,662

Federal Home Loan Bank ("FHLB") stock, at cost
7,410

 
9,882

Accrued interest receivable
4,664

 
4,084

Deferred tax assets, net
2,092

 
1,211

Other real estate owned ("OREO")
483

 
483

Premises and equipment, net
21,277

 
20,614

Bank owned life insurance ("BOLI"), net
29,745

 
29,027

Prepaid expenses and other assets
4,460

 
5,738

Goodwill
889

 
889

Core deposit intangible
1,153

 
1,266

Total assets
$
1,234,859

 
$
1,210,229

 
 
 
 
Liabilities and Stockholders' Equity
 

 
 
Deposits:
 
 
 
Noninterest-bearing deposits
$
51,180

 
$
45,434

Interest-bearing deposits
865,099

 
794,068

Total deposits
916,279

 
839,502

FHLB Advances
149,000

 
216,000

Advance payments from borrowers for taxes and insurance
4,737

 
2,515

Accrued interest payable
541

 
326

Other liabilities
9,589

 
9,252

Total liabilities
1,080,146

 
1,067,595

 
 

 
 
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 10,914,556 shares at September 30, 2018, and 10,748,437
shares at December 31, 2017
109

 
107

Additional paid-in capital
96,664

 
94,173

Retained earnings, substantially restricted
65,004

 
54,642

Accumulated other comprehensive loss, net of tax
(2,550
)
 
(928
)
Unearned Employee Stock Ownership Plan ("ESOP") shares
(4,514
)
 
(5,360
)
Total stockholders' equity
154,713

 
142,634

Total liabilities and stockholders' equity
$
1,234,859

 
$
1,210,229


See accompanying selected notes to consolidated financial statements.

3


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

 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
Interest income
 
 
 
 
 
 
 
Loans, including fees
$
12,631

 
$
10,959

 
$
38,103

 
$
31,338

Investments available-for-sale
1,063

 
869

 
3,002

 
2,601

Interest-earning deposits with banks
59

 
108

 
141

 
194

Dividends on FHLB stock
135

 
67

 
343

 
211

Total interest income
13,888

 
12,003

 
41,589

 
34,344

Interest expense
 
 
 
 
 

 
 

Deposits
2,912

 
1,933

 
7,623

 
5,400

FHLB advances and other borrowings
917

 
695

 
2,794

 
1,710

Total interest expense
3,829

 
2,628

 
10,417

 
7,110

Net interest income
10,059

 
9,375

 
31,172

 
27,234

Provision (recapture of provision) for loan losses
200

 
500

 
(4,200
)
 
800

Net interest income after provision (recapture of provision) for loan losses
9,859

 
8,875

 
35,372

 
26,434

Noninterest income
 
 
 
 
 

 
 

Net gain (loss) on sale of investments
1

 
47

 
(20
)
 
103

BOLI income
245

 
173

 
718

 
490

Wealth management revenue
145

 
252

 
400

 
699

Deposit related fees
167

 
113

 
503

 
277

Loan related fees
273

 
144

 
533

 
420

Other
10

 
2

 
16

 
8

Total noninterest income
841

 
731

 
2,150

 
1,997

Noninterest expense
 

 
 
 
 

 
 

Salaries and employee benefits
4,732

 
4,406

 
14,325

 
13,100

Occupancy and equipment
814

 
726

 
2,412

 
1,785

Professional fees
353

 
458

 
1,123

 
1,379

Data processing
356

 
372

 
1,031

 
1,131

OREO related expenses (reimbursements), net
1

 
(6
)
 
4

 
14

Regulatory assessments
126

 
122

 
391

 
330

Insurance and bond premiums
95

 
105

 
355

 
302

Marketing
85

 
102

 
269

 
202

Other general and administrative
639

 
551

 
1,805

 
1,497

Total noninterest expense
7,201

 
6,836

 
21,715

 
19,740

Income before federal income tax provision
3,499

 
2,770

 
15,807

 
8,691

Federal income tax provision
707

 
909

 
3,071

 
2,618

Net income
$
2,792

 
$
1,861

 
$
12,736

 
$
6,073

Basic earnings per common share
$
0.27

 
$
0.18

 
$
1.24

 
$
0.59

Diluted earnings per common share
$
0.27

 
$
0.18

 
$
1.22

 
$
0.58

Basic weighted average number of common shares outstanding
10,356,994

 
10,287,663

 
10,280,287

 
10,323,459

Diluted weighted average number of common shares outstanding
10,468,802

 
10,427,038

 
10,405,315

 
10,480,061

See accompanying selected notes to consolidated financial statements.

4


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


 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
Net income
$
2,792

 
$
1,861

 
$
12,736

 
$
6,073

Other comprehensive income, before tax:
 
 
 
 
 
 
 
Unrealized holding (losses) gains on investments available-for-sale
(600
)
 
214

 
(3,002
)
 
1,043

Tax benefit (provision)
126

 
(75
)
 
630

 
(365
)
Reclassification adjustment for net (gains) losses realized in income
(1
)
 
(47
)
 
20

 
(103
)
Tax benefit (provision)

 
17

 
(4
)
 
36

Gain (loss) on cash flow hedge
88

 
28

 
928

 
(215
)
Tax (provision) benefit
(18
)
 
(10
)
 
(194
)
 
75

Other comprehensive (loss) income, net of tax
$
(405
)
 
$
127

 
$
(1,622
)
 
$
471

Total comprehensive income
$
2,387

 
$
1,988

 
$
11,114

 
$
6,544


See accompanying selected notes to consolidated financial statements.



5


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

 
Shares
 
Common Stock
 
Additional Paid-in Capital
 
Retained Earnings
 
Accumulated Other Comprehensive Loss,
 net of tax
 
Unearned
ESOP
Shares
 
Total Stockholders’ Equity
Balances at December 31, 2016
10,938,251

 
$
109

 
$
96,852

 
$
48,981

 
$
(1,328
)
 
$
(6,489
)
 
$
138,125

Net income

 

 

 
6,073

 

 

 
6,073

Other comprehensive income

 

 

 

 
471

 

 
471

Exercise of stock options
134,880

 
2

 
1,307

 

 

 

 
1,309

Issuance of common stock - restricted stock awards, net
3,984

 

 
(105
)
 

 

 

 
(105
)
Compensation related to stock options and restricted stock awards

 

 
505

 

 

 

 
505

Allocation of 84,642 ESOP shares

 

 
625

 

 

 
846

 
1,471

Repurchase and retirement of common stock
(313,200
)
 
(3
)
 
(5,016
)
 

 

 

 
(5,019
)
Cash dividend declared and paid ($0.20 per share)

 

 

 
(2,070
)
 

 

 
(2,070
)
Balances at September 30, 2017
10,763,915

 
$
108

 
$
94,168

 
$
52,984

 
$
(857
)
 
$
(5,643
)
 
$
140,760

 
Shares
 
Common 
Stock
 
Additional 
Paid-in
Capital
 
Retained
Earnings
 
Accumulated Other Comprehensive Loss,  net of tax
 
Unearned
ESOP
Shares
 
Total
Stockholders' Equity
Balances at December 31, 2017
10,748,437

 
$
107

 
$
94,173

 
$
54,642

 
$
(928
)
 
$
(5,360
)
 
$
142,634

Net income

 

 

 
12,736

 

 

 
12,736

Other comprehensive loss

 

 

 

 
(1,622
)
 

 
(1,622
)
Exercise of stock options
137,940

 
1

 
1,364

 

 

 

 
1,365

Issuance of common stock - restricted stock awards, net
30,179

 
1

 
(41
)
 

 

 

 
(40
)
Compensation related to stock options and restricted stock awards

 

 
539

 

 

 

 
539

Allocation of 84,640 ESOP shares

 

 
629

 

 

 
846

 
1,475

Canceled common stock - restricted stock awards
(2,000
)
 

 

 

 

 

 

Cash dividend declared and paid ($0.23 per share)

 

 

 
(2,374
)
 

 

 
(2,374
)
Balances at September 30, 2018
10,914,556

 
$
109

 
$
96,664

 
$
65,004

 
$
(2,550
)
 
$
(4,514
)
 
$
154,713


See accompanying selected notes to consolidated financial statements.

6


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

 
Nine Months Ended September 30,
 
2018
 
2017
Cash flows from operating activities:
 
 
 
Net income
$
12,736

 
$
6,073

Adjustments to reconcile net income to net cash provided by
operating activities:
 

 
 
(Recapture of provision) provision for loan losses
(4,200
)
 
800

OREO market value adjustments

 
50

Gain on sale of OREO property, net

 
(5
)
Net amortization of premiums and discounts on investments
812

 
500

Loss (gain) on sale of investments available-for-sale
20

 
(103
)
Depreciation of premises and equipment
1,228

 
883

Loss on sale of premises and equipment

 
65

Deferred federal income taxes
(449
)
 
507

Allocation of ESOP shares
1,475

 
1,471

Stock compensation expense
539

 
505

Increase in cash surrender value of BOLI
(718
)
 
(490
)
Changes in operating assets and liabilities:
 
 
 

Decrease (increase) in prepaid expenses and other assets
2,319

 
(840
)
Net increase in advance payments from borrowers for taxes and insurance
2,222

 
2,008

Increase in accrued interest receivable
(580
)
 
(562
)
Increase in accrued interest payable
215

 
49

Increase in other liabilities
337

 
3,038

Net cash provided by operating activities
15,956

 
13,949

Cash flows from investing activities:
 

 
 

Proceeds from sales of OREO properties

 
461

Proceeds from sales, calls and maturities of investments available-for-sale
15,186

 
7,494

Principal repayments on investments available-for-sale
5,385

 
7,980

Purchases of investments available-for-sale
(33,011
)
 
(23,518
)
Net increase in loans receivable
(2,695
)
 
(117,619
)
Redemption (purchase) of FHLB stock
2,472

 
(871
)
Purchase of premises and equipment
(1,891
)
 
(2,399
)
Proceeds from sale or disposal of premises and equipment, net

 
7

Purchase of BOLI

 
(4,251
)
Net cash received from acquisition of branches

 
71,568

Net cash used by investing activities
(14,554
)
 
(61,148
)
 
 
 
 
Continued
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

7


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

 
Nine Months Ended September 30,
 
2018
 
2017
Cash flows from financing activities:
 

 
 

Net increase in deposits
$
76,777

 
$
23,735

Advances from the FHLB
320,500

 
40,000

Repayments of advances from the FHLB
(387,500
)
 
(20,000
)
Proceeds from stock options exercises
1,365

 
1,309

Net share settlement of stock awards
(40
)
 
(105
)
Repurchase and retirement of common stock

 
(5,019
)
Dividends paid
(2,374
)
 
(2,070
)
Net cash provided by financing activities
8,728

 
37,850

Net increase (decrease) in cash and cash equivalents
10,130

 
(9,349
)
Cash and cash equivalents at beginning of period
16,131

 
31,352

Cash and cash equivalents at end of period
$
26,261

 
$
22,003

 
 
 
 
Supplemental disclosures of cash flow information:
 

 
 

Cash paid during the period for:
 

 
 

Interest paid
$
10,202

 
$
7,061

Federal income taxes paid
3,175

 
2,810

Assets acquired in acquisition of branches

 
72,239

Liabilities assumed in acquisition of branches

 
74,657

 
 
 
 
Noncash items:
 
 
 

Change in unrealized loss on investments available-for-sale
$
(2,982
)
 
$
940

Change in gain on cash flow hedge
928

 
(215
)

See accompanying selected notes to consolidated financial statements.


8



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”), a Washington corporation, was formed on June 1, 2007 for the purpose of becoming the holding company for First Financial Northwest Bank (the “Bank”) in connection with the conversion from a mutual holding company structure to a stock holding company structure completed on October 9, 2007. First Financial Northwest’s business activities generally are limited to passive investment activities and oversight of its investment in First Financial Northwest Bank. Accordingly, the information presented in the consolidated financial statements and accompanying data, relates primarily to First Financial Northwest Bank. First Financial Northwest is a bank holding company, having converted from a savings and loan holding company on March 31, 2015, and as a bank holding company is subject to regulation by the Federal Reserve Bank of San Francisco. First Financial Northwest Bank is regulated by the Federal Deposit Insurance Corporation (“FDIC”) and the Washington State Department of Financial Institutions (“DFI”).

As of September 30, 2018, First Financial Northwest Bank operated in ten locations in Washington with the headquarters and four additional branch locations in King County and five branch locations in Snohomish County. The Bank acquired four bank branches (one in King and three in Snohomish counties) and $74.7 million in retail deposits from Opus Bank on August 25, 2017. No loans were acquired in this transaction. The Bank’s primary market area consists of King, Snohomish, Pierce and Kitsap counties, Washington. The Bank has received FDIC approval to open an additional branch in Kent, Washington, which is expected to open in the first quarter of 2019.

The Bank is a portfolio lender, originating and purchasing one-to-four family residential, multifamily, commercial real estate, construction/land development, business, and consumer loans. Loans are primarily funded by deposits from the general public, supplemented by borrowings from the Federal Home Loan Bank of Des Moines (“FHLB”) and deposits raised in the national brokered deposit market.

As used throughout this report, the terms “we,” “our,” “us,” or the “Company” refer to First Financial Northwest, Inc. and its consolidated subsidiary First Financial Northwest Bank, unless the context otherwise requires.

Note 2 - Basis of Presentation

The accompanying unaudited interim consolidated financial statements have been prepared pursuant to the rules and regulations of the U.S. Securities and Exchange Commission ("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 interim consolidated financial statements should be read in conjunction with the Company's Annual Report on Form 10-K for the year ended December 31, 2017, as filed with the SEC (“2017 Form 10-K”). In our opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of the unaudited interim 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 nine months ended September 30, 2018, are not necessarily indicative of the results that may be expected for the year ending December 31, 2018. In preparing the unaudited consolidated financial statements, we are required to make 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 allowance for loan and lease losses (“ALLL”), the valuation of other real estate owned (“OREO”) and the underlying collateral of impaired loans, deferred tax assets, and the fair value of financial instruments.

The Company’s activities are considered to be a single industry segment for financial reporting purposes. The Company is engaged in the business of attracting deposits from the general public and originating and purchasing loans for its portfolio. Substantially all income is derived from a diverse base of commercial, multifamily, and residential real estate loans, consumer lending activities, and investments.

Certain amounts in the unaudited interim consolidated financial statements for prior periods have been reclassified to conform to the current unaudited financial statement presentation with no effect on consolidated net income or stockholders’ equity.



9


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


Note 3 - Recently Issued Accounting Pronouncements

Recent Accounting Pronouncements Adopted in 2018

In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers (Topic 606). In August 2015, FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606) which postponed the effective date of 2014-09. Subsequently, in March 2016, the FASB issued ASU 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations. This amendment clarifies that an entity should determine if it is the principal or the agent for each specified good or service promised in a contract with a customer. In April 2016, the FASB issued ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing. The core principle of Topic 606 is that an entity must recognize revenue when it has satisfied a performance obligation of transferring promised goods or services to a customer. These standards were effective for interim and annual periods beginning after December 15, 2017. The Company has analyzed its sources of noninterest income to determine when the satisfaction of the performance obligation occurs and the appropriate recognition of revenue. The adoption of these ASUs did not have a material impact on the Company’s consolidated financial statements. For more discussion on this topic, see Note 12 - Revenue Recognition in this report.

In January 2016, FASB issued ASU No. 2016-01, Financial Instruments - Overall, Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 requires equity investments (except those accounted for under the equity method of accounting) to be measured at fair value with changes in fair value recognized in net income. In addition, the amendments in this ASU require an entity to disclose the fair value of its financial instruments using the exit price notion. Exit price is 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. The amendments in this ASU were effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company has updated the fair value disclosure on Note 7 in this report to reflect adoption of this standard, to include using the exit price notion in the fair value disclosure of financial instruments. The adoption of ASU 2016-01 did not have a material impact on the Company’s consolidated financial statements.

In August 2016, FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. This ASU addresses the appropriate classification of eight specific cash flow issues on the cash flow statement. Debt prepayment costs should be classified as an outflow for financing activities. Settlement of zero-coupon debt instruments divides the interest portion as an outflow for operating activities and the principal portion as an outflow for financing activities. Contingent consideration payments made after a business combination should be classified as outflows for financing and operating activities. Proceeds from the settlement of bank-owned life insurance policies should be classified as inflows from investing activities. Other specific areas are identified in the ASU as to the appropriate classification of the cash inflows or outflows. The amendments in this ASU were effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company does not currently have items on its cash flow statement that were impacted by adoption of this ASU and therefore adoption of ASU 2016-15 did not have a material impact on the Company’s consolidated financial statements.

In January 2017, FASB issued ASU 2017-01, Business Combinations (Topic 805). This ASU clarifies the definition of a business to assist in determining whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The amendments in this ASU provide a screen to determine when a set of assets and activities is not a business, thereby reducing the number of transactions requiring further evaluation. If the screen is not met, the amendments in this ASU further provide a framework to evaluate if the criteria is present to qualify for a business. This ASU was effective for annual periods beginning after December 15, 2017. Adoption of ASU 2017-01 did not have a material impact on the Company’s consolidated financial statements.

In May 2017, FASB issued ASU No. 2017-09, Compensation - Stock Compensation (Topic 718): Scope of Modification Accounting. The ASU was issued to provide clarity as to when to apply modification accounting when there is a change in the terms or conditions of a share-based payment award. According to this ASU, an entity should account for the effects of a modification unless the fair value, vesting conditions, and balance sheet classification of the award is the same after the modification as compared to the original award prior to the modification. This ASU was effective for reporting periods beginning after December 15, 2017. The Company has not had any modifications on share-based payment awards and therefore the adoption of ASU No. 2017-09 did not have a material impact on the Company’s consolidated financial statements.

In February 2018, FASB issued ASU 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220). This ASU was issued to allow a reclassification from accumulated other comprehensive income to retained earnings from stranded tax effects resulting from the revaluation of the net deferred tax asset (“DTA”) to the new corporate tax rate of 21% as a result of the Tax Cuts and Jobs Act (“Tax Act”). This ASU is effective for reporting periods beginning after December 15, 2018, with early

10


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


adoption permitted. The Company adopted this ASU as of December 31, 2017, which resulted in reclassifying a net unrealized gain from the change in tax rate with an increase to accumulated other comprehensive income and a decrease to retained earnings by $41,000, respectively.
        
In March 2018, FASB issued ASU No. 2018-05, Income Taxes (Topic 740). This ASU was issued to provide guidance on the income tax accounting implications of the Tax Act and allows for entities to report provisional amounts for specific income tax effects of the Act for which the accounting under Topic 740 was not yet complete but a reasonable estimate could be determined. A measurement period of one-year is allowed to complete the accounting effects under Topic 740 and revise any previous estimates reported. Any provisional amounts or subsequent adjustments included in an entity’s financial statements during the measurement period should be included in income from continuing operations as an adjustment to tax expense in the reporting period the amounts are determined. The Company adopted this ASU with the provisional adjustments as reported in the Consolidated Financial Statements included in the 2017 Form 10-K. As of September 30, 2018, the Company did not incur any adjustments to the provisional recognition.

In June 2018, FASB issued ASU No. 2018-07, Compensation - Stock Compensation (Topic 718). This ASU was issued to expand the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from nonemployees. Previously, these awards were recorded at the fair value of consideration received or the fair value of the equity instruments issued and was measured as the earlier of the commitment date or date performance was completed. The amendments in this ASU require the awards to be measured at the grant-date fair value of the equity instrument. This ASU is effective for fiscal years beginning after December 15, 2018, and early adoption is permitted once the entity has adopted Topic 606. The Company has adopted this ASU with the nonemployee share-based payment awards granted in June 2018, with no material impact on the Company’s consolidated financial statements.

Recent Accounting Pronouncements

In February 2016, FASB issued ASU No. 2016-02, Leases (Topic 842). ASU No. 2016-02 requires lessees to recognize on the balance sheet the assets and liabilities arising from operating leases. In July 2018, FASB issued ASU No. 2018-11, Leases (Topic 842) to address the comparative reporting requirements when this ASU is adopted. Under this ASU, a lessee should recognize a liability to make lease payments and a right-of-use asset representing its right to use the underlying asset for the lease term. A lessee should include payments to be made in an optional period only if the lessee is reasonably certain to exercise an option to extend the lease or not to exercise an option to terminate the lease. For a finance lease, interest payments should be recognized separately from amortization of the right-of-use asset in the statement of comprehensive income. For operating leases, the lease cost should be allocated over the lease term on a generally straight-line basis. The amendments in ASU 2016-02 are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. According to ASU 2018-11, the Company may recognize the cumulative-effect adjustment to the opening balance of retained earnings at the time ASU 2016-02 is adopted. Early application of the amendments in the ASU is permitted. The effect of the adoption will depend on leases at the time of adoption. Once adopted, we expect to report higher assets and liabilities as a result of including right-of-use assets and lease liabilities related to certain banking offices under noncancelable operating lease agreements, however, based on current leases, the adoption is expected to increase our consolidated balance sheets by less than 5% and not to have a material impact on our regulatory capital ratios.
        
In June 2016, FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326). This ASU replaces the existing incurred loss impairment methodology that recognizes credit losses when a probable loss has been incurred with new methodology where loss estimates are based upon lifetime expected credit losses. The amendments in this ASU require a financial asset that is measured at amortized cost to be presented at the net amount expected to be collected. The income statement would then reflect the measurement of credit losses for newly recognized financial assets as well as changes to the expected credit losses that have taken place during the reporting period. The measurement of expected credit losses will be based on historical information, current conditions, and reasonable and supportable forecasts that impact the collectability of the reported amount. Available-for-sale securities will bifurcate the fair value mark and establish an allowance for credit losses through the income statement for the credit portion of that mark. The interest portion will continue to be recognized through accumulated other comprehensive income or loss. The change in allowance recognized as a result of adoption will occur through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the ASU is adopted. The amendments in this ASU are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years, with early adoption permitted for fiscal years beginning after December 15, 2018. The Company is evaluating our current expected loss methodology of our loan and investment portfolios to identify the necessary modifications in accordance with this standard and expects a change in the processes and procedures to calculate the ALLL, including changes in assumptions and estimates to consider expected credit losses over the life of the loan versus the current accounting practice that utilizes the incurred loss model. A valuation adjustment

11


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


to our ALLL or investment portfolio that is identified in this process will be reflected as a one-time adjustment in equity rather than earnings. We are in the process of compiling historical data that will be used to calculate expected credit losses on our loan portfolio to ensure we are fully compliant with the ASU at the adoption date and are evaluating the potential impact adoption of this ASU will have on our consolidated financial statements. The Company intends to adopt ASU 2016-13 in the first quarter of 2020, and as a result, we expect our allowance for loan losses to increase. Until our evaluation is complete, however, the magnitude of the increase will not be known.
    
In January 2017, FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350). This ASU simplifies the impairment calculation for subsequent measurement of goodwill by eliminating the step of comparing the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill. Under the amendments in this ASU, an entity will evaluate the carrying amount of a reporting unit to its fair value, as if the reporting unit had been acquired in a business combination. An impairment charge should be recognized for the amount that the carrying amount exceeds the fair value, not to exceed the amount of goodwill. The income tax effect should be considered for any tax deductible goodwill when measuring the impairment loss. The amendments in this ASU are effective for goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for reporting periods after January 1, 2017. The Company recognized goodwill from its recent acquisition on August 25, 2017 of four branches from Opus Bank, a California state-chartered commercial bank (the “Branch Acquisition”) and expects to early adopt this ASU for the annual goodwill impairment test in 2018. Adoption of ASU 2017-04 is not expected to have a material impact on the Company’s consolidated financial statements.

In March 2017, FASB issued ASU No. 2017-08, Receivables - Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. The ASU shortens the amortization period for certain callable debt securities held at a premium. The standard will take effect for SEC filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company is currently evaluating its available-for-sale securities that fit the criteria of this ASU but has not yet quantified the impact. The adoption of ASU No. 2017-08 is not expected to have a material impact on the Company's consolidated financial statements.

In August 2017, FASB issued ASU No. 2017-12, Derivatives and Hedging (Topic 815). This ASU was issued to provide investors better insight to an entity’s risk management hedging strategies by permitting companies to recognize the economic results of its hedging strategies in its financial statements. The amendments in this ASU permit hedge accounting for hedging relationships involving non-financial risk and interest rate risk by removing certain limitations in cash flow and fair value hedging relationships. In addition, the ASU requires an entity to present the earnings effect of the hedging instrument in the same income statement line item in which the earnings effect of the hedged item is reported. This ASU is effective for fiscal years beginning after December 15, 2018, and early adoption is permitted. The Company intends to adopt this ASU during 2018, however its current cash flow hedge will not likely be impacted by the adoption of ASU 2017-12, and consequently, is not expected to have a material impact on the Company’s consolidated financial statements.

In August 2018, FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820) - Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement. The amendments in this ASU remove certain disclosure requirements regarding transfers between Level 1 and Level 2 of the fair value hierarchy and changes in unrealized gains and losses for recurring Level 3 fair value measurements. In addition, the amendments modified and added certain disclosure requirements for Level 3 fair value measurements. This ASU is effective for fiscal years beginning after December 15, 2019, and early adoption is permitted. Entities are permitted to early adopt any removed or modified disclosures and adopt the additional disclosures at the effective date. Adoption of ASU 2018-13 is not expected to have a material impact on the Company’s consolidated financial statements.

Note 4 - Investments

Investments available-for-sale are summarized as follows at the dates indicated:

12


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


 
September 30, 2018
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value

(In thousands)
Mortgage-backed investments:
 
 
 
 
 
 
 
   Fannie Mae
$
26,488

 
$
11

 
$
(1,165
)
 
$
25,334

   Freddie Mac
5,372

 
1

 
(161
)
 
5,212

   Ginnie Mae
23,500

 

 
(1,521
)
 
21,979

   Other
6,028

 

 
(13
)
 
6,015

Municipal bonds
10,640

 
5

 
(179
)
 
10,466

U.S. Government agencies
49,564

 
79

 
(925
)
 
48,718

Corporate bonds
23,490

 
245

 
(591
)
 
23,144

Total
$
145,082

 
$
341

 
$
(4,555
)
 
$
140,868

 
December 31, 2017
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
 
(In thousands)
Mortgage-backed investments:
 
 
 
 
 
 
 
   Fannie Mae
$
26,961

 
$
69

 
$
(466
)
 
$
26,564

   Freddie Mac
5,510

 
18

 
(56
)
 
5,472

   Ginnie Mae
22,288

 
14

 
(726
)
 
21,576

Municipal bonds
13,126

 
290

 
(21
)
 
13,395

U.S. Government agencies
43,088

 
81

 
(536
)
 
42,633

Corporate bonds
22,502

 
527

 
(427
)
 
22,602

Total
$
133,475

 
$
999

 
$
(2,232
)
 
$
132,242

     
The tables below summarize the aggregate fair value and gross unrealized loss by length of time those investment securities have been continuously in an unrealized loss position at the dates indicated:
 
September 30, 2018
 
Less Than 12 Months
 
12 Months or Longer
 
Total
 
Fair Value
 
Gross Unrealized
Loss
 
Fair Value
 
Gross Unrealized
Loss
 
Fair Value
 
Gross Unrealized
Loss
 
(In thousands)
Mortgage-backed investments:
 
 
 
 
 
 
 
 
 
 
 
   Fannie Mae
$
11,129

 
$
(238
)
 
$
13,736

 
$
(927
)
 
$
24,865

 
$
(1,165
)
   Freddie Mac
5,102

 
(161
)
 

 

 
5,102

 
(161
)
   Ginnie Mae
6,951

 
(207
)
 
15,028

 
(1,314
)
 
21,979

 
(1,521
)
   Other
6,015

 
(13
)
 

 

 
6,015

 
(13
)
Municipal bonds
6,378

 
(134
)
 
963

 
(45
)
 
7,341

 
(179
)
U.S. Government agencies
32,551

 
(708
)
 
6,451

 
(217
)
 
39,002

 
(925
)
Corporate bonds
993

 
(7
)
 
6,916

 
(584
)
 
7,909

 
(591
)
Total
$
69,119

 
$
(1,468
)
 
$
43,094

 
$
(3,087
)
 
$
112,213

 
$
(4,555
)

13


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


 
December 31, 2017
 
Less Than 12 Months
 
12 Months or Longer
 
Total
 
Fair Value
 
Gross Unrealized
Loss
 
Fair Value
 
Gross Unrealized
Loss
 
Fair Value
 
Gross Unrealized
Loss
 
(In thousands)
Mortgage-backed investments:
 
 
 
 
 
 
 
 
 
 
 
   Fannie Mae
$
15,202

 
$
(91
)
 
$
6,759

 
$
(375
)
 
$
21,961

 
$
(466
)
   Freddie Mac
3,189

 
(56
)
 

 

 
3,189

 
(56
)
   Ginnie Mae
6,454

 
(61
)
 
14,234

 
(665
)
 
20,688

 
(726
)
Municipal bonds
1,403

 
(21
)
 

 

 
1,403

 
(21
)
U.S. Government agencies
33,268

 
(435
)
 
1,800

 
(101
)
 
35,068

 
(536
)
Corporate bonds
1,499

 
(1
)
 
7,074

 
(426
)
 
8,573

 
(427
)
Total
$
61,015

 
$
(665
)
 
$
29,867

 
$
(1,567
)
 
$
90,882

 
$
(2,232
)

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. The Company considers 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. If the Company intends to sell a debt security, or it is likely that the Company will be required to sell the debt security before recovering its cost basis, the entire impairment loss would be recognized in earnings as an OTTI. If the Company does not intend to sell the debt security and it is not likely that it will be required to sell the debt security but does not expect to recover the entire amortized cost basis of the debt security, only the portion of the impairment loss representing credit losses would be recognized in earnings. The credit loss on a debt 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 debt 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. At September 30, 2018, and December 31, 2017, the Company had 57 securities and 36 securities in an unrealized loss position, respectively, with 18 and 13 of these securities in an unrealized loss position for 12 months or more, respectively. Management does not believe that any individual unrealized loss as of September 30, 2018, or December 31, 2017, represented OTTI. The decline in fair market value of these securities was generally due to changes in interest rates and changes in market-desired spreads subsequent to their purchase. Management also reviewed the financial condition of the entities issuing municipal or corporate bonds at September 30, 2018, and December 31, 2017, and determined that an OTTI charge was not warranted.

The amortized cost and estimated fair value of investments available-for-sale at September 30, 2018, 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.
 
September 30, 2018
 
Amortized Cost
 
Fair Value
 
(In thousands)
Due within one year
$
253

 
$
251

Due after one year through five years
7,655

 
7,725

Due after five years through ten years
19,673

 
19,196

Due after ten years
56,113

 
55,156

 
83,694

 
82,328

Mortgage-backed investments
61,388

 
58,540

Total
$
145,082

 
$
140,868



14


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


Under Washington state law, in order to participate in the public funds program the Company is required to pledge eligible securities as collateral in an amount equal to 50% of the public deposits held less the FDIC insured amount. Investment securities with market values of $14.5 million and $14.2 million were pledged as collateral for public deposits at September 30, 2018, and December 31, 2017, respectively, both of which exceeded the collateral requirements established by the Washington Public Deposit Protection Commission.

For the three and nine months ended September 30, 2018, we had calls, sales, and maturities on investment securities of $5.4 million, and $15.2 million, respectively, generating a net gain of $1,000 and a net loss of $20,000, respectively. For the three and nine months ended September 30, 2017, we had calls, sales and a maturity on investment securities of $2.8 million, and $7.5 million, respectively, generating a net gain of $47,000 and $103,000, respectively.

    


15


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


Note 5 - Loans Receivable

Loans receivable are summarized as follows at the dates indicated: 
 
September 30, 2018
 
December 31, 2017
 
(In thousands)
One-to-four family residential:
 
 
 
Permanent owner occupied
$
184,698

 
$
148,304

Permanent non-owner occupied
143,226

 
130,351

 
327,924

 
278,655

 
 
 
 
Multifamily
176,521

 
184,902

 
 
 
 
Commercial real estate
360,485

 
361,842

 
 
 
 
Construction/land:
 
 
 

One-to-four family residential
84,912

 
87,404

Multifamily
80,607

 
108,439

Commercial
21,385

 
5,325

Land
7,113

 
36,405

 
194,017

 
237,573

 
 
 
 
Business
29,655

 
23,087

Consumer
12,419

 
9,133

Total loans
1,101,021

 
1,095,192

 
 
 
 
Less:
 
 
 

Loans in process ("LIP")
91,232

 
92,498

Deferred loan fees, net
1,116

 
1,150

Allowance for loan and lease losses ("ALLL")
13,116

 
12,882

Loans receivable, net
$
995,557

 
$
988,662


At September 30, 2018, loans totaling $475.9 million were pledged to secure borrowings from the FHLB of Des Moines compared to $422.6 million at December 31, 2017.
    
ALLL. The Company maintains an ALLL as a reserve against probable and inherent risk of losses in its loan portfolios. The ALLL is comprised of a general reserve component for loans evaluated collectively for loss and a specific reserve component for loans evaluated individually. When an issue is identified, and it is determined that the loan needs to be classified as nonperforming and/or impaired, an evaluation of the discounted expected cash flows is done, and an appraisal may be obtained on the collateral. Based on this evaluation, additional provision for loan loss or charge-offs is recorded prior to the end of the financial reporting period.


16


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


The following tables summarize changes in the ALLL and loan portfolio by loan type and impairment method at the dates and for the periods shown: 
 
At or For the Three Months Ended September 30, 2018
 
One-to-Four
Family
Residential
 
Multifamily
 
Commercial 
Real Estate
 
Construction/
Land
 
Business
 
Consumer
 
Total
 
(In thousands)
ALLL:
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
3,265

 
$
1,928

 
$
4,494

 
$
2,121

 
$
674

 
$
272

 
$
12,754

   Recoveries
2

 

 

 
160

 

 

 
162

Provision (recapture)
265

 
(189
)
 
(16
)
 
(84
)
 
236

 
(12
)
 
200

Ending balance
$
3,532

 
$
1,739

 
$
4,478

 
$
2,197

 
$
910

 
$
260

 
$
13,116

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
At or For the Nine Months Ended September 30, 2018
 
One-to-Four
Family
Residential
 
Multifamily
 
Commercial 
Real Estate
 
Construction/
Land
 
Business
 
Consumer
 
Total
 
(In thousands)
ALLL:
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
2,837

 
$
1,820

 
$
4,418

 
$
2,816

 
$
694

 
$
297

 
$
12,882

   Recoveries
4,248

 

 
14

 
172

 

 

 
4,434

(Recapture) provision
(3,553
)
 
(81
)
 
46

 
(791
)
 
216

 
(37
)
 
(4,200
)
Ending balance
$
3,532

 
$
1,739

 
$
4,478

 
$
2,197

 
$
910

 
$
260

 
$
13,116

 

 

 

 

 

 

 

ALLL by category:


 


 


 


 


 


 


General reserve
$
3,446

 
$
1,739

 
$
4,471

 
$
2,197

 
$
910

 
$
260

 
$
13,023

Specific reserve
86

 

 
7

 

 

 

 
93

 

 

 

 

 

 

 

Loans: (1)

 

 

 

 

 

 
 
Total loans
$
327,924

 
$
176,521

 
$
360,261

 
$
103,009

 
$
29,655

 
$
12,419

 
$
1,009,789

Loans collectively evaluated for impairment (2)
318,353

 
175,405

 
357,335

 
103,009

 
29,655

 
12,330

 
996,087

Loans individually evaluated for impairment (3)
9,571

 
1,116

 
2,926

 

 

 
89

 
13,702

____________ 

(1) Net of LIP.
(2) Loans collectively evaluated for general reserves.
(3) Loans individually evaluated for specific reserves.




17


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


 
At or For the Three Months Ended September 30, 2017
 
One-to-Four
Family
Residential
 
Multifamily
 
Commercial 
Real Estate
 
Construction/
Land
 
Business
 
Consumer
 
Total
 
(In thousands)
ALLL:
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
2,627

 
$
1,231

 
$
3,733

 
$
2,942

 
$
457

 
$
295

 
$
11,285

   Recoveries
247

 

 
78

 

 

 

 
325

   (Recapture) provision
(157
)
 
472

 
(68
)
 
40

 
211

 
2

 
500

Ending balance
$
2,717

 
$
1,703

 
$
3,743

 
$
2,982

 
$
668

 
$
297

 
$
12,110

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
At or For the Nine Months Ended September 30, 2017
 
One-to-Four
Family
Residential
 
Multifamily
 
Commercial 
Real Estate
 
Construction/
Land
 
Business
 
Consumer
 
Total
 
(In thousands)
ALLL:
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
2,551

 
$
1,199

 
$
3,893

 
$
2,792

 
$
237

 
$
279

 
$
10,951

   Recoveries
280

 

 
78

 

 

 
1

 
359

   (Recapture) provision
(114
)
 
504

 
(228
)
 
190

 
431

 
17

 
800

Ending balance
$
2,717

 
$
1,703

 
$
3,743

 
$
2,982

 
$
668

 
$
297

 
$
12,110

 

 

 

 

 

 

 

ALLL by category:


 


 


 


 


 


 


General reserve
$
2,582

 
$
1,703

 
$
3,723

 
$
2,982

 
$
668

 
$
297

 
$
11,955

Specific reserve
135

 

 
20

 

 

 

 
155

 

 

 

 

 

 

 

Loans: (1)

 

 

 

 

 

 
 
Total loans
$
266,447

 
$
173,681

 
$
319,872

 
$
153,914

 
$
22,243

 
$
9,301

 
$
945,458

Loans collectively evaluated for impairment (2)
251,141

 
172,541

 
316,656

 
153,914

 
22,243

 
9,205

 
925,700

Loans individually evaluated for impairment (3)
15,306

 
1,140

 
3,216

 

 

 
96

 
19,758

_____________ 

(1) Net of LIP.
(2) Loans collectively evaluated for general reserves.
(3) Loans individually evaluated for specific reserves.


18


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



Past Due Loans. Loans are considered past due if a scheduled principal or interest payment is due and unpaid for 30 days or more. At September 30, 2018, past due loans were 0.08% of total loans receivable, net of LIP. In comparison, past due loans were 0.01% of total loans receivable, net of LIP at December 31, 2017. The following tables represent a summary of the aging of loans by type at the dates indicated:

 
Loans Past Due as of September 30, 2018
 
 
 
 
 
30-59 Days
 
60-89 Days
 
90 Days and
Greater
 
Total Past
Due
 
Current
 
Total (1) (2)
 
(In thousands)
Real estate:
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential:
 
 
 
 
 
 
 
 
 
 
 
Owner occupied
$
496

 
$

 
$

 
$
496

 
$
184,202

 
$
184,698

Non-owner occupied

 

 

 

 
143,226

 
143,226

Multifamily

 

 

 

 
176,521

 
176,521

Commercial real estate
325

 

 

 
325

 
359,936

 
360,261

Construction/land

 

 

 

 
103,009

 
103,009

Total real estate
821

 

 

 
821

 
966,894

 
967,715

Business

 

 

 

 
29,655

 
29,655

Consumer

 

 

 

 
12,419

 
12,419

Total loans
$
821

 
$

 
$

 
$
821

 
$
1,008,968

 
$
1,009,789

 ________________ 

(1) There were no loans 90 days and greater past due and still accruing interest at September 30, 2018.
(2) Net of LIP.

 
Loans Past Due as of December 31, 2017
 
 
 
 
 
30-59 Days
 
60-89 Days
 
90 Days and
Greater
 
Total Past
Due
 
Current
 
Total (1) (2)
 
(In thousands)
Real estate:
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential:
 
 
 
 
 
 
 
 
 
 
 
Owner occupied
$
101

 
$

 
$

 
$
101

 
$
148,203

 
$
148,304

Non-owner occupied

 

 

 

 
130,351

 
130,351

Multifamily

 

 

 

 
184,902

 
184,902

Commercial real estate

 

 

 

 
361,299

 
361,299

Construction/land

 

 

 

 
145,618

 
145,618

Total real estate
101

 

 

 
101

 
970,373

 
970,474

Business

 

 

 

 
23,087

 
23,087

Consumer

 

 

 

 
9,133

 
9,133

Total loans
$
101

 
$

 
$

 
$
101

 
$
1,002,593

 
$
1,002,694

_________________ 

(1) There were no loans 90 days and greater past due and still accruing interest at December 31, 2017.
(2) Net of LIP.





19


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


Nonaccrual Loans. The following table is a summary of nonaccrual loans by loan type at the dates indicated:

 
September 30, 2018
 
December 31, 2017
 
(In thousands)
One-to-four family residential
$
113

 
$
128

Commercial real estate
325

 

Consumer
46

 
51

Total nonaccrual loans
$
484

 
$
179


During the three and nine months ended September 30, 2018, interest income that would have been recognized had these nonaccrual loans been performing in accordance with their original terms was $4,000 and $10,000, respectively. For the three and nine months ended September 30, 2017, foregone interest on nonaccrual loans was $3,000 and $21,000, respectively.

The following tables summarize the loan portfolio by type and payment status at the dates indicated:

 
September 30, 2018
 
One-to-Four
Family
Residential
 
Multifamily
 
Commercial
Real Estate
 
Construction/
Land
 
Business
 
Consumer
 
Total (1)
 
(In thousands)
Performing (2)
$
327,811

 
$
176,521

 
$
359,936

 
$
103,009

 
$
29,655

 
$
12,373

 
$
1,009,305

Nonperforming (3)
113

 

 
325

 

 

 
46

 
484

Total loans
$
327,924

 
$
176,521

 
$
360,261

 
$
103,009

 
$
29,655

 
$
12,419

 
$
1,009,789

_____________

(1) 
Net of LIP.
(2) 
There were $184.6 million of owner-occupied one-to-four family residential loans and $143.2 million of non-owner occupied one-to-four family residential loans classified as performing.
(3) 
The $113,000 of one-to-four family residential loans classified as nonperforming are all owner-occupied.
 
December 31, 2017
 
One-to-Four
Family
Residential
 
Multifamily
 
Commercial
Real Estate
 
Construction/
Land
 
Business
 
Consumer
 
Total (1)
 
(In thousands)
Performing (2)
$
278,527

 
$
184,902

 
$
361,299

 
$
145,618

 
$
23,087

 
$
9,082

 
$
1,002,515

Nonperforming (3)
128

 

 

 

 

 
51

 
179

Total loans
$
278,655

 
$
184,902

 
$
361,299

 
$
145,618

 
$
23,087

 
$
9,133

 
$
1,002,694

_____________

(1) Net of LIP.    
(2) There were $148.2 million of owner-occupied one-to-four family residential loans and $130.3 million of non-owner occupied one-to-four family residential loans classified as performing.
(3) The $128,000 of one-to-four family residential loans classified as nonperforming are all owner-occupied.

Impaired Loans. 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 original loan document. There were no funds committed to be advanced in connection with impaired loans at either September 30, 2018, or December 31, 2017.

20


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



The following tables present a summary of loans individually evaluated for impairment by loan type at the dates indicated:

 
September 30, 2018

Recorded Investment (1)
 
Unpaid Principal Balance (2)
 
Related Allowance
 
(In thousands)
Loans with no related allowance:
 
 
 
 
 
  One-to-four family residential:

 

 

      Owner occupied
$
1,045

 
$
1,213

 
$

      Non-owner occupied
4,857

 
4,857

 

  Multifamily
1,116

 
1,116

 

   Commercial real estate
2,556

 
2,556

 

   Consumer
89

 
141

 

Total
9,663

 
9,883

 

 
 
 
 
 
 
Loans with an allowance:


 


 


  One-to-four family residential:


 


 


      Owner occupied
516

 
562

 
23

      Non-owner occupied
3,153

 
3,174

 
63

   Commercial real estate
370

 
370

 
7

Total
4,039

 
4,106

 
93

 
 
 
 
 
 
Total impaired loans:


 


 


  One-to-four family residential:


 


 


      Owner occupied
1,561

 
1,775

 
23

      Non-owner occupied
8,010

 
8,031

 
63

   Multifamily
1,116

 
1,116

 

   Commercial real estate
2,926

 
2,926

 
7

   Consumer
89

 
141

 

Total
$
13,702

 
$
13,989

 
$
93

_________________ 

(1) Represents the loan balance less charge-offs.
(2) Contractual loan principal balance.




21


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


 
December 31, 2017
 
Recorded Investment (1)
 
Unpaid Principal Balance (2)
 
Related Allowance
 
(In thousands)
Loans with no related allowance:
 
 
 
 
 
  One-to-four family residential:
 
 
 
 
 
      Owner occupied
$
1,321

 
$
1,516

 
$

      Non-owner occupied
8,409

 
8,409

 

  Multifamily
1,134

 
1,134

 

   Commercial real estate
1,065

 
1,065

 

   Consumer
94

 
144

 

Total
12,023

 
12,268

 

 
 
 
 
 
 
Loans with an allowance:
 
 
 
 
 
  One-to-four family residential:
 
 
 
 
 
      Owner occupied
522

 
568

 
5

      Non-owner occupied
3,310

 
3,332

 
111

   Commercial real estate
2,129

 
2,129

 
19

Total
5,961

 
6,029

 
135

 
 
 
 
 
 
Total impaired loans:
 
 
 
 
 
  One-to-four family residential:
 
 
 
 
 
      Owner occupied
1,843

 
2,084

 
5

      Non-owner occupied
11,719

 
11,741

 
111

   Multifamily
1,134

 
1,134

 

   Commercial real estate
3,194

 
3,194

 
19

   Consumer
94

 
144

 

Total
$
17,984

 
$
18,297

 
$
135

_________________ 

(1) Represents the loan balance less charge-offs.
(2) Contractual loan principal balance.



22


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



The following tables present the average recorded investment in loans individually evaluated for impairment and the interest income recognized for the three and nine months ended September 30, 2018 and 2017:

 
Three Months Ended September 30, 2018
 
Nine Months Ended September 30, 2018
 
Average Recorded Investment
 
Interest Income Recognized
 
Average Recorded Investment
 
Interest Income Recognized
 
(In thousands)
Loans with no related allowance:
 
 
 
 
 
 
 
   One-to-four family residential:
 
 
 
 
 
 
 
      Owner occupied
$
1,049

 
$
18

 
$
1,182

 
$
55

      Non-owner occupied
5,112

 
83

 
6,385

 
298

Multifamily
1,119

 
19

 
1,125

 
55

Commercial real estate
2,402

 
42

 
1,732

 
133

Consumer
90

 
2

 
92

 
6

Total
9,772

 
164

 
10,516

 
547


 
 
 
 
 
 
 
Loans with an allowance:
 
 
 
 
 
 
 
   One-to-four family residential:
 
 
 
 
 
 
 
      Owner occupied
517

 
9

 
519

 
26

      Non-owner occupied
3,160

 
40

 
3,232

 
122

Commercial real estate
373

 
5

 
1,247

 
22

Total
4,050

 
54

 
4,998

 
170


 
 
 
 
 
 
 
Total impaired loans:
 
 
 
 
 
 
 
   One-to-four family residential:
 
 
 
 
 
 
 
      Owner occupied
1,566

 
27

 
1,701

 
81

      Non-owner occupied
8,272

 
123

 
9,617

 
420

Multifamily
1,119

 
19

 
1,125

 
55

Commercial real estate
2,775

 
47

 
2,979

 
155

Consumer
90

 
2

 
92

 
6

Total
$
13,822

 
$
218

 
$
15,514

 
$
717


23


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


 
Three Months Ended September 30, 2017
 
Nine Months Ended September 30, 2017
 
Average Recorded Investment
 
Interest Income Recognized
 
Average Recorded Investment
 
Interest Income Recognized
 
(In thousands)
Loans with no related allowance:
 
 
 
 
 
 
 
   One-to-four family residential:
 
 
 
 
 
 
 
      Owner occupied
$
1,658

 
$
22

 
$
1,886

 
$
69

      Non-owner occupied
11,395

 
158

 
13,445

 
485

Multifamily
1,143

 
19

 
1,251

 
56

Commercial real estate
2,693

 
49

 
2,818

 
135

Consumer
97

 
2

 
99

 
6

Total
16,986

 
250

 
19,499

 
751

 
 
 
 
 
 
 
 
Loans with an allowance:
 
 
 
 
 
 
 
   One-to-four family residential:
 
 
 
 
 
 
 
      Owner occupied
1,099

 
10

 
1,495

 
22

      Non-owner occupied
3,343

 
47

 
3,773

 
128

Commercial real estate
745

 
10

 
749

 
31

Construction/land

 

 
124

 

Total
5,187

 
67

 
6,141

 
181

 
 
 
 
 
 
 
 
Total impaired loans:
 
 
 
 
 
 
 
   One-to-four family residential:
 
 
 
 
 
 
 
      Owner occupied
2,757

 
32

 
3,381

 
91

      Non-owner occupied
14,738

 
205

 
17,218

 
613

Multifamily
1,143

 
19

 
1,251

 
56

Commercial real estate
3,438

 
59

 
3,567

 
166

Construction/land

 

 
124

 

Consumer
97

 
2

 
99

 
6

Total
$
22,173

 
$
317

 
$
25,640

 
$
932



Troubled Debt Restructurings. Certain loan modifications are accounted for as troubled debt restructured loans (“TDRs”). At September 30, 2018, the TDR portfolio totaled $13.2 million. At December 31, 2017, the TDR portfolio totaled $17.8 million. At both dates, all TDRs were performing according to their modified repayment terms.

At September 30, 2018, the Company had no 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 as part of the calculation of the ALLL. No loans accounted for as TDRs were charged-off to the ALLL for the three months ended September 30, 2018 and 2017.

The following tables present TDR modifications for the periods indicated and their recorded investment prior to and after the modification:


24


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


 
Three Months Ended September 30, 2018
 
Nine Months Ended September 30, 2018
 
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)
One-to-four family residential
 
 
 
 
 
 
 
 
 
 
 
Advancement of maturity date
1
 
563

 
563

 
1
 
563

 
563

Commercial
 
 
 
 
 
 
 
 
 
 
 
Advancement of maturity date

 
$

 
$

 
1

 
$
1,124

 
$
1,124

Total
1

 
$
563

 
$
563

 
2

 
$
1,687

 
$
1,687

 
Three Months Ended September 30, 2017
 
Nine Months Ended September 30, 2017
 
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)
One-to-four family residential
 
 
 
 
 
 
 
 
 
 
 
Principal and interest with interest rate concession and advancement of maturity date
1

 
$
524

 
$
524

 
8

 
$
2,492

 
$
2,492

Total
1

 
$
524

 
$
524

 
8

 
$
2,492

 
$
2,492


TDRs that default after they have been modified are typically evaluated individually on a collateral basis. Any additional impairment is charged to the ALLL. For the three and nine months ended September 30, 2018, and September 30, 2017, no loans that had been modified in the previous 12 months defaulted.

Credit Quality Indicators. The Company utilizes a nine-category risk rating system and assigns 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 include assets, such as cash secured loans with funds on deposit with the Bank, where there is virtually no credit risk. Pass credits also include credits that are on the Company’s 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 do not expose the Company to sufficient risk to warrant adverse classification in the substandard, doubtful or loss categories. 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 the Company 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 Company. There were no loans classified as doubtful or loss at September 30, 2018, and December 31, 2017.
        
The following tables represent a summary of loans by type and risk category at the dates indicated:

25


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


 
September 30, 2018
 
One-to-Four
Family
Residential
 
Multifamily
 
Commercial
Real Estate
 
Construction/ 
Land
 
Business
 
Consumer
 
Total (1)
 
(In thousands)
Risk Rating:
 
 
 
 
 
 
 
 
 
 
 
 
 
   Pass
$
325,509

 
$
176,521

 
$
359,021

 
$
103,009

 
$
29,655

 
$
12,373

 
$
1,006,088

   Special mention
1,762

 

 
370

 

 

 

 
2,132

   Substandard
653

 

 
870

 

 

 
46

 
1,569

Total loans
$
327,924

 
$
176,521

 
$
360,261

 
$
103,009

 
$
29,655

 
$
12,419

 
$
1,009,789

 _____________ 

(1) Net of LIP.

 
December 31, 2017
 
One-to-Four
Family
Residential
 
Multifamily
 
Commercial
Real Estate
 
Construction/
Land
 
Business
 
Consumer
 
Total (1)
 
(In thousands)
Risk Rating:
 
 
 
 
 
 
 
 
 
 
 
 
 
   Pass
$
275,653

 
$
184,902

 
$
358,285

 
$
145,618

 
$
23,087

 
$
8,893

 
$
996,438

   Special mention
2,329

 

 
2,459

 

 

 
188

 
4,976

   Substandard
673

 

 
555

 

 

 
52

 
1,280

Total loans
$
278,655

 
$
184,902

 
$
361,299

 
$
145,618

 
$
23,087

 
$
9,133

 
$
1,002,694

  _____________ 

(1) Net of LIP.

Note 6 - Other Real Estate Owned

OREO includes properties acquired by the Company through foreclosure and deed in lieu of foreclosure. The following table is a summary of OREO activity during the periods shown: 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
 
(In thousands)
Balance at beginning of period
$
483

 
$
1,825

 
$
483

 
$
2,331

Gross proceeds from sale of OREO

 

 

 
(461
)
Gain on sale of OREO

 

 

 
5

Market value adjustments

 

 

 
(50
)
Balance at end of period
$
483

 
$
1,825

 
$
483

 
$
1,825

 
For the three and nine months ended September 30, 2018, there were no OREO properties sold and no market value adjustments taken on the remaining properties in OREO. During the nine months ended September 30, 2017, a $50,000 market value adjustment was recognized prior to the sale of the one OREO property sold during that period. OREO at September 30, 2018, consisted of $483,000 in commercial real estate properties. At September 30, 2018, foreclosure proceedings were underway on a $325,000 nonaccrual commercial loan and there were no loans secured by residential real estate properties for which formal foreclosure proceedings were in process.


26


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


Note 7 - Fair Value

The fair value of financial instruments presented in this note, with the exception of loans receivable, are based on the same methodology as presented in Note 7 of the Notes to Consolidated Financial Statements contained in the Company’s 2017 10-K. The Company has adopted ASU 2016-01, and therefore is measuring the fair value of loans receivable under the exit price notion rather than the previous method of entry price notion. Under the entry price notion, the fair value estimate of loans receivable was based on discounted cash flow. At September 30, 2018, the exit price notion used to estimate the fair value of loans receivable was based on similar techniques, with the addition of current origination spreads, liquidity premiums, or credit adjustments. The fair value of nonperforming loans is based on the underlying value of the collateral for periods prior to and after adoption of ASU 2016-01.

The Company determines the fair values of its 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 its estimate 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 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 the Company’s 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 measured at fair value on a recurring basis (there were no transfers between Level 1, Level 2 and Level 3 recurring measurements) at September 30, 2018 and December 31, 2017:
 
Fair Value Measurements at September 30, 2018
 
Fair Value Measurements
 
Quoted Prices in Active Markets for Identical Assets (Level 1)
 
Significant Other Observable Inputs (Level 2)
 
Significant Unobservable Inputs (Level 3)
 
(In thousands)
Investments available-for-sale:
 
 
 
 
 
 
 
Mortgage-backed investments:
 
 
 
 
 
 
 
Fannie Mae
$
25,334

 
$

 
$
25,334

 
$

Freddie Mac
5,212

 

 
5,212

 

Ginnie Mae
21,979

 

 
21,979

 

Other
6,015

 

 
6,015

 

Municipal bonds
10,466

 

 
10,466

 

U.S. Government agencies
48,718

 

 
48,718

 

Corporate bonds
23,144

 

 
23,144

 

Total available-for-sale
investments
140,868

 

 
140,868

 

Derivative fair value asset
2,454

 

 
2,454

 

Total
$
143,322

 
$

 
$
143,322

 
$


27


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


 
Fair Value Measurements at December 31, 2017
 
Fair Value Measurements
 
Quoted Prices in Active Markets for Identical Assets (Level 1)
 
Significant Other Observable Inputs (Level 2)
 
Significant Unobservable Inputs (Level 3)
 
(In thousands)
Investments available-for-sale:
 
 
 
 
 
 
 
Mortgage-backed investments:
 
 
 
 
 
 
 
Fannie Mae
$
26,564

 
$

 
$
26,564

 
$

Freddie Mac
5,472

 

 
5,472

 

Ginnie Mae
21,576

 

 
21,576

 

Municipal bonds
13,395

 

 
13,395

 

U.S. Government agencies
42,633

 

 
42,633

 

Corporate bonds
22,602

 

 
22,602

 

Total available-for-sale
investments
132,242

 

 
132,242

 

Derivative fair value asset
1,526

 

 
1,526

 

Total
$
133,768

 
$

 
$
133,768

 
$


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 measured at fair value on a nonrecurring basis at September 30, 2018 and December 31, 2017
 
Fair Value Measurements at September 30, 2018
 
Fair Value
Measurements
 
Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
 
Significant
Other
Observable
Inputs (Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
(In thousands)
Impaired loans (included in loans
receivable, net)
(1)
$
13,609

 
$

 
$

 
$
13,609

OREO
483

 

 

 
483

Total
$
14,092

 
$

 
$

 
$
14,092

_____________

(1) 
Total fair value of impaired loans is net of $93,000 of specific reserves on performing TDRs.

 
Fair Value Measurements at December 31, 2017
 
Fair Value
Measurements
 
Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
 
Significant
Other
Observable
Inputs (Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
(In thousands)
Impaired loans (included in loans
receivable, net)
(1)
$
17,849

 
$

 
$

 
$
17,849

OREO
483

 

 

 
483

Total
$
18,332

 
$

 
$

 
$
18,332

_____________

(1)    Total fair value of impaired loans is net of $135,000 of specific reserves on performing TDRs.

28


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


 
The fair value of impaired loans reflects the exit price and is calculated using the collateral value method or on a discounted cash flow basis. Inputs used in the collateral value method include appraised values, less estimated costs to sell. Some of these inputs may not be observable in the marketplace. Appraised values may be discounted based on management’s knowledge of the marketplace, subsequent changes in market conditions, or management’s knowledge of the borrower.

OREO properties are measured at the lower of their carrying amount or fair value, less estimated 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 estimated costs to sell, an impairment loss is recognized.

The following tables present quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a nonrecurring basis at September 30, 2018 and December 31, 2017:
 
September 30, 2018
 
Fair Value
 
Valuation Technique
 
Unobservable Input(s)
 
Range (Weighted Average)
 
(Dollars in thousands)
Impaired Loans
$
13,609

 
Market approach
 
Appraised value discounted by market or borrower conditions
 
0.0%
(0.00%)
 
 
 
 
 
 
 
 
OREO
$
483

 
Market approach
 
Appraised value less selling costs
 
0.0%
(0.00%)

 
December 31, 2017
 
Fair Value
 
Valuation Technique
 
Unobservable Input(s)
 
Range (Weighted Average)
 
(Dollars in thousands)
Impaired Loans
$
17,849

 
Market approach
 
Appraised value discounted by market or borrower conditions
 
0.0%
(0.0%)
 
 
 
 
 
 
 
 
OREO
$
483

 
Market approach
 
Appraised value less selling costs
 
0.0%
(0.0%)

The carrying amounts and estimated fair values of financial instruments were as follows at the dates indicated: 

29


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


 
September 30, 2018
 
 
 
Estimated
 
Fair Value Measurements Using:
 
Carrying Value
 
Fair Value
 
Level 1
 
Level 2
 
Level 3
 
(In thousands)
Financial Assets:
 
 
 
 
 
 
 
 
 
Cash on hand and in banks
$
7,167

 
$
7,167

 
$
7,167

 
$

 
$

Interest-earning deposits with banks
19,094

 
19,094

 
19,094

 

 

Investments available-for-sale
140,868

 
140,868

 

 
140,868

 

Loans receivable, net
995,557

 
977,320

 

 

 
977,320

FHLB stock
7,410

 
7,410

 

 
7,410

 

Accrued interest receivable
4,664

 
4,664

 

 
4,664

 

Derivative fair value asset
2,454

 
2,454

 

 
2,454

 

 
 
 
 
 
 
 
 
 
 
Financial Liabilities:
 

 
 

 
 

 
 

 
 
Deposits
440,265

 
440,265

 
440,265

 

 

Certificates of deposit, retail
373,931

 
370,948

 

 
370,948

 

Certificates of deposit, brokered
102,083

 
101,812

 

 
101,812

 

Advances from the FHLB
149,000

 
145,108

 

 
145,108

 

Accrued interest payable
541

 
541

 

 
541

 


 
December 31, 2017
 
 
 
Estimated
 
Fair Value Measurements Using:
 
Carrying Value
 
Fair Value
 
Level 1
 
Level 2
 
Level 3
 
(In thousands)
Financial Assets:
 
 
 
 
 
 
 
 
 
Cash on hand and in banks
$
9,189

 
$
9,189

 
$
9,189

 
$

 
$

Interest-earning deposits with banks
6,942

 
6,942

 
6,942

 

 

Investments available-for-sale
132,242

 
132,242

 

 
132,242

 

Loans receivable, net
988,662

 
980,578

 

 

 
980,578

FHLB stock
9,882

 
9,882

 

 
9,882

 

Accrued interest receivable
4,084

 
4,084

 

 
4,084

 

Derivative fair value asset
1,526

 
1,526

 

 
1,526

 

 
 
 
 
 
 
 
 
 
 
Financial Liabilities:
 

 
 

 
 

 
 

 
 
Deposits
430,750

 
430,750

 
430,750

 

 

Certificates of deposit, retail
333,264

 
331,199

 

 
331,199

 

Certificates of deposit, brokered
75,488

 
74,947

 

 
74,947

 

Advances from the FHLB
216,000

 
214,477

 

 
214,477

 

Accrued interest payable
326

 
326

 

 
326

 


Fair value estimates are measured at the exit price notion. The methods and calculation assumptions are set forth below for the Company’s 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-earning deposits with banks, FHLB stock, accrued interest

30


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


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. The fair value is therefore equal to the book value.

Investments available-for-sale: 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: Prior to the adoption of ASU 2016-01, loan fair value estimates were primarily calculated using discounted cash flows. With the adoption of ASU 2016-01, the fair value of loans receivable at September 30, 2018 were calculated from inputs reflective of current market pricing for similar instruments, to include current origination spreads, liquidity premiums, and credit adjustments. The fair value of nonperforming loans is estimated using the fair value of the underlying collateral.

Derivatives: The fair value of derivatives is based on dealer quotes, pricing models, discounted cash flow methodologies or similar techniques for which the determination of fair value may require significant management judgment or estimation.

Liabilities: The fair value of deposits with no stated maturity, such as statement savings, interest-bearing checking 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 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 8 - Derivatives

The Company uses a derivative financial instrument, which qualifies as a cash flow hedge, to manage the risk of changes in future cash flows due to interest rate fluctuations. The hedged instrument is a $50.0 million three-month FHLB advance that will be renewed every three months at the fixed interest rate at that time. The agreement has a five-year term and stipulates that the counterparty will pay the Company interest at three-month LIBOR and the Company will pay fixed interest of 1.34% on the $50.0 million notional amount. The Company pays or receives the net interest amount quarterly and includes this amount as part of interest expense on the Consolidated Income Statement.

Quarterly, the effectiveness evaluation is based upon the fluctuation of the interest the Company pays to the FHLB for the hedge instrument as compared to the three-month LIBOR interest received from the counterparty. At September 30, 2018, the fair value of the cash flow hedge of $2.5 million was reported with other assets. The tax effected amount of $1.9 million was included in Accumulated Other Comprehensive Income. There were no amounts recorded in the Consolidated Income Statements for the quarters ended September 30, 2018 or 2017, related to ineffectiveness.

Fair value for this derivative instrument, which generally changes as a result of changes in the level of market interest rates, is estimated based on dealer quotes and secondary market sources.

The following table presents the fair value of this derivative instrument as of September 30, 2018 and December 31, 2017:

31


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


 
Balance Sheet Location
 
Fair Value at
September 30, 2018
 
Fair Value at
December 31, 2017
 
(In thousands)
Interest rate swap on FHLB debt
   designated as cash flow hedge
Other Assets
 
$
2,454

 
$
1,526

 
 
 
 
 
 
Total derivatives
 
 
$
2,454

 
$
1,526


The following table presents the effect of this derivative instrument on the Consolidated Statements of Comprehensive Income for the quarters ended September 30, 2018, and December 31, 2017:

 
Balance Sheet Location
 
Amount Recognized in OCI at
September 30, 2018
 
Amount Recognized in
OCI at
December 31, 2017
 
(In thousands)
Interest rate swap on FHLB debt
designated as cash flow hedge
Other assets
 
$
70

 
$
125



Note 9 - Stock-Based Compensation

In June 2016, First Financial Northwest’s shareholders approved the First Financial Northwest, Inc. 2016 Equity Incentive Plan (“2016 Plan”). This plan provides for the granting of incentive stock options (“ISO”), non-qualified stock options (“NQSO”), restricted stock and restricted stock units until June 2026. The 2016 Plan established 1,400,000 shares available to grant with a maximum of 400,000 of these shares available to grant as restricted stock awards. Each share issued as a restricted stock award counts as two shares towards the total shares available to award.

Under the 2016 Plan, the vesting date for each option award or restricted stock award is determined by an award committee and specified in the award agreement. In the case of restricted stock awards granted in lieu of cash payments of directors’ fees, the grant date is used as the vesting date unless the award agreement provides otherwise.

As a result of the approval of the 2016 Plan, the First Financial Northwest, Inc. 2008 Equity Incentive Plan (“2008 Plan”) was frozen and no additional awards will be made. At September 30, 2018, there were no unvested shares of restricted stock awards under the 2008 Plan. In addition, 43,000 stock options granted under the 2008 Plan are expected to vest and be available for exercise, and an additional 272,000 stock options from the 2008 Plan were available for exercise at September 30, 2018, subject to the 2008 Plan provisions. At September 30, 2018, there were 1,290,670 total shares available for grant under the 2016 Plan, including 345,335 shares available to be granted as restricted stock.

For the three months ended September 30, 2018 and 2017, total compensation expense for both the 2008 and 2016 Plans was $130,000 and $104,000, respectively, and the related income tax benefit was $27,000 and $36,000, respectively.

For the nine months ended September 30, 2018 and 2017, total compensation expense for both the 2008 and 2016 Plans was $539,000 and $505,000, respectively, and the related income tax benefit was $113,000 and $177,000, respectively.

Stock Options

Under the 2008 Plan, stock option awards were granted with an exercise price equal to the market price of First Financial Northwest’s common stock at the grant date. 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 10 years. Any unexercised stock options expires ten years after the grant date, or sooner in the event of the award recipient’s death, disability or termination of service with the Company and the Bank.

Under the 2016 Plan, the exercise price and vesting period for stock options are determined by the award committee and specified in the award agreement, however, the exercise price shall not be less than the fair market value of a share as of the grant date. Any unexercised stock option will expire 10 years after the award date or sooner in the event of the award recipient’s death, disability, retirement, or termination of service.


32


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


The fair value of each option award is estimated on the grant date 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. The historical volatility of the Company’s stock price over a specified period of time is used for the expected volatility assumption. First Financial Northwest bases the risk-free interest rate on the U.S. Treasury Constant Maturity Indices in effect on the date of the grant. First Financial Northwest 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.

Under certain conditions, a cashless exercise of vested stock options may occur by the option holder surrendering the number of options valued at the current stock price at the time of exercise to cover the total cost to exercise. The surrendered options are canceled and are unavailable for reissue.
        
A summary of the Company’s stock option plan awards and activity for the three and nine months ended September 30, 2018, follows: 

 
For the Three Months Ended September 30, 2018
 
Shares
 
Weighted-Average Exercise Price
 
Weighted-Average Remaining Contractual Term in Years
 
Aggregate Intrinsic Value
Outstanding at July 1, 2018
315,000

 
$
10.34

 

 
$
2,891,350

Exercised

 


 

 


Outstanding at September 30, 2018
315,000

 
10.34

 
5.24
 
1,962,100

Vested and expected to vest assuming a 3% forfeiture
rate over the vesting term
313,710

 
10.33

 
5.23
 
1,956,260

Exercisable at September 30, 2018
272,000

 
10.07

 
5.02
 
1,767,430

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
For the Nine Months Ended September 30, 2018
 
Shares
 
Weighted-Average Exercise Price
 
Weighted-Average Remaining Contractual Term in Years
 
Aggregate Intrinsic Value
Outstanding at January 1, 2018
452,940

 
$
10.21

 

 
$
2,402,096

Exercised
(137,940
)
 
9.90

 

 
1,112,026

Outstanding at September 30, 2018
315,000

 
10.34

 
5.24
 
1,962,100

Vested and expected to vest assuming a 3% forfeiture
    rate over the vesting term
313,710

 
10.33

 
5.23
 
1,956,260

Exercisable at September 30, 2018
272,000

 
10.07

 
5.02
 
1,767,430


As of September 30, 2018, there was $144,000 of total unrecognized compensation cost related to nonvested stock options granted under the 2008 Plan. The cost is expected to be recognized over the remaining weighted-average vesting period of 1.55 years. There were no stock options granted during the nine months ended September 30, 2018.

Restricted Stock Awards

The 2008 Plan authorized the grant of restricted stock awards to 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 grant date. The restricted stock awards’ fair value is equal to the stock price on the grant date. Shares awarded under this plan 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. The final vesting of shares previously granted under the 2008 Plan occurred during the quarter ended September 30, 2018.

33


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



The 2016 Plan authorizes the grant of restricted stock awards subject to vesting periods or terms as defined by the award committee and specified in the award agreement. Restricted stock awards granted in lieu of cash payments for directors’ fees are subject to immediate vesting on the grant date unless the award agreement provides otherwise.
    
A summary of changes in nonvested restricted stock awards for the three and nine months ended September 30, 2018, follows: 

For the Three Months Ended September 30, 2018

Shares
 
Weighted-Average
Grant Date
Fair Value
Nonvested at July 1, 2018
25,987

 
$
14.93

Granted

 

Vested
(5,000
)
 
10.88
Nonvested at September 30, 2018
20,987

 
15.90

Expected to vest assuming a 3% forfeiture rate over the vesting term
20,357

 
15.90

 
 
 
 
 
 
 
 
 
For the Nine Months Ended September 30, 2018
 
Shares
 
Weighted-Average
Grant Date
 Fair Value
Nonvested at January 1, 2018
5,000

 
10.88

Granted
30,179

 
17.14

Vested
(14,192
)
 
16.77

Nonvested at September 30, 2018
20,987

 
15.90

Expected to vest assuming a 3% forfeiture rate over the vesting term
20,357

 
15.90


As of September 30, 2018, there was $138,000 of total unrecognized compensation costs related to nonvested shares granted as restricted stock awards. The cost is expected to be recognized over the remaining weighted-average vesting period of five months.

Note 10 - Earnings Per Share

Per the provisions of FASB ASC 260, Earnings Per Share, nonvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents are participating securities and are included in the computation of EPS pursuant to the two-class method. The two-class method is an earnings allocation formula that determines earnings per share for each class of common stock and participating security according to dividends declared (or accumulated) and participation rights in undistributed earnings. ESOP shares are considered outstanding for basic and diluted earnings per share when the shares are committed to be released. Certain of the Company’s nonvested restricted stock awards qualify as participating securities.

Net income is allocated between the common stock and participating securities pursuant to the two-class method, based on their rights to receive dividends, participate in earnings, or absorb losses. Basic earnings per common shares is computed by dividing net earnings available to common shareholders by the weighted-average number of common shares outstanding during the period, excluding participating nonvested restricted shares.

The following table presents a reconciliation of the components used to compute basic and diluted earnings per share for the periods indicated:

34


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


 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
 
 
(Dollars in thousands, except share data)
Net income
 
$
2,792

 
$
1,861

 
$
12,736

 
$
6,073

Less: Earnings allocated to participating
securities
 
(5
)
 
(2
)
 
$
(24
)
 
$
(6
)
Earnings allocated to common shareholders
 
$
2,787

 
$
1,859

 
$
12,712

 
$
6,067

 
 
 
 
 
 
 
 
 
Basic weighted average common shares
outstanding
 
10,356,994

 
10,287,663

 
10,280,287

 
10,323,459

Dilutive stock options
 
101,350

 
126,044

 
117,645

 
142,755

Dilutive restricted stock grants
 
10,458

 
13,331

 
7,383

 
13,847

Diluted weighted average common shares outstanding
 
10,468,802

 
10,427,038

 
10,405,315

 
10,480,061

 
 
 
 
 
 
 
 
 
Basic earnings per share
 
$
0.27

 
$
0.18

 
$
1.24

 
$
0.59

Diluted earnings per share
 
$
0.27

 
$
0.18

 
$
1.22

 
$
0.58


Potential dilutive shares are excluded from the computation of earnings per share if their effect is anti-dilutive. For the three and nine months ended September 30, 2018, and September 30, 2017, there were no options to purchase shares of common stock that were omitted from the computation of diluted earnings per share because their effect would be anti-dilutive.

Note 11 - Branch Acquisition

On August 25, 2017, First Financial Northwest Bank completed the acquisition of four branches from Opus Bank, a California state-chartered commercial bank. The Branch Acquisition included four retail branches located in Woodinville, Clearview, Lake Stevens, and Smokey Point, Washington. The Bank acquired $74.7 million of retail deposits, prior to the fair value adjustment, one owned bank branch, three leased branches, and certain fixed assets at these branches. The purchase price of the Branch Acquisition paid by the Bank included a deposit premium of 3.125% of the average daily balance of acquired deposits for 20 days prior to the closing date, or $2.5 million; 80% of the fair market value of the owned branch, or $488,000; the net book value of fixed assets, or $56,000; and $14,000 for other pro rations and adjustments as of the closing date. Opus Bank paid the Bank $71.6 million in cash for the difference between these amounts and the total deposits assumed.

The Branch Acquisition was accounted for under the acquisition method of accounting, and accordingly, the assets received and liabilities assumed were recorded at their fair market value as of August 25, 2017. The application of the acquisition method of accounting resulted in recognition of a core deposit intangible asset (“CDI”) of $1.3 million and goodwill of $889,000. The acquired CDI has been determined to have a useful life of approximately ten years and is amortized on an accelerated basis. Goodwill is not amortized but will be evaluated for impairment on an annual basis, or more often if circumstances dictate, to determine if the carrying value remains appropriate.

The operating results of the Company include the operating results produced by the acquired liabilities and additional branch locations. For illustrative purposes, the following table provides certain unaudited pro forma information for the three and nine months ended September 30, 2017, with the information calculated as if the four Opus branches had been acquired as of January 1, 2017, the beginning of the year prior to the date of acquisition. The pro forma information is an estimate of the additional interest expense, noninterest income and noninterest expense that might have been incurred during this period. The unaudited pro forma statement does not include interest income earned on the investment of the acquired funds into either loans receivable or available-for-sale investment securities. Actual results would have differed from the unaudited pro forma information presented.

35


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


 
 
Unaudited Pro Forma
 
 
Three Months Ended September 30, 2017
 
Nine Months Ended September 30, 2017
 
 
(In thousands except share data)
Total revenues (net interest income plus noninterest income)
 
$
9,954

 
$
28,845

Net income
 
1,514

 
4,976

Earnings per share - basic
 
0.15

 
0.48

Earnings per share - diluted
 
0.14

 
0.47


The Company recognized no acquisition related expenses for the three months ended September 30, 2018, and $6,000 for the nine months ended September 30, 2018. For the three and nine months ended September 30, 2017, the Company recognized $222,000 and $542,000, respectively.

The following table includes noninterest expenses for the four acquired branches for the three and nine months ended September 30, 2018. These expenses are included in the Consolidated Income Statements in Item 1 of this report:

 
 
Three Months Ended September 30, 2018
 
Nine Months Ended
 September 30, 2018
 
 
(In thousands)
Salaries and employee benefits
 
$
251

 
$
792

Occupancy and equipment
 
91

 
309

Data processing
 
1

 
1

Marketing
 
7

 
23

Other general and administrative
 
15

 
58

Total noninterest expense
 
$
365

 
$
1,183


Note 12 - Revenue Recognition

In accordance with Topic 606, revenues are recognized when goods or services are transferred to the customer in exchange for the consideration the Company expects to be entitled to receive. To determine the appropriate recognition of revenue for transactions within the scope of Topic 606, the Company performs the following five steps: (i) identify the contract(s) with the customer; (ii) identify the separate performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the separate performance obligations in the contract; and (v) recognize revenue when the entity satisfies a performance obligation. A contract may not exist if there are doubts as to collectability of the amounts the Company is entitled to in exchange for the goods or services transferred. If a contract is determined to be within the scope of Topic 606, the Company recognizes revenue as it satisfies a performance obligation. The largest portion of the Company’s revenue is from net interest income which is not within the scope of Topic 606.

Disaggregation of Revenue

The following table includes the Company’s noninterest income disaggregated by type of service for the three and nine months ended September 30, 2018 and 2017:

36


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


 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30, 2018
 
September 30, 2017
 
September 30, 2018
 
September 30, 2017
 
 
(In thousands)
Gain (loss) on sale of investments (1)
 
$
1

 
$
47

 
$
(20
)
 
$
103

BOLI change in cash surrender value (1)
 
245

 
173

 
718

 
490

Wealth management revenue
 
145

 
252

 
400

 
699

Deposit related fees
 
63

 
56

 
197

 
155

Debit card and ATM fees
 
104

 
57

 
306

 
122

Loan related fees
 
163

 
61

 
353

 
215

Loan interest swap fees
 
110

 
83

 
180

 
205

Other
 
10

 
2

 
16

 
8

Total noninterest income
 
$
841

 
$
731

 
$
2,150

 
$
1,997

_______________
(1) Not within scope of Topic 606

For the three and nine months ended September 30, 2018, substantially all of the Company’s revenues under the scope of Topic 606 are for performance obligations satisfied at a specified date.

Revenues recognized within scope of Topic 606

Wealth management revenue: Our wealth management revenue consists of commissions received on the investment portfolio managed by Bank personnel but held by a third party. Commissions are earned on brokerage services and advisory services based on contract terms at the onset of a new customer’s investment agreement or quarterly for ongoing services. Commissions are paid by the third party to the Bank when the performance obligation has been completed by both entities.

Deposit related fees: Fees are earned on our deposit accounts for various products or services performed for our customers. Fees include business account fees, non-sufficient fund fees, stop payment fees, wire services, safe deposit box, and others. These fees are recognized on a daily or monthly basis, depending on the type of service.

Debit card and ATM fees: Fees are earned when a debit card issued by the Bank is used or when other bank’s customers use our ATM services. Revenue is recognized at the time the fees are collected from the customer’s account or remitted by the VISA interchange network.

Loan related fees: Noninterest fee income is earned on our loans for servicing or annual fees on certain loan types.

Loan interest swap fees: For loans participating in an interest rate swap agreement, fees are earned at the onset of the agreement and are not contingent on any future performance or term length of the loan itself. The performance obligation is satisfied by entering into the contract and receipt of the fees from the counterparty.

Other: Fees earned on other services, such as merchant services or occasional non-recurring type services, are recognized at the time of the event or the applicable billing cycle.

Contract Balances

At September 30, 2018, the Company had no contract liabilities where the Company had an obligation to transfer goods or services for which the Company had already received consideration. In addition, the Company had no material performance obligations as of this date.     

Note 13 - Subsequent Events

On October 25, 2018, the Company announced that the Company’s Board of Directors declared a quarterly cash dividend of $0.08 per share on the Company’s outstanding common stock. The cash dividend will be payable on December 14, 2018, to shareholders of record as of the close of business on November 30, 2018. Also on October 25, 2018, the Board of Directors authorized the repurchase of approximately 5% of the Company’s common stock, or 550,000 shares. The plan allows for the

37


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


repurchase from November 5, 2018 through May 3, 2019, under a pre-arranged stock trading plan in accordance with guidelines specified under Rule 10b5-1 of the Securities Exchange Act of 1934, as amended. Repurchases under the Company’s Rule 10b5-1 plan will be administered through an independent broker subject to SEC requirements as well as certain price, market volume, and timing constraints as specified in the plan. As a result, there can be no assurance as to the exact number of shares, if any, that will be repurchased under the plan.

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 “believes,” “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, that may be affected by deterioration in the housing and commercial real estate markets, and 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 Federal Reserve Bank of San Francisco and our bank subsidiary by the Federal Deposit Insurance Corporation (“FDIC”), the Washington State Department of Financial Institutions, Division of Banks (“DFI”) or other regulatory authorities, including the possibility that any such regulatory authority may initiate an enforcement action against the Company or the Bank which could require us to increase our reserve for loan losses, write-down assets, change our regulatory capital position, affect our ability to borrow funds or maintain or increase deposits, or impose additional requirements or restrictions on us, any of which could adversely affect our liquidity and earnings; our ability to pay dividends on our common stock; our ability to attract and retain deposits; increases in premiums for deposit insurance; our ability to control operating costs and expenses; the use of estimates in determining the fair value 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; disruptions, security breaches, or other adverse events, failures or interruptions in, or attacks on, our information technology systems or on the third-party vendors who perform several of our critical processing functions; 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; costs and effects of litigation, including settlements and judgments; 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, including as a result of Basel III; the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank 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 detailed in our filings with the U.S. Securities and Exchange Commission (“SEC”), including our Annual Report on Form 10-K for the year ended December 31, 2017 (“2017 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

38



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.

Overview

First Financial Northwest Bank (“the Bank”) is a wholly-owned subsidiary of First Financial Northwest, Inc. (“the Company”) and, as such, comprises substantially all of the activity for the Company. First Financial Northwest Bank was a community-based savings bank until February 4, 2016, when the Bank converted to a Washington chartered commercial bank reflecting the commercial banking services it now provides to its customers. The Bank primarily serves King, Pierce, Snohomish, and Kitsap counties, Washington, through its full-service banking office and headquarters in Renton, Washington, as well as four retail branches in King County, Washington and five retail branches in Snohomish County, Washington. On August 25, 2017, the Bank completed the purchase of four retail branches in Woodinville in King County, and Lake Stevens, Clearview, and Smokey Point communities in Snohomish County and acquired $74.7 million in deposits. The Branch Acquisition expanded our retail footprint and provided an opportunity to extend our unique brand of community banking into those communities. The Bank has received FDIC approval to open a new branch in Kent, Washington. This additional King County location is expected to open in the first quarter of 2019.

The Bank’s business consists predominantly of attracting deposits from the general public, combined with borrowing from the Federal Home Loan Bank of Des Moines (“FHLB”) and raising funds in the wholesale market, then utilizing these funds to originate one-to-four family residential, multifamily, commercial real estate, construction/land, business, and consumer loans. Our current business strategy emphasizes commercial real estate, construction, one-to-four family residential, and multifamily lending. We anticipate that construction/land lending will continue to be a strong element of our total loan portfolio in future periods. We will continue to take a disciplined approach in our construction/land lending by concentrating our efforts on residential loans to builders known to us, including multifamily loans to developers with proven success in this type of construction. These short-term loans typically mature in six to eighteen months. In addition, the funding is usually not fully disbursed at origination, thereby reducing our net loans receivable in the short term. We have also geographically expanded our loan portfolio through loan purchases or loan participations of commercial and multifamily real estate loans that are outside of our primary market area. Through our efforts to geographically diversify our loan portfolio with direct loan originations, loan participations, or loan purchases, our portfolio includes loans in 24 other states, including concentrations in California, Oregon and Arizona of $39.8 million, $11.9 million and $14.7 million, respectively.

In support of our strategic growth plan, the Bank has developed a national line of business to originate and service aircraft loans. These loans are collateralized by new or used, single-engine piston aircraft to light jets for business or personal use which have demonstrated an acceptable valuation history under industry accepted valuation resources. These loans will generally range in size from $250,000 to $8.0 million with underwriting guidelines primarily based on the asset value of the collateral with secondary emphasis placed on the ability of the borrower to repay the loan. We began originating aircraft loans in the fourth quarter of 2016. At September 30, 2018, our business loans included $10.2 million in fixed and adjustable rate aircraft loans.

Our primary source of revenue is interest income, which is the income that we earn on our loans and investments. Interest expense is the interest that we pay on our deposits and borrowings. Net interest income is the difference between interest income and interest expense. Changes in levels of interest rates affect interest income and interest expense differently and, thus, impacts our net interest income.

An offset to net interest income is the provision for loan losses which is required to establish the allowance for loan and lease losses (“ALLL”) at a level that adequately provides for probable losses inherent in our loan portfolio. As our loan portfolio increases, or due to an increase for probable losses inherent in our loan portfolio, our ALLL may increase, resulting in a decrease to net interest income. Improvements in loan risk ratings, increases in property values, or receipt of recoveries of amounts previously charged off may partially or fully offset any increase to ALLL due to loan growth or an increase in probable loan losses.

Noninterest income is generated from various loan or deposit fees, increases in the cash surrender value of bank owned life insurance (“BOLI”), and revenue earned on our wealth management brokerage services. This income is increased or partially offset by any net gain or loss on sales of investment securities.

Our noninterest expenses consist primarily of salaries and employee benefits, professional fees, regulatory assessments, occupancy and equipment, and other general and administrative expenses. Salaries and employee benefits consist primarily of the salaries and wages paid to our employees, payroll taxes, expenses for retirement, and other employee benefits. OREO-related expenses consist primarily of maintenance and costs of utilities for the OREO inventory, market valuation adjustments, build-out expenses, gains and losses from OREO sales, legal fees, real estate taxes, and insurance related to the properties included in the

39



OREO inventory. Professional fees include legal services, auditing and accounting services, computer support services, and other professional services in support of strategic plans. Occupancy and equipment expenses, which are the fixed and variable costs of buildings and equipment, consist primarily of real estate taxes, depreciation expenses, maintenance, and costs of utilities. Also included in noninterest expense is the change to the Company’s unfunded commitment reserve which is reflected in general and administrative expenses. This unfunded commitment reserve expense can vary significantly each quarter, based on the amount believed by management to be sufficient to absorb estimated probable losses related to unfunded credit facilities, and reflects changes in the amounts that the Company has committed to fund but has not yet disbursed.

Critical Accounting Policies

Our significant accounting policies are fundamental to understanding our results of operations and financial condition because they require that we use estimates and assumptions that may affect the value of our assets or liabilities and our financial results. These policies are critical because they require management to make difficult, subjective, and complex judgments about matters that are inherently uncertain and because it is likely that materially different amounts would be reported under different conditions or by using different assumptions. These policies govern the ALLL, the valuation of OREO, and the calculation of deferred taxes, fair values, and other-than-temporary impairments on the market value of investments and derivatives. These policies and estimates are described in further detail in Part II, Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 1, Summary of Significant Accounting Policies in the 2017 Form 10-K. There have not been any material changes in the Company’s critical accounting policies and estimates as compared to the disclosure contained in the 2017 Form 10-K.

Comparison of Financial Condition at September 30, 2018 and December 31, 2017

Total assets were $1.23 billion at September 30, 2018, an increase of 2.0%, from $1.21 billion at December 31, 2017. The following table details the $24.6 million net change in the composition of our assets at September 30, 2018 from December 31, 2017.
 
Balance at
September 30, 2018
 
Change from December 31, 2017
 
Percent Change
 
(Dollars in thousands)
Cash on hand and in banks                                           
$
7,167

 
$
(2,022
)
 
(22.0
)%
Interest-earning deposits with banks                                           
19,094

 
12,152

 
175.1

Investments available-for-sale, at fair value
140,868

 
8,626

 
6.5

Loans receivable, net                                           
995,557

 
6,895

 
0.7

FHLB stock, at cost                                
7,410

 
(2,472
)
 
(25.0
)
Accrued interest receivable
4,664

 
580

 
14.2

Deferred tax assets, net
2,092

 
881

 
72.7

OREO
483

 

 

Premises and equipment, net
21,277

 
663

 
3.2

BOLI, net
29,745

 
718

 
2.5

Prepaid expenses and other assets
4,460

 
(1,278
)
 
(22.3
)
Goodwill
889

 

 

Core deposit intangible
1,153

 
(113
)
 
(8.9
)
Total assets                                
$
1,234,859

 
$
24,630

 
2.0
 %

Interest-earning deposits with banks. Our interest-earning deposits with banks, consisting primarily of funds held at the Federal Reserve Bank of San Francisco (“FRB”), increased by $12.2 million from December 31, 2017, to September 30, 2018. These funds fluctuate based on our funding needs. Deposit growth late in the third quarter of 2018 resulted in an increase to our cash held at the FRB.

Investments available-for-sale. Our investments available-for-sale portfolio increased by $8.6 million during the first nine months of 2018. During this period, we purchased $33.0 million of securities which included four mortgage-backed securities, two corporate bonds, three tax-exempt municipal securities, four asset-backed securities, and four U.S. government agency bonds. These purchases were made to complete the restructuring of our available-for-sale investment securities that

40



began in December 2017, as well as to invest excess cash earning a nominal yield into higher-yielding assets. The purchases included certain longer-term securities as well as Community Reinvestment Act (“CRA”) qualified investments. During the nine months ended September 30, 2018, we sold $5.5 million of securities, had a $1.5 million security called, and maturities or early payoffs of securities of $8.2 million. At September 30, 2018, corporate bonds issued by financial institutions represented $23.1 million, or 16.4% of our investments available-for-sale and municipal bonds represented $10.5 million, or 7.4% of our investments available-for-sale.

The effective duration of the investments available-for-sale at September 30, 2018, was 3.1% as compared to 2.9% at December 31, 2017, partially due to the longer-term securities purchased during the year. Effective duration is a measure that attempts to quantify the anticipated percentage change in the value of an investment security (or portfolio) in the event of a 100 basis point change in market yields. Since the Bank’s portfolio includes securities with embedded options (including call options on bonds and prepayment options on mortgage-backed securities), management believes that effective duration is an appropriate metric to use as a tool when analyzing the Bank’s investment securities portfolio, as effective duration incorporates assumptions relating to such embedded options, including changes in cash flow assumptions as interest rates change.

Loans receivable. Net loans receivable increased by $6.9 million to $995.6 million at September 30, 2018, as compared to December 31, 2017. Loan originations of $237.9 million were supplemented with $19.1 million of loan purchases to offset loan repayments. During the first nine months of 2018, our one‑to‑four family portfolio increased by $49.3 million, with specific emphasis on loans for investment properties and to foreign nationals. Both of these sectors have challenges obtaining secondary market eligible loans, making them a desirable niche for our portfolio. In addition, our portfolio of non-aircraft business and consumer loans continued to grow with increases of $8.9 million and $3.3 million, respectively. Offsetting these increases, multifamily loans and commercial loans decreased by $8.4 million and $1.4 million, respectively, as paydowns and payoffs outpaced new loan originations for these loan types. Total construction/land loans decreased by $43.6 million at September 30, 2018, as compared to December 31, 2017, primarily due to a $20.0 million paydown in January 2018 of a land loan and a slowdown of originations on construction projects.

The growth in one-to-four family residential loans and decrease in construction/land loans have improved our commercial concentrations. At September 30, 2018 and December 31, 2017, the Bank’s construction loans totaled 77.1% and 108.6% of total capital, respectively, and total non-owner occupied commercial real estate was 454.5% and 514.0% of total capital, respectively. The Bank has set aggregate concentration guidelines that total commercial real estate, including residential, non‑residential, and construction, should not exceed 550% of total risk-based capital. Our concentration guideline for construction/land loans is to limit these loans to 100% of total risk-based capital. The concentration of construction/land loans is calculated using the funded balance of these loans and consequently can fluctuate based on the timing of construction draws and loan payoffs. Management reviews estimated construction draws and loan payoffs and adjusts loan originations based on these estimates to achieve compliance with our construction guidelines. Our commercial and multifamily real estate and construction/land loan portfolios are subject to ongoing credit reviews performed by both independent loan review staff, as well as an external third-party review firm to assist with identifying potential adverse trends and risks in the portfolio allowing management to initiate timely corrective action, as necessary. Such reviews also assist with ensuring loan risk grades are accurately assigned and thereby properly accounted for in the ALLL. The review places emphasis on large borrowing relationships, stress testing, compliance with loan covenants, as well as other risk factors warranting enhanced review.

The following table presents a breakdown of our commercial and construction loan portfolio by collateral type at September 30, 2018 and December 31, 2017:


41



 
September 30, 2018
 
December 31, 2017
 
(In thousands)
Multifamily real estate:
 
 
 
Micro-unit apartments
$
14,141

 
$
14,331

Other multifamily
162,380

 
170,571

Total multifamily real estate
176,521

 
184,902

 
 
 
 
Commercial real estate:
 
 
 
Office
96,542

 
112,327

Retail
139,085

 
129,875

Mobile home park
15,649

 
19,970

Warehouse
22,252

 
22,701

Storage
32,625

 
32,201

Other non-residential
54,332

 
44,768

Total commercial real estate
360,485

 
361,842

 
 
 
 
Construction/land:
 
 
 
One-to-four family residential
84,912

 
87,404

Multifamily
80,607

 
108,439

Commercial
21,385

 
5,325

Land
7,113

 
36,405

Total construction/land
194,017

 
237,573

Total multifamily, commercial and construction/land loans
$
731,023

 
$
784,317


The LIP related to our commercial real estate and construction/land loans decreased by $1.3 million as draws and payoffs of existing loans outpaced originations during the first nine months of 2018. Included in total construction/land loans at September 30, 2018, are $63.6 million of multifamily loans and $21.4 million of commercial loans that will roll over to permanent loans at the completion of their construction period in accordance with the terms of the construction/land loan. At December 31, 2017, construction/land loans included $71.4 million of multifamily loans, $5.3 million of commercial loans and $2.6 million of one-to-four family loans that roll over to permanent loans in accordance with the terms of the construction/land loan.

To assist in our strategic initiatives for loan growth and to achieve geographic diversification, the Bank will originate and purchase loans and utilize loan participations with the underlying collateral located within areas of Washington State outside our primary market area or in other states. The Bank’s goal with respect to loan participations is to locate a selling bank that is unable to make an entire loan due to legal or lending concentration limitations. Sellers of these loans are reviewed for management/lending experience, financial condition, asset quality metrics, and regulatory matters. Loans acquired through participation or purchase must meet the Bank’s underwriting standards. During the nine months ended September 30, 2018, the Bank purchased $16.2 million of loans that included $1.2 million of one-to-four family residential loans secured by properties located in Washington State and $15.0 million of commercial loans secured by properties located in New York, Utah, Pennsylvania and California.
 
The majority of our loan portfolio continues to be secured by properties located in our primary market area, however a significant amount is secured by properties in other areas of Washington, in California, and in other states. At September 30, 2018, total loans secured by collateral located in California represented 3.9% of our total loans, net of LIP and total loans secured by collateral located outside the states of California and Washington represented 8.4% of our total loans, net of LIP. The following table details geographic concentrations in our loan portfolio, net of LIP:


42



 
 
At September 30, 2018
 
 
One-to-Four Family Residential
 
Multifamily
 
Commercial Real Estate
 
Construction/Land
 
Business
 
Consumer
 
Total
 
 
(In thousands)
King County
 
$
253,610

 
$
102,666

 
$
186,093

 
$
91,354

 
$
14,359

 
$
10,816

 
$
658,898

Pierce County
 
33,881

 
10,397

 
27,703

 
7,087

 

 
606

 
79,674

Snohomish County
 
21,323

 
3,230

 
26,870

 
1,404

 

 
292

 
53,119

Kitsap County
 
5,872

 
1,497

 
791

 
2,441

 

 

 
10,601

Other Washington Counties
9,775

9,775

 
24,087

 
46,341

 
723

 
1,306

 
705

 
82,937

California
 
2,744

 
17,694

 
18,690

 

 
687

 

 
39,815

Outside Washington
and California
(1)
 
719

 
16,950

 
53,773

 

 
13,303

 

 
84,745

Total loans, net of LIP
 
$
327,924

 
$
176,521

 
$
360,261

 
$
103,009

 
$
29,655

 
$
12,419

 
$
1,009,789

_______________
(1) Includes loans in Oregon, Arizona, Utah and 20 other states.

Our five largest borrowing relationships, which represent 8.2% of our net loans, decreased by $6.2 million to $82.3 million at September 30, 2018, from $88.5 million at December 31, 2017. The total number of loans represented by this group of borrowers remained relatively stable with 19 loans at September 30, 2018, and 18 loans at December 31, 2017. At September 30, 2018, all five borrowers were current on their loan payments. We monitor the performance of these borrowing relationships very closely due to their concentration risk in relation to the entire loan portfolio.

The following table details our five largest lending relationships at September 30, 2018:

Borrower (1)
 
Number
of Loans
 
One-to-Four Family
Residential
(2)

Multifamily

Commercial
Real Estate

Construction/Land
 
Business
 
Consumer

Aggregate
Balance of
Loans (3)

 
(Dollars in thousands)
Real estate investor
 
5
 
$

 
$
8,658

 
$
13,313

 
$

 
$

 
$

 
$
21,971

Real estate investor
 
4
 
465

 

 

 
3,704

 
12,840

 

 
17,009

Real estate investor
 
3
 
434

 

 
15,079

 

 

 

 
15,513

Real estate investor
 
4
 
447

 

 
13,765

 

 

 

 
14,212

Real estate investor
 
3
 

 
5,102

 

 
8,537

 

 

 
13,639

Total
 
19
 
$
1,346

 
$
13,760

 
$
42,157

 
$
12,241

 
$
12,840

 
$

 
$
82,344

________
(1)
The composition of borrowers represented in the table may change between periods.
(2) 
All of the one-to-four family residential loans for these borrowers are for owner occupied properties. The commercial real estate loans are for non-owner occupied properties.
(3) 
Net of LIP.

The ALLL increased to $13.1 million at September 30, 2018, from $12.9 million at December 31, 2017, and represented 1.30% and 1.28% of total loans receivable, net of LIP at September 30, 2018, and December 31, 2017, respectively. The ALLL consists of two components, the general allowance and the specific reserves. The increase in the ALLL was primarily the result of growth in our loan portfolio with a $276,000 increase in the general reserve and a $42,000 decrease in the specific reserves.

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For additional information, see “Comparison of Operating Results for the Nine Months Ended September 30, 2018 and 2017 - Provision for Loan Losses” discussed below.

We believe that the ALLL at September 30, 2018, 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, that the actual amount of future losses 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 additions to the allowance may become necessary based upon changing economic conditions, the level of problem loans, business conditions, credit concentrations, increased 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 bank regulators as part of the routine examination process, which may result in the establishment of additional loss reserves or the charge-off of specific loans against established loss reserves based upon their judgment of information available to them at the time of their examination.

As we work with our borrowers that face difficult financial circumstances, we explore various 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. Certain loan modifications are accounted for as troubled debt restructured loans (“TDRs”). These modifications have included a reduction in interest rate on the loan for a period of time, advancing the maturity date of the loan, or allowing interest-only payments for a specific time frame. These modifications are granted only when there is a reasonable and attainable restructured loan plan that has been agreed to by the borrower and is considered to be in the Bank’s best interest.
    
The following table presents a breakdown of our TDRs at the dates indicated, all of which were performing:

September 30, 2018
 
December 31, 2017
 
Nine Month Change

(Dollars in thousands)
One-to-four family residential
$
9,458

 
$
13,434

 
$
(3,976
)
Multifamily
1,116

 
1,134

 
(18
)
Commercial real estate
2,601

 
3,194

 
(593
)
Consumer
43

 
43

 

Total TDRs
$
13,218

 
$
17,805

 
$
(4,587
)
% TDRs classified as performing
100.0
%
 
100.0
%
 
 

Our TDRs decreased $4.6 million at September 30, 2018, compared to December 31, 2017, as a result of principal repayments and loan payoffs. At September 30, 2018, there were no TDRs on nonaccrual status. In addition, there were no committed but undisbursed funds in connection with our TDRs and impaired loans. The largest TDR relationship at September 30, 2018, totaled $2.9 million and was secured by $2.5 million in one-to-four family residential rental properties and an owner occupied commercial property of $370,000, all located in King County.

Loans are considered past due if a scheduled principal or interest payment is due and unpaid for 30 days or more. At September 30, 2018, total past due loans represented 0.08% of total loans receivable, as compared to 0.01% at December 31, 2017.
    
Nonperforming assets increased by $305,000 during the first nine months of 2018 as a result of a $325,000 commercial real estate loan converting to nonaccrual status. The following table presents detailed information on our nonperforming assets at the dates indicated:


44




September 30, 2018
 
December 31, 2017
 
Nine Month Change

(Dollars in thousands)
Nonperforming loans:

 

 

  One-to-four family residential
$
113

 
$
128

 
$
(15
)
  Commercial real estate
325

 

 
325

  Consumer
46

 
51

 
(5
)
Total nonperforming loans
484

 
179

 
305



 

 

OREO
483

 
483

 

Total nonperforming assets (1)
$
967

 
$
662

 
$
305




 


 

Nonperforming assets as a
percent of total assets
0.08
%
 
0.05
%
 

____________ 
(1) The difference between nonperforming assets reported above, and the totals reported by other industry sources, is due to their inclusion of all TDRs as nonperforming loans, although 100.0% of our TDRs were performing in accordance with their restructured terms at September 30, 2018.

Nonaccrual loans are loans that are 90 days or more delinquent or other loans which, in management's opinion, the borrower is unable to meet scheduled payment obligations. The largest nonaccrual loan at September 30, 2018 was $325,000 commercial real estate loan secured by a retail property located in Pierce County. Formal foreclosure proceedings are in process on this loan. The Bank believes that the collateral securing the loan is adequate and no specific reserve has been established. The remaining two nonaccrual loans in the loan portfolio at September 30, 2018, included a $113,000 one-to-four family residential loan secured by an owner occupied single family residence in Snohomish County and a $46,000 home equity second mortgage secured by a non-owner occupied single family residence in King County. At September 30, 2018, both of these loans were current on their loan payments.

We continue to focus our efforts on working with borrowers to bring their loans current or converting nonaccrual loans to OREO and subsequently selling the properties. By taking ownership of these properties, we can generally convert nonearning assets into earning assets on a more timely basis than which may otherwise be the case. Our success in this area is reflected by the low ratio of our nonperforming assets as a percent of total assets of 0.08% at September 30, 2018, and 0.05% at December 31, 2017, as well as the minimal amount of OREO held at September 30, 2018.

OREO. OREO includes properties acquired by the Bank through foreclosure or acceptance of a deed in lieu of foreclosure. At September 30, 2018, and December 31, 2017, OREO was $483,000 and consisted of two undeveloped lots located in Pierce County with carrying values of $270,000 and $213,000.

Intangible assets. The balance of goodwill was $889,000 at both September 30, 2018 and December 31, 2017. Goodwill was calculated as the excess purchase price of the branches acquired in the Branch Acquisition over the fair value of the assets acquired and liabilities assumed at August 25, 2017.

The core deposit intangible (“CDI”) recorded as part of the Branch Acquisition represents the fair value of the customer relationships on the acquired noninterest-bearing checking, interest-bearing checking, savings, and money market accounts. The CDI balance was $1.2 million and $1.3 million at September 30, 2018 and December 31, 2017, respectively. The initial ratio of CDI to the acquired balances of core deposits was 2.23%. This amount amortizes into noninterest expense on an accelerated basis over ten years.
    
Deposits. During the first nine months of 2018, deposits increased $76.8 million to $916.3 million at September 30, 2018, compared to $839.5 million at December 31, 2017. Deposit accounts consisted of the following:

45



 
September 30, 2018
 
Change from December 31, 2017
 
Percent Change
 
(Dollars in thousands)
Noninterest-bearing
$
51,180

 
$
5,746

 
12.6
 %
Interest-bearing checking
41,954

 
3,730

 
9.8

Statement savings
24,106

 
(4,350
)
 
(15.3
)
Money market
323,025

 
4,389

 
1.4

Certificates of deposit, retail
373,931

 
40,667

 
12.2

Certificates of deposit, brokered
102,083

 
26,595

 
35.2


$
916,279

 
$
76,777

 
9.1

 
The balances at our four acquired branches grew with a net increase of $5.6 million at September 30, 2018, as compared to the acquisition date of August 25, 2017. In addition, our branch in the Crossroads community of Bellevue, Washington had an increase in deposits of $16.4 million during the first nine months of 2018. The largest change in our retail deposits was a $40.7 million increase in retail certificates of deposit as we competitively priced our products to increase our deposit portfolio ahead of anticipated market rate increases.

To assist in our funding needs, our portfolio of brokered certificates of deposits increased by $26.6 million to $102.1 million at September 30, 2018, from $75.5 million at December 31, 2017. While brokered certificates of deposit may carry a higher cost than our retail certificates, their remaining maturity periods of one to sixty months, along with the enhanced call features on a portion of these deposits, assist us in our efforts to manage interest rate risk.

At September 30, 2018 and December 31, 2017, we held $25.3 million and $21.5 million in public funds, respectively, primarily in retail certificates of deposit and money market accounts.

Advances. We use advances from the FHLB as an alternative funding source to manage interest rate risk and to leverage our balance sheet. Total FHLB advances were $149.0 million at September 30, 2018, a $67.0 million decrease from $216.0 million at December 31, 2017. At September 30, 2018, the Bank had $69.0 million in borrowings that are due in less than one year and $80.0 million in borrowings that are due in three years. Our long-term advances at September 30, 2018, consisted of three Member Option Variable Rate advances that reprice quarterly and allow prepayment without penalties at the repricing date. In addition, we held $4.0 million in overnight FHLB advances at that date. The repayment option on our Member Option Variable Rate advances and short term nature of overnight FHLB advances provides us flexibility to adjust the level of our borrowings as our customer deposit balances grow consistent with our asset/liability objectives. Our FHLB advances also include a $50.0 million fixed rate three‑month advance that renews quarterly at the fixed interest rate in effect at that time designated as a cash flow hedge, as described below.

Cash Flow Hedge. To assist in managing interest rate risk, the Bank entered into a five-year, $50 million notional, pay fixed, receive floating cash flow hedge or interest rate swap with a qualified institution on October 25, 2016. Under the terms of the Cash Flow Hedge agreement, the Bank pays a fixed rate of 1.34% for five years and, in turn, receives an interest payment based on the three-month LIBOR index, which resets quarterly. Concurrently, the Bank borrowed a $50.0 million fixed rate three-month advance that will be renewed quarterly at the fixed interest rate in effect at that time. Effectiveness of the swap is evaluated quarterly with any ineffectiveness recognized as a gain or a loss on the income statement in noninterest income. A change in the fair value of the cash flow hedge is recognized as an other asset or other liability on the balance sheet with the tax-effected portion of the change included in other comprehensive income. At September 30, 2018, we recognized a $2.5 million fair value asset as a result of the increase in the market value of the hedge agreement.

Stockholders’ Equity. Total stockholders’ equity increased $12.1 million during the first nine months of 2018 to $154.7 million at September 30, 2018, from $142.6 million at December 31, 2017. The primary source of the increase was a $10.4 million increase in retained earnings as the result of $12.7 million in net income for the nine months ended September 30, 2018, partially offset by shareholder cash dividends of $2.4 million, or $0.23 per share, paid during this period. In addition, net stock-based compensation totaled $2.0 million and other comprehensive loss, net of tax, increased $1.6 million during the nine months ended September 30, 2018. Additional shares of common stock were issued with the exercise of 137,940 stock options and awarding of 30,179 shares of restricted stock, contributing $1.3 million to stockholders’ equity during the first nine months of 2018.

The following table shows cash dividends paid per share and the related dividend payout ratio for the periods indicated:

46



 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
 
 
 
 
 
 
 
 
Dividend declared per common share
$
0.08

 
$
0.07

 
$
0.23

 
$
0.20

Dividend payout ratio (1)
29.6
%
 
38.9
%
 
18.6
%
 
33.9
%
______________
(1) Dividends paid per common share divided by basic earnings per common share.     

Comparison of Operating Results for the Three Months Ended September 30, 2018 and 2017

General. Net income for the three months ended September 30, 2018, was $2.8 million, or $0.27 per diluted share as compared to net income of $1.9 million, or $0.18 per diluted share for the three months ended September 30, 2017. The $931,000 increase in net income during the three months ended September 30, 2018, was primarily the result of a $684,000 increase in net interest income and a decrease of $300,000 in the provision for loan loss as compared to the same period in 2017.

Net Interest Income. Net interest income for the three months ended September 30, 2018, increased $684,000 to $10.1 million from $9.4 million for the three months ended September 30, 2017. The increase was due primarily to the growth in the average balance of net loans receivable between periods, partially offset by increased interest expense due to increased short-term interest rates and higher deposit balances. Our average interest earning assets increased by $99.6 million and the average yield increased 26 basis points for the three months ended September 30, 2018, as compared to the same period in 2017.

The average balance of our interest-bearing liabilities increased by $77.5 million during the three months ended September 30, 2018, as compared to the same period in 2017 as our customer deposits increased to meet the funding needs of our loan portfolio and reduce the level of borrowings. In response to increases in the short-term market interest rates, the cost of our interest-bearing liabilities has increased by 39 basis points between these same time periods.

The Company’s net interest margin and interest rate spread decreased by 7 basis points and 13 basis points, respectively, primarily due to increases in our cost of funds as our interest‑bearing liabilities generally reprice faster than our interest-earning assets in response to changes in market interest rates. For more information on this, see “How We Measure the Risk of Interest Rate Changes” in Item 3 of this report.

The following table details the change in net interest income due to changes in yield or cost, or changes in the average balance of the related asset or liability:


47



 
Three Months Ended September 30, 2018
Compared to September 30, 2017
Net Change in Interest

Rate
 
Volume
 
Total

(In thousands)
Interest-earning assets:

 

 

   Loans receivable, net
$
248

 
$
1,424

 
$
1,672

   Investments available-for-sale
144

 
50

 
194

   Interest-earning deposits with banks
20

 
(69
)
 
(49
)
   FHLB stock
72

 
(4
)
 
68

Total net change in income on interest-earning assets
484

 
1,401

 
1,885



 

 

Interest-bearing liabilities:

 

 

   Interest-bearing demand
(11
)
 
12

 
1

   Statement savings
(1
)
 
(1
)
 
(2
)
   Money market
303

 
117

 
420

   Certificates of deposit, retail
363

 
11

 
374

   Certificates of deposit, brokered
106

 
80

 
186

   Advances from the FHLB
292

 
(70
)
 
222

Total net change in expense on interest-bearing liabilities
1,052

 
149

 
1,201

Total net change in net interest income
$
(568
)
 
$
1,252

 
$
684


The $1.7 million increase in loan interest income during the third quarter of 2018, as compared to the same period in 2017, was a combined result of a $114.2 million increase in the average outstanding loan balance with an increase in the average loan yield of ten basis points. Loan originations during the past year were generally made at higher market rates as compared to the existing loan portfolio. Also contributing to the increase in loan yield, the portion of our loan portfolio of variable rate loans increased to 52.7% at September 30, 2018, from 49.4% at September 30, 2017.
 
Interest expense increased by $1.2 million for the three months ended September 30, 2018, as compared to the same period in 2017, primarily as a result of increases in the cost of interest-bearing liabilities, in particular money market deposits, certificates of deposit and FHLB advances. In response to market rate increases, the average cost of our interest-bearing deposits increased by 35 basis points and the average cost of our FHLB advances increased by 65 basis points for the three months ended September 30, 2018 as compared to the same period in 2017. Also contributing to the increase in interest expense during these periods, the average balance of our interest-bearing deposits increased by $97.4 million, with $78.5 million of this from growth in our retail operations and $18.9 million from an increase in brokered certificates of deposit. Money market interest expense increased by $420,000 as a result of a $62.0 million increase in the average balance combined with a 38 basis point increase in the average cost of these funds. The cost of retail and brokered certificates of deposit increased by 42 and 44 basis points, respectively, as the growth in the rates needed to compete for these deposits in the marketplace have increased in response to increases in the Federal Funds targeted rate. The growth in our retail and brokered deposits more than met our funding needs, allowing the Bank to pay down certain FHLB advances, resulting in a $19.8 million decrease in the average balance of these borrowings for the three months ended September 30, 2018, as compared to the same period in 2017.

The following table compares detailed average balances, related interest income or interest expense, associated yields and rates, and the resulting net interest margin for the three months ended September 30, 2018 and 2017. Nonaccrual loans are included in the average balance of net loans receivable and are considered to carry a zero yield.

48



 
Three Months Ended September 30,
 
2018
 
2017
 
Average
Balance
 
Interest Earned / Paid
 
Yield /
Cost
 
Average
Balance
 
Interest Earned / Paid
 
Yield /
Cost
 
(Dollars in thousands)
Assets
 
 
 
 
 
 
 
 
 
 
 
Loans receivable, net                                           
$
993,272

 
$
12,631

 
5.05
%
 
$
879,075

 
$
10,959

 
4.95
%
Investments available-for-sale
140,584

 
1,063

 
3.00

 
132,959

 
869

 
2.59

Interest-earning deposits with banks                                          
12,223

 
59

 
1.92

 
33,854

 
108

 
1.27

FHLB stock                      
8,540

 
135

 
6.27

 
9,126

 
67

 
2.91

Total interest-earning assets                                                      
1,154,619

 
13,888

 
4.77

 
1,055,014

 
12,003

 
4.51

Noninterest earning assets
70,570

 
 
 
 
 
65,162

 
 
 
 
Total average assets
$
1,225,189

 
 
 
 
 
$
1,120,176

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities and Stockholders' Equity
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing demand
$
42,090

 
$
21

 
0.20
%
 
$
26,280

 
$
20

 
0.30
%
Statement savings
25,376

 
8

 
0.13

 
28,238

 
10

 
0.14

Money market
317,089

 
901

 
1.13

 
255,097

 
481

 
0.75

Certificates of deposit, retail
346,065

 
1,479

 
1.70

 
342,599

 
1,105

 
1.28

Certificates of deposit, brokered
94,435

 
503

 
2.11

 
75,488

 
317

 
1.67

Total interest-bearing deposits
825,055

 
2,912

 
1.40

 
727,702

 
1,933

 
1.05

Advances from the FHLB and other borrowings
177,250

 
917

 
2.05

 
197,098

 
695

 
1.40

Total interest-bearing liabilities
1,002,305

 
3,829

 
1.52

 
924,800

 
2,628

 
1.13

Noninterest bearing liabilities
68,440

 
 
 
 
 
51,401

 
 
 
 
Average equity
154,444

 
 
 
 
 
143,975

 
 
 
 
Total average liabilities and equity
$
1,225,189

 
 
 
 
 
$
1,120,176

 
 
 
 
Net interest income
 
 
$
10,059

 
 
 
 
 
$
9,375

 
 
Net interest margin
 
 
 
 
3.46
%
 
 
 
 
 
3.53
%

Provision for Loan 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 reserves. The general reserve is determined by applying factors to our various groups of loans. Management considers factors such as charge-off history, the prevailing economy, the regulatory environment, competition, geographic and loan type concentrations, policy and underwriting standards, nature and volume of the loan portfolio, managements’ 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 reserve component is created when management believes that the collectability of a specific loan has been impaired and a loss is probable or a concession is granted that reduces the value of the loan. 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 if future events differ from current estimates.

During the quarter ended September 30, 2018, management evaluated the adequacy of the ALLL and concluded that a provision for loan losses in the amount of $200,000 was appropriate, as a combined result of a $7.0 million increase in total loans receivable, net of LIP, reduced by recoveries received on loans previously charged off during the current quarter. Increases of $4.8 million for construction/land loans and $7.5 million for business loans resulted in a proportionately higher increase in the provision for loan losses as these loans generally carry higher credit risk. The provision increase related to loan balances was partially offset by $162,000 of loan recoveries received on previously charged off loans. In comparison, during the quarter ended

49



September 30, 2017, a $500,000 provision for loan losses was recognized as a result of growth in loans receivable, partially offset by recoveries received on loans previously charged off.

The following table summarizes selected financial data related to our ALLL and loan portfolio. All loan balances and ratios are calculated using loan balances that are net of LIP.

At or For the Three Months Ended September 30,

2018

2017
 
(Dollars in thousands)
Total loans receivable, net of LIP, end of period
$
1,009,789

 
$
945,458

Average loans receivable during period
993,272

 
879,075

ALLL balance at beginning of period
12,754

 
11,285

Provision for loan losses
200

 
500

Charge-offs:


 
 
Total charge-offs

 

Recoveries:


 
 
One-to-four family
2

 
247

Commercial real estate

 
78

Construction/land development
160

 

Total recoveries
162

 
325

Net recovery
162

 
325

ALLL balance at end of period
$
13,116

 
$
12,110

ALLL as a percent of total loans, net of LIP
1.30
%
 
1.28
%
Ratio of net recoveries to average net loans receivable
0.02

 
0.15


Noninterest Income. Noninterest income increased $110,000 to $841,000 for the quarter ended September 30, 2018, from $731,000 for the quarter ended September 30, 2017. The following table provides a detailed analysis of the changes in the components of noninterest income:
 
Three Months Ended September 30, 2018
 
Change from Three Months Ended
September 30, 2017
 
Percent Change
 
(Dollars in thousands)
Net gain on sale of investments
$
1

 
$
(46
)
 
(97.9
)%
BOLI change in cash surrender value
245

 
72

 
41.6

Wealth management revenue
145

 
(107
)
 
(42.5
)
Deposit related fees
167

 
54

 
47.8

Loan related fees
273

 
129

 
89.6

Other           
10

 
8

 
400.0

Total noninterest income                                           
$
841

 
$
110

 
15.0
 %

During the three months ended September 30, 2018, compared to the three months ended September 30, 2017, loan related fees increased by $129,000, primarily from an increase in the annual fees for business lines of credit and loan prepayment penalties. In addition, deposit related fees increased by $54,000 as a result of the increase in our number of deposit accounts and transaction volumes from our branch expansion. Partially offsetting these increases, wealth management revenue decreased by $107,000 for the three months ended September 30, 2018, as compared to the same period in 2017, as a combined result of a reduction in sales staff and fluctuations in the timing and mix of commissions received on serviced accounts.

Noninterest income from our BOLI policies increased by $72,000 for the three months ended September 30, 2018, as compared to the three months ended September 30, 2017, as the increase in cash surrender value on the $4.2 million in policies purchased in 2017 was partially offset by plan expenses during the first year subsequent to the purchase date.

50




Noninterest Expense. Noninterest expense increased $365,000 to $7.2 million for the three months ended September 30, 2018, from $6.8 million for the comparable period in 2017.

The following table provides a detailed analysis of the changes in the components of noninterest expense:
 
Three Months Ended September 30, 2018
 
Change from Three Months Ended
September 30, 2017
 
Percent Change
 
(Dollars in thousands)
Salaries and employee benefits
$
4,732

 
$
326

 
7.4
 %
Occupancy and equipment                                           
814

 
88

 
12.1

Professional fees                                
353

 
(105
)
 
(22.9
)
Data processing                                
356

 
(16
)
 
(4.3
)
OREO related expenses, net
1

 
7

 
116.7

Regulatory assessments
126

 
4

 
3.3

Insurance and bond premiums                                           
95

 
(10
)
 
(9.5
)
Marketing
85

 
(17
)
 
(16.7
)
Other general and administrative
639

 
88

 
16.0

Total noninterest expense                                           
$
7,201

 
$
365

 
5.3
 %

Expenses for salaries and employee benefits increased $326,000 for the three months ended September 30, 2018, as compared to the same period in 2017. As a result of our de novo branches and the development of new products, the number of full-time employees increased to 152 at September 30, 2018, from 146 at September 30, 2017. In addition to the impact on employee expenses, the increase in the number of our branch locations over the last year resulted in an $88,000 increase in occupancy and equipment expenses. Partially offsetting these increases, professional fees and data processing expenses decreased by $105,000 and $16,000, respectively, for the three months ended September 30, 2018, as we incurred additional expenses during the same period in 2017 in support of our Branch Acquisition.

Federal Income Tax Expense. Income before federal income taxes increased by $729,000 for the three months ended September 30, 2018, as compared to the same period in 2017; however, the provision for income taxes was lower as a result of utilizing a lower effective federal corporate income tax rate for the three months ended September 30, 2018, due to the Tax Act. As of January 1, 2018, our statutory federal corporate income tax rate was 21%, as compared to 35% for prior years. We recorded federal income tax provisions of $707,000 and $909,000 for the three months ended September 30, 2018, and 2017, respectively.

Comparison of Operating Results for the Nine Months Ended September 30, 2018 and 2017

General. Net income for the nine months ended September 30, 2018 was $12.7 million, or $1.22 per diluted share as compared to net income of $6.1 million, or $0.58 per diluted share for the nine months ended September 30, 2017. The increase during the nine months ended September 30, 2018, was primarily the result of a $3.9 million increase in net interest income and a $4.2 million recapture of loan loss provision, partially offset by a $2.0 million increase in noninterest expense.

Net Interest Income. Net interest income for the nine months ended September 30, 2018 was $31.2 million, as compared to $27.2 million for the same period in 2017, due to the $7.2 million increase in our interest income, partially offset by a $3.3 million increase in interest expense. The increase in total interest income was primarily the result of the $142.1 million increase in the average balance of loans receivable combined with an increase in the average loan yield of 21 basis points for the nine months ended September 30, 2018, as compared to the same period in 2017. Also contributing to the increase in loan interest income was the receipt of an additional $1.0 million in loan interest income during the first quarter of 2018 from repayment of balances on previously charged off loans.

The average balance of our interest-bearing liabilities increased by $122.8 million during the nine months ended September 30, 2018, as compared to the same period in 2017 as our customer deposits and borrowings increased to meet the funding needs of our loan portfolio. In response to increases in the short-term market interest rates, the cost of our interest-bearing liabilities increased by 31 basis points between these same time periods.


51



Generally, our interest-bearing liabilities reprice faster than our interest-earning assets in response to changes in market interest rates. The additional $1.0 million in loan interest received early in 2018 offset the impact of the increase in market rates by stabilizing our net interest margin and interest rate spread at 3.61% and 3.44%, respectively, for the nine months ended September 30, 2018, compared to 3.59% and 3.45%, respectively, for the nine months ended September 30, 2017. For more information on this, see “How We Measure the Risk of Interest Rate Changes” in Item 3 of this report.

The following table details the change in net interest income due to changes in yield or cost, or changes in the average balance of the related asset or liability:
    
 
Nine Months Ended September 30, 2018
Compared to September 30, 2017
Net Change in Interest
 
Rate
 
Volume
 
Total
 
(In thousands)
Interest-earning assets:
 
 
 
 
 
   Loans receivable, net
$
1,524

 
$
5,241

 
$
6,765

   Investments available-for-sale
207

 
194

 
401

   Interest-earning deposits with banks
48

 
(101
)
 
(53
)
   FHLB stock
113

 
19

 
132

Total net change in income on interest-earning assets
1,892

 
5,353

 
7,245

 
 
 
 
 
 
Interest-bearing liabilities:
 
 
 
 
 
   Interest-bearing demand
(36
)
 
43

 
7

   Statement savings
(4
)
 
(2
)
 
(6
)
   Money market
901

 
468

 
1,369

   Certificates of deposit, retail
732

 
(96
)
 
636

   Certificates of deposit, brokered
137

 
80

 
217

   Advances from the FHLB
942

 
142

 
1,084

Total net change in expense on interest-bearing liabilities
2,672

 
635

 
3,307

Total net change in net interest income
$
(780
)
 
$
4,718

 
$
3,938


The $6.8 million increase in loan interest income during the first nine months of 2018, as compared to the same period in 2017, was a primarily the result of a $142.1 million increase in the average outstanding loan balance with a smaller impact from the increase in the average loan yield of 21 basis points. While a portion of the yield increase was due to the receipt of $1.0 million in additional interest income discussed above, loan originations during the past year at generally higher market interest rates, and the variable rate nature of a majority of our loan portfolio also helped to increase the average yield on our loan portfolio.

Interest income on our investments available-for-sale increased $401,000 for the nine months ended September 30, 2018, as compared to the same period in 2017 as a combined result of a $9.8 million increase in the average balance of our investment portfolio and a yield increase of 19 basis points. Interest income on our interest-earning deposits decreased $53,000 for the nine months ended September 30, 2018, as compared to the same period in 2017, primarily as a result of the $13.1 million decrease in the average balance of these deposits. We converted excess cash earning a nominal yield into higher yielding assets. Partially offsetting the impact of the decrease in average balance of our interest-earning deposits, the average yield earned on interest-earning deposits increased by 54 basis points for the nine months ended September 30, 2018, as compared to the same period in 2017 as a response to increases in the Federal Funds targeted rate.

Interest expense increased $3.3 million for the nine months ended September 30, 2018, as compared to the same period in 2017. The average cost of interest-bearing deposits increased by 23 basis points for the nine months ended September 30, 2018, as compared to the same period in 2017 due to rising market interest rates. Interest expense on money market accounts increased by $1.4 million, year over year, due to an increase in the average balance of these accounts of $95.3 million, primarily from the Branch Acquisition. Also contributing to the increase in interest expense, the cost of these funds increased by 37 basis points for the nine months ended September 30, 2018, as compared to the same period in 2017. Interest expense on retail certificates of deposit increased by $636,000 as a result of a 28 basis point increase in the cost of these funds partially offset by a $10.3 million decrease in their average balance, as certain maturing certificates of deposit were allowed to runoff during the nine months ended

52



September 30, 2018. Interest expense on our FHLB advances and other borrowings increased by $1.1 million for the nine months ended September 30, 2018, as compared to the same period in 2017, as a result of a 63 basis point increase in the cost of these funds and, to a lesser extent, a $15.4 million increase in the average balance of FHLB advances.

The following table compares detailed average balances, associated yields and rates, and the resulting changes in interest and dividend income or expense for the nine months ended September 30, 2018 and 2017. Nonaccrual loans are included in the average balance of net loans receivable and are considered to carry a zero yield.

 
Nine Months Ended September 30,
 
2018
 
2017
 
Average Balance
 
Interest Earned / Paid
 
Yield or Cost
 
Average Balance
 
Interest Earned / Paid
 
Yield or Cost
 
(Dollars in thousands)
Assets
 
 
 
 
 
 
 
 
 
 
 
Loans receivable, net                                           
$
992,071

 
$
38,103

 
5.14
%
 
$
849,923

 
$
31,338

 
4.93
%
Investments available-for-sale
141,279

 
3,002

 
2.84

 
131,457

 
2,601

 
2.65

Interest-earning deposits with banks                                          
11,957

 
141

 
1.58

 
25,008

 
194

 
1.04

FHLB stock                      
9,375

 
343

 
4.89

 
8,596

 
211

 
3.28

Total interest-earning assets                                                      
1,154,682

 
41,589

 
4.82

 
1,014,984

 
34,344

 
4.52

Noninterest earning assets
69,659

 
 
 
 
 
62,965

 
 
 
 
Total average assets
$
1,224,341

 
 
 
 
 
$
1,077,949

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities and Stockholders' Equity
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing demand
$
39,714

 
$
61

 
0.21
%
 
$
22,087

 
$
54

 
0.33
%
Statement savings
26,319

 
26

 
0.13

 
27,893

 
32

 
0.15

Money market
323,865

 
2,491

 
1.03

 
228,559

 
1,122

 
0.66

Certificates of deposit, retail
338,757

 
3,888

 
1.53

 
349,091

 
3,252

 
1.25

Certificates of deposit, brokered
81,873

 
1,157

 
1.89

 
75,488

 
940

 
1.66

Total interest-bearing deposits
810,528

 
7,623

 
1.26

 
703,118

 
5,400

 
1.03

Advances from the FHLB and other borrowings
199,769

 
2,794

 
1.87

 
184,412

 
1,710

 
1.24

Total interest-bearing liabilities
1,010,297

 
10,417

 
1.38

 
887,530

 
7,110

 
1.07

Noninterest bearing liabilities
64,184

 
 
 
 
 
47,685

 
 
 
 
Average equity
149,860

 
 
 
 
 
142,734

 
 
 
 
Total average liabilities and equity
$
1,224,341

 
 
 
 
 
$
1,077,949

 
 
 
 
Net interest income
 
 
$
31,172

 
 
 
 
 
$
27,234

 
 
Net interest margin
 
 
 
 
3.61
%
 
 
 
 
 
3.59
%

Provision for Loan Losses. During the nine months ended September 30, 2018, management evaluated the adequacy of the ALLL and concluded that a recapture of provision for loan losses in the amount of $4.2 million was appropriate for the period. The recapture for the nine months ended September 30, 2018, was primarily a result of $4.4 million of recoveries received on previously charged off loans, partially offset by the increase in total loans receivable of $7.1 million, net of LIP, during the nine months ended September 30, 2018. In comparison, the $800,000 provision for loan losses recorded for the nine months ended September 30, 2017, was primarily a reflection of the $117.3 million growth in total loans receivable, net of LIP, during this period, partially offset by recoveries of $359,000 on previously charged off loans.

The following table summarizes selected financial data related to our ALLL and loan portfolio. All loan balances and ratios are calculated using loan balances that are net of LIP.

53



 
At or For the Nine Months Ended September 30,
 
2018
 
2017
 
(Dollars in thousands)
Total loans receivable, net of LIP, end of period
$
1,009,789

 
$
945,458

Average loans receivable during period
992,071

 
849,923

ALLL balance at beginning of period
12,882

 
10,951

(Recapture of provision) provision for loan losses
(4,200
)
 
800

Charge-offs:
 
 
 
Total charge-offs

 

Recoveries:
 
 
 
One-to-four family
4,248

 
280

Commercial real estate
14

 
78

Construction/land development
172

 

Consumer

 
1

Total recoveries
4,434

 
359

Net recovery
4,434

 
359

ALLL balance at end of period
$
13,116

 
$
12,110

ALLL as a percent of total loans, net of LIP
1.30
%
 
1.28
%
Ratio of net recoveries to average net loans receivable
0.45

 
0.06


Noninterest Income. Noninterest income increased by $153,000 to $2.2 million for the nine months ended September 30, 2018, as compared to $$2.0 million for the same period in 2017. The following table provides a detailed analysis of the changes in the components of noninterest income:
 
Nine Months Ended September 30, 2018
 
Change from
Nine Months Ended
September 30, 2017
 
Percent Change
 
(Dollars in thousands)
Net loss on sale of investments
$
(20
)
 
$
(123
)
 
(119.4
)%
BOLI change in cash surrender value
718

 
228

 
46.5

Wealth management revenue
400

 
(299
)
 
(42.8
)
Deposit related fees
503

 
226

 
81.6

Loan related fees
533

 
113

 
26.9

Other           
16

 
8

 
100.0

Total noninterest income                                           
$
2,150

 
$
153

 
7.7
 %

BOLI noninterest income increased by $228,000 for the nine months ended September 30, 2018, as compared to the same period in 2017. During 2017, $4.2 million in new BOLI policies were purchased where certain policy expenses were deducted from earnings over the first year subsequent to the purchase date, partially reducing the noninterest income on our BOLI policies we otherwise would recognize. Also contributing to the increase in noninterest income, deposit and loan related fees increased by $226,000 and $113,000, respectively, primarily due to the increased volume in our accounts and related transactions.

Partially offsetting these increases, wealth management revenue decreased by $299,000 for the nine months ended September 30, 2018, as compared to the nine months ended September 30, 2017. This decrease is a combined result of a reduction in sales staff and normal fluctuations in the timing and mix of commissions received on serviced accounts. In addition, sales of investments available-for-sale generated a net loss of $20,000 for the nine months ended September 30, 2018, as compared to a net gain of $103,000 for the nine months ended September 30, 2017, primarily as a result of the partial restructure in the 2017 period of our securities portfolio in favor of investments expected to perform better in a rising rate environment.

Noninterest Expense. Noninterest expense increased $2.0 million to $21.7 million for the nine months ended September 30, 2018, as compared to $19.7 million for the same period in 2017.

54




The following table provides a detailed analysis of the changes in the components of noninterest expense:
 
Nine Months Ended September 30, 2018
 
Change from
Nine Months Ended
September 30, 2017
 
Percent Change
 
(Dollars in thousands)
Salaries and employee benefits
$
14,325

 
$
1,225

 
9.4
 %
Occupancy and equipment                                           
2,412

 
627

 
35.1

Professional fees                                
1,123

 
(256
)
 
(18.6
)
Data processing                                
1,031

 
(100
)
 
(8.8
)
OREO-related expenses, net
4

 
(10
)
 
(71.4
)
Regulatory assessments
391

 
61

 
18.5

Insurance and bond premiums                                           
355

 
53

 
17.5

Marketing
269

 
67

 
33.2

Other general and administrative
1,805

 
308

 
20.6

Total noninterest expense                                           
$
21,715

 
$
1,975

 
10.0
 %

The primary contributor to the increase in noninterest expense was our branch expansion over the past year. Salaries and employee benefits expense increased by $1.2 million for the nine months ended September 30, 2018, as compared to the nine months ended September 30, 2017, due to increased staffing in support of the new branches and development of new products. In addition, occupancy and equipment expenses increased by $627,000 with our growth to ten locations at September 30, 2018. Other general and administrative expenses increased by $308,000 for the nine months ended September 30, 2018, as compared to the same period in 2017, reflecting the growth in our operations.

Partially offsetting the increases in noninterest expense, professional fees decreased by $256,000 and data processing decreased by $100,000 for the nine months ended September 30, 2018, as compared to the nine months ended September 30, 2017 as we incurred additional expenses in the 2017 period for these services in support of our Branch Acquisition.

Federal Income Tax Expense. Income before federal income taxes increased by $7.1 million for the nine months ended September 30, 2018, as compared to the same period in 2017. As a result of the reduction in our statutory federal corporate income tax rate to 21% in 2018, we recorded a federal corporate income tax provision of $3.1 million for the nine months ended September 30, 2018, as compared to $2.6 million for the same period last year. During the nine months ended September 30, 2018 and 2017, the exercise of certain stock options resulted in a tax benefit, partially offsetting the year-to-date tax provision; however, a larger number of stock options were exercised during 2018 resulting in a greater reduction in our tax rate for this period.

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 flows 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 customer deposits, cash flow from the loan and investment portfolios, advances from the FHLB, and to a lesser extent, brokered certificates of deposit. These funds, together with equity, are used to make loans, acquire investment securities and other assets, and fund continuing operations. At September 30, 2018, retail certificates of deposit of $180.1 million and brokered certificates of deposit of $35.7 million were scheduled to mature in one year or less. Management’s practice is to maintain deposit rates at levels that are competitive with other local financial institutions. While maturities and the scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by the level of interest rates, economic conditions and competition. We measure our liquidity based on our ability to fund our assets and to meet liability obligations when they come due. Liquidity (and funding) risk occurs when funds cannot be raised at reasonable prices or in a reasonable time frame to meet our normal or unanticipated obligations. We regularly monitor the mix between our assets and our liabilities to manage effectively our liquidity and funding requirements.

When deposits are not readily available and/or cost effective to provide the funds for our assets, we use alternative funding sources. These sources include, but are not limited to: advances from the FHLB, which are collateral dependent, wholesale funding,

55



national certificates of deposit listing services, brokered deposits, federal funds purchased and dealer repurchase agreements, as well as other short-term alternatives. We may also liquidate assets to meet our funding needs. The balance of our investments available-for-sale increased $8.6 million from December 31, 2017, to $140.9 million at September 30, 2018, and represents a ready source of cash if needed. The balance of our interest-earning deposits with banks increased by $12.2 million to $19.1 million at September 30, 2018, from December 31, 2017, as a result of fluctuations in our funding needs for loans receivable and retail deposits. At September 30, 2018, the Bank maintained credit facilities with the FHLB totaling $550.0 million, with an outstanding balance of $149.0 million. At September 30, 2018, we also had available a total of $35.0 million credit facilities with other financial institutions, with no balance outstanding. For additional information, see the Consolidated Statements of Cash Flows in Item 1 of this Form 10-Q.

To assist in our funds acquisition and interest rate risk management efforts, management utilizes the national brokered deposit market and maintained a balance at September 30, 2018, of $102.1 million of brokered certificates of deposit. In contrast to most retail certificate of deposit offerings which provide the depositor with an option to withdraw their funds prior to maturity, subject to an early withdrawal penalty, certificates of deposit acquired in the brokered market limits the depositor ability to withdraw the funds before the end of the term (except in the case of death or adjudication of incompetence of a depositor) which greatly reduces early redemption risk associated with retail deposits. This strategy may include, but is not necessarily limited to, raising longer term deposits (with terms greater than three years) that assist the Bank in its interest rate risk management efforts. At September 30, 2018, brokered certificates of deposit had a remaining maturity of up to 60 months. Most of these certificates also provide the Bank the option to redeem the deposit after six months, a favorable distinction compared to retail certificate of deposit terms that are offered in our local market. With these redemption limitations and call features, the cost of these brokered deposits is generally higher than our retail certificate of deposit offerings. Consequently, as we increase our brokered deposits, our cost of funds may increase.

First Financial Northwest is a separate legal entity from the Bank and, on a stand-alone level, must provide for its own liquidity and pay its own operating expenses and cash dividends. First Financial Northwest's primary sources of funds consist of dividends from the Bank, although there are regulatory requirements related to the ability of the Bank to pay dividends. At September 30, 2018, the Company (on an unconsolidated basis) had liquid assets of $23.9 million and short-term liabilities of $322,000.

On a monthly basis, we estimate our liquidity sources and needs for the next six months. Also, we determine funding concentrations and our need for sources of funds other than deposits. This information is used by our Asset/Liability Management Committee (“ALCO”) in forecasting funding needs and investing opportunities. We believe that our current liquidity position and our expected operating results are sufficient to fund all of our existing commitments.

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 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 by us until the instrument is exercised. At September 30, 2018 and December 31, 2017, 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 the 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 advance additional amounts pursuant to outstanding lines of credit and to disburse funds related to our construction loans at September 30, 2018:

56



 
 
 
Amount of Commitment Expiration
 
Total Amounts Committed
 
Through One Year
 
After One Through Three Years
 
After Three Through Five Years
 
After Five Years
 
(In thousands)
Commitments to originate loans                                                      
$
1,033

 
$
1,033

 
$

 
$

 
$

Unused portion of lines of credit                                                      
36,833

 
3,737

 
15,955

 
1,863

 
15,278

Undisbursed portion of construction loans
91,232

 
39,526

 
51,706

 

 

Total commitments
$
129,098

 
$
44,296

 
$
67,661

 
$
1,863

 
$
15,278


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

As of September 30, 2018, the Bank had nine operating leases with remaining terms of 23 months to seven years which carry minimum lease payments of $43,000 per month. All nine leases offer extension periods. During the first quarter of 2018, the Bank moved the branch offices in Lake Stevens and Smokey Point, Washington to new leased facilities in those communities, replacing the assumed leases from our 2017 Branch Acquisition. A new leased branch office in Bothell, Washington officially opened in April 2018. In September 2018, the Bank signed a lease agreement for a branch office in Kent, Washington and expects to open this location in the first quarter of 2019.
    
First Financial Northwest and its subsidiaries from time to time are 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 First Financial Northwest’s consolidated financial position, results of operation, or liquidity.

Capital

At September 30, 2018, stockholders’ equity totaled $154.7 million, or 12.5% of total assets. Our book value per share of common stock was $14.17 at September 30, 2018, compared to $13.27 at December 31, 2017. Consistent with our goal to operate a sound and profitable financial organization, we actively seek to maintain a “well-capitalized” status in accordance with regulatory standards.

As of September 30, 2018, the Bank exceeded all regulatory capital requirements and was considered “well capitalized” under regulatory capital guidelines of the FDIC. Effective September 30, 2018, the Bank is no longer required to file consolidated capital ratios as part of the Federal Reserve Bank’s regulatory filings. The following table provides the Bank’s capital requirements and actual results.

 
At September 30, 2018
 
Actual
 
For Minimum Capital Adequacy Purposes
 
To be Categorized as “Well Capitalized”
 
 Amount
 
Ratio
 
 Amount
 
Ratio
 
 Amount
 
Ratio
 
 (Dollars in thousands)
Tier I leverage capital (to average assets)
$
127,041

 
10.37
%
 
$
48,983

 
4.00
%
 
$
61,229

 
5.00
%
Common equity tier I ("CET1") (to risk-weighted assets)
127,041

 
13.58

 
42,101

 
4.50

 
60,813

 
6.50

Tier I risk-based capital (to risk-weighted assets)
127,041

 
13.58

 
56,135

 
6.00

 
74,847

 
8.00

Total risk-based capital (to risk-weighted assets)
138,759

 
14.83

 
74,847

 
8.00

 
93,559

 
10.00


In addition to the minimum CET1, Tier I total capital and leverage ratios, the Bank is required to maintain a capital conservation buffer consisting of additional CET1 capital above the required minimum levels in order to avoid limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses based on percentages of eligible retained income that could be utilized for such actions. This new capital conservation buffer requirement began to be phased in starting in January 2016 at more than 0.625% of risk-weighted assets and increases each year until fully implemented to an amount more

57



than 2.5% of risk-weighted assets in January 2019. As of September 30, 2018, the required conservation buffer was an amount more than 1.875% and the Bank’s conservation buffer was 6.83%.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

General. Our Board of Directors has approved an asset/liability management policy to guide management in maximizing net interest income by managing the differences in terms between interest-earning assets and interest-bearing liabilities while maintaining acceptable levels of liquidity, capital adequacy, interest rate sensitivity, credit risk, and profitability. The policy established an ALCO, comprised of certain members of senior management and the Board of Directors. The Committee’s purpose is to manage, coordinate, and communicate our asset/liability position consistent with our business plan and Board-approved policy. The ALCO meets quarterly to review various areas including:
economic conditions;
interest rate outlook;
asset/liability mix;
interest rate risk sensitivity;
current market opportunities to promote specific products;
historical financial results;
projected financial results; and
capital position.

Additionally, the Committee reviews current and projected liquidity needs. As part of its procedures, the ALCO regularly reviews our interest rate risk by modeling the impact that changes in interest rates may have on earnings, particularly net interest income. The market value of portfolio equity, which is the net present value of an institution’s existing assets less its liabilities and off-balance sheet instruments, is also modeled under several scenarios of changing interest rates. In both cases, results are evaluated and compared with the maximum potential change that is authorized by the Board of Directors.
 
Our Risk When Interest Rates Change. The rates of interest we earn on assets and pay on liabilities generally are established contractually for a period of time. Market interest rates change over time. Our loans generally have longer maturities than our deposits. Accordingly, our results of operations, like those of other financial institutions, are impacted by changes in interest rates and the interest rate sensitivity of our assets and liabilities. The risk associated with changes in interest rates and our ability to adapt to these changes is known as interest rate risk and is our most significant market risk.

We have utilized the following strategies in our efforts to manage interest rate risk:

we are originating shorter term higher yielding loans, whenever possible;
we have attempted, where possible, to extend the maturities of our deposits which typically fund our long-term assets;
we have invested in securities with relatively short average lives, generally less than eight years;
we have added adjustable-rate loans to our loan portfolio;
we utilize brokered certificates of deposit with a call option as a funding source; and
we have utilized an interest rate swap to effectively fix the rate on $50.0 million of FHLB advances.

We have evaluated the use of derivative instruments to limit the impact of interest rate changes on earnings, prepayment penalties and cash flows and to lower our cost of borrowing while taking into account variable interest rate risk. On October 25, 2016, the Bank entered into a Cash Flow Hedge agreement to effectively fix the rate for five years on $50.0 million of short-term FHLB advances. We are using this interest rate swap as a tool to lower the cost of certain FHLB advances as compared to the fixed rates offered by the FHLB for its longer term advances. At September 30, 2018, pursuant to the Cash Flow Hedge agreement we held a $50.0 million notional pay fixed, receive floating cash flow hedge. The Bank pays a fixed rate of 1.34% for five years and in turn, receives an interest payment based on three-month LIBOR, which resets quarterly. The hedge instrument is a $50.0 million FHLB fixed-rate three-month advance that is renewed at the fixed rate at maturity. Entering into this hedge agreement has allowed the Bank to secure fixed rate funding at a lower cost than a traditional five-year fixed rate FHLB advance. We will continue to review similar instruments and may utilize them for interest rate risk management in the future.

Interest rate contracts, however, may expose us to the risk of loss associated with variations in the spread between the interest rate contract and the hedged item. In addition, these contracts carry volatility risk that the expected uncertainty relating to

58



the price of the underlying asset differs from what is anticipated. If any interest rate swaps we enter into prove ineffective, it could result in volatility in our operating results, including potential losses, which could have a material adverse effect on our results of operations and cash flows.

Brokered Deposits. Management utilizes the national brokered deposit market as an additional source of funds and to assist efforts in managing interest rate risk. Utilizing brokered deposits might result in increased regulatory scrutiny, as such deposits are not viewed as favorably as core retail deposits and there can be no assurance that the Bank will be allowed to include brokered deposits in its deposit mix in the future. While management will attempt to weigh the benefits of brokered deposits against the costs and risks, there can be no assurance that its conclusions will necessarily be aligned with those of the Bank’s regulators.

How We Measure the Risk of Interest Rate Changes. We monitor our interest rate sensitivity on a quarterly basis to measure the change in projected net interest income in varying rate environments. Management uses various assumptions to evaluate the sensitivity of our operations to changes in interest rates. Although management believes these assumptions are reasonable, the interest rate sensitivity of our assets and liabilities on net interest income and the market value of portfolio equity could vary substantially if different assumptions were used or actual experience differs from these assumptions. Although certain assets and liabilities may have similar maturities or periods of repricing, they may react differently to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities lag behind changes in market interest rates. Non-uniform changes and fluctuations in market interest rates across various maturities will also affect the results presented. In addition, certain assets, such as adjustable-rate mortgage loans, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. A portion of our adjustable-rate loans have interest rate floors below which the loan’s contractual interest rate may not adjust. Approximately 52.7% of our total loans, net of LIP, were adjustable-rate loans at September 30, 2018. At that date, $229.4 million, or 43.1% of these loans were at their floor, with a weighted-average interest rate of 4.25%.

The inability of our loans to adjust downward can contribute to increased income in periods of declining interest rates. However, when loans are at their floors, there is a risk that our interest income may not increase as rapidly as our cost of funds during periods of increasing interest rates. Furthermore, in the event of a significant change in interest rates, prepayment and early withdrawal levels would likely deviate from those assumed. Finally, the ability of many borrowers to service their debt may decrease in the event of an interest rate increase. We consider all these factors in monitoring our interest rate exposure.

The assumptions we use are based upon a combination of proprietary and market data that reflect historical results and current market conditions. These assumptions relate to interest rates, loan prepayments, deposit decay rates and the market value of certain assets under the various interest rate scenarios. We use market data to determine prepayments and maturities of loans, investments and borrowings and use our own assumptions on deposit decay rates. Time deposits are modeled to reprice at rates that change in proportion to market rates upon their stated maturities. We also assume that non-maturity deposit rates can be maintained with rate adjustments proportionate to the change in market interest rates, based upon our historical deposit decay rates. We have demonstrated in the past that the tiering structure of our deposit accounts during changing rate environments results in relatively lower volatility and less than market rate changes in our interest expense for deposits. We tier our deposit accounts by balance and rate, whereby higher balances within an account earn higher rates of interest. Therefore, deposits that are not very rate sensitive (generally, lower balance tiers) are separated from deposits that are rate sensitive (generally, higher balance tiers). When interest rates rise, we do not have to raise interest rates proportionately on less rate sensitive accounts to retain these deposits. These assumptions are based upon our analysis of our customer base, competitive factors and historical experience.

Our income simulation model examines changes in net interest income in which interest rates were assumed to remain at their base level, instantaneously increase by 100, 200 and 300 basis points or decline immediately by 100 and 200 basis points. Reductions of rates by 300 basis points were not reported due to the current low rate environment.

The following table illustrates the change in our net interest income at September 30, 2018, that would occur in the event of an instantaneous change in interest rates equally across all maturities, with no effect given to any steps that we might take to counter the effect of that interest rate movement.

59



    
Net Interest Income Change at September 30, 2018
Basis Point Change in Rates
 
Net Interest Income
 
% Change
(Dollars in thousands)
+300
 
$
37,472

 
1.22
 %
+200
 
37,279

 
0.70

+100
 
37,184

 
0.44

Base
 
37,020

 

(100)
 
36,716

 
(0.82
)
(200)
 
36,301

 
(1.94
)

The following table illustrates the change in our net portfolio value (“NPV”) at September 30, 2018, that would occur in the event of an immediate change in interest rates equally across all maturities, with no effect given to any steps that we might take to counter the effect of that interest rate movement.
Basis Point
 
 
 
 
 
 
 
Net Portfolio as % of
 
Market
Change in
 
Net Portfolio Value (1)
 
Portfolio Value of Assets
 
Value of
Rates
 
Amount
 
$ Change (2)
 
% Change
 
NPV Ratio (3)
 
% Change (4)
 
Assets (5)
 
 
(Dollars in thousands)
+300
 
$
122,454

 
$
(40,247
)
 
(24.74
)%
 
10.85
%
 
(3.31
)%
 
$
1,128,802

+200
 
134,572

 
(28,129
)
 
(17.29
)
 
11.65

 
(2.32
)
 
1,155,412

+100
 
149,515

 
(13,186
)
 
(8.10
)
 
12.61

 
(1.09
)
 
1,185,384

Base
 
162,701

 

 

 
13.40

 

 
1,214,585

(100)
 
172,636

 
9,935

 
6.11

 
13.91

 
0.82

 
1,241,446

(200)
 
174,591

 
11,890

 
7.31

 
13.81

 
0.98

 
1,263,969

_____________ 

(1) The net portfolio value is the difference between the present value of the discounted cash flows of assets and liabilities and represents the market value of the Company’s equity for any given interest rate scenario. Net portfolio value is useful for determining, on a market value basis, how the market value of equity changes in response to various interest rate scenarios. Large changes in net portfolio value reflect increased interest rate sensitivity and generally more volatile earnings streams.
(2) The increase or decrease in net portfolio value at the indicated interest rates compared to the net portfolio value assuming no change in interest rates.
(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.
(5) The market value of assets represents the value of assets under the various interest rate scenarios and reflects the sensitivity of those assets to interest rate changes.

The net interest income and net portfolio value tables presented above are predicated upon a stable balance sheet with no growth or change in asset or liability mix. In addition, the net portfolio value is based upon the present value of discounted cash flows using our estimates of current replacement rates to discount the cash flows. The effects of changes in interest rates in the net interest income table are based upon a cash flow simulation of our existing assets and liabilities and assuming that delinquency rates would not change as a result of changes in interest rates, although there can be no assurance that this will be the case. Delinquency rates may change when interest rates change as a result of changes in the loan portfolio mix, underwriting conditions, loan terms or changes in economic conditions that have a delayed effect on the portfolio. Even if interest rates change in the designated amounts, there can be no assurance that our assets and liabilities would perform as set forth above. Also, a change in U.S. Treasury rates in the designated amounts accompanied by a change in the shape of the Treasury yield curve would cause changes to the net portfolio value and net interest income other than those indicated above.

At September 30, 2018, other than the interest rate swap we entered into through the Cash Flow Hedge agreement, we did not have any derivative financial instruments or trading accounts for any class of financial instruments, nor have we engaged in any other hedging activities or purchased off-balance sheet derivative instruments. However, we continue to review such

60



instruments and may utilize them for interest rate risk management in the future. 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. Furthermore, 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 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, 2018, 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, 2018, 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.

PART II
Item 1. Legal Proceedings

From time to time, we are engaged in various 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 2017 Form 10-K.

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

(a)     Not applicable

(b)     Not applicable


(c)    Not applicable


Item 3. Defaults Upon Senior Securities

Not applicable.

61




Item 4. Mine Safety Disclosures

Not applicable.

Item 5. Other Information

Not applicable.

62




Item 6. Exhibits and Financial Statement Schedules
 
(a)       Exhibits
 
3.1

 
3.2

 
4.0

 
10.1

 
10.2

 
10.3

 
10.4

 
10.5

 
10.6

 
10.7

 
10.8

 
10.9

 
10.10

 
10.11

 
10.12

 
10.13

 
31.1

 
31.2

 
32

 
101

 
The following materials from First Financial Northwest’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2018, formatted in Extensible Business Reporting Language (XBRL): (1) Consolidated Balance Sheets; (2) Consolidated Income Statements; (3) Consolidated Statements of Comprehensive Income; (4) Consolidated Statements of Stockholders’ Equity; (5) Consolidated Statements of Cash Flows; and (6) Selected Notes to Consolidated Financial Statements.

 _____________
(1) 
Filed as an exhibit to First Financial Northwest’s Registration Statement on Form S-1 on June 6, 2007 (333-143539)
(2) 
Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated June 15, 2017.
(3) 
Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated December 5, 2013.
(4) 
Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated September 9, 2014.
(5) 
Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated July 11, 2017.
(6) 
Filed as Appendix A to First Financial Northwest’s definitive proxy statement dated April 15, 2008.
(7) 
Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated June 15, 2016.
(8) 
Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated July 1, 2008.
(9) 
Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated September 8, 2017.
(10) 
Filed as an exhibit to First Financial Northwest’s Quarterly Report on Form 10-Q for March 31, 2018 filed on May 8, 2018.
(11) 
Filed as an exhibit to First Financial Northwest’s Registration Statement on Form S-8 on June 15, 2016 (333-212029)


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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, 2018
By: 
/s/Joseph W. Kiley III
 
 
Joseph W. Kiley III
 
 
President and Chief Executive Officer (Principal Executive Officer)
Date: November 7, 2018
By: 
/s/Richard P. Jacobson
 
 
Richard P. Jacobson
 
 
Executive Vice President and Chief Financial Officer (Principal Financial Officer)
 
 
 
Date: November 7, 2018
By: 
/s/Christine A. Huestis
 
 
Christine A. Huestis
 
 
Vice President and Controller (Principal Accounting Officer)

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Exhibit Index

Exhibit No.
 
Description
10.13

 
31.1

 
31.2

 
32

 
101

 
The following materials from First Financial Northwest’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2018, formatted in Extensible Business Reporting Language (XBRL): (1) Consolidated Balance Sheets; (2) Consolidated Income Statements; (3) Consolidated Statements of Comprehensive Income; (4) Consolidated Statements of Stockholders’ Equity; (5) Consolidated Statements of Cash Flows; and (6) Selected Notes to Consolidated Financial Statements.




65