NORTHRIM BANCORP INC - Annual Report: 2006 (Form 10-K)

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

ANNUAL REPORT UNDER SECTION 13 OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2006

 

Commission File Number 0-33501

 

Northrim BanCorp, Inc.

(Exact name of registrant as specified in its charter)

 

3111 C Street

Anchorage, Alaska 99503

(Address of principal executive offices) (Zip Code)

 

Registrant’s Telephone Number, Including Area Code:

(907) 562-0062

 

Securities Registered Pursuant to Section 12(b) of the Act:

None

 

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock, $1.00 Par Value

(Title of Class)

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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 þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (17 C.F.R. 229.405) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K.  Yes o     No þ

 

Indicate by check mark if the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o               Accelerated filer þ               Non-Accelerated filer o

 

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

 

The aggregate market value of common stock held by non-affiliates of registrant at June 30, 2006, was $133,680,506.

 

The number of shares of registrant’s common stock outstanding at March 1, 2007, was 6,115,822.

 

Documents incorporated by reference and parts of Form 10-K into which incorporated: The portions of the Proxy Statement for Northrim BanCorp’s Annual Shareholders’ Meeting to be held on May 3, 2007, referenced in Part III of this Form 10-K are incorporated by reference therein.

 

 

Northrim BanCorp, Inc.
Table of Contents

 

 

 

Note Regarding Forward-Looking Statements

 

This report includes forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements describe Northrim’s management’s expectations about future events and developments such as future operating results, growth in loans and deposits, continued success of Northrim’s style of banking, and the strength of the local economy. All statements other than statements of historical fact, including statements regarding industry prospects and future results of operations or financial position, made in this report are forward-looking. We use words such as “anticipates,” “believes,” “expects,” “intends” and similar expressions in part to help identify forward-looking statements. Forward-looking statements reflect management’s current expectations and are inherently uncertain. Our actual results may differ significantly from management’s expectations, and those variations may be both material and adverse. Forward-looking statements are subject to various risks and uncertainties that may cause our actual results to differ materially and adversely from our expectations as indicated in the forward-looking statements. These risks and uncertainties include: the general condition of, and changes in, the Alaska economy; factors that impact our net interest margins; and our ability to maintain asset quality. Further, actual results may be affected by our ability to compete on price and other factors with other financial institutions; customer acceptance of new products and services; the regulatory environment in which we operate; and general trends in the local, regional and national banking industry and economy. Many of these risks, as well as other risks that may have a material adverse impact on our operations and business, are identified in our filings with the SEC. However, you should be aware that these factors are not an exhaustive list, and you should not assume these are the only factors that may cause our actual results to differ from our expectations. In addition, you should note that we do not intend to update any of the forward-looking statements or the uncertainties that may adversely impact those statements.

 

Overview

 

Northrim BanCorp, Inc. (the “Company”) is a publicly traded bank holding company with four wholly-owned subsidiaries, Northrim Bank (the “Bank”), a state chartered, full-service commercial bank; Northrim Investment Services Company (“NISC”), which we formed in November 2002 to hold the Company’s equity interest in Elliott Cove Capital Management LLC, (“Elliott Cove”), an investment advisory services company; Northrim Capital Trust 1 (“NCT1”), an entity that we formed in May of 2003 to facilitate a trust preferred security offering by the Company; and Northrim Statutory Trust 2 (“NST2”), an entity that we formed in December of 2005 to facilitate a trust preferred security offering by the Company. We also hold a 24% interest in the profits and losses of a residential mortgage holding company, Residential Mortgage Holding Company LLC (“RML Holding Company”) through Northrim Bank’s wholly-owned subsidiary, Northrim Capital Investments Co. (“NCIC”). The predecessor of RML Holding Company, Residential Mortgage LLC (“RML”), was formed in 1998 and has offices throughout Alaska. We also operate in the Washington and Oregon market areas through Northrim Funding Services, a division of the Bank that was formed in 2004. In March and December of 2005, NCIC purchased ownership interests totaling 50.1% in Northrim Benefits Group, LLC (“NBG”), an insurance brokerage company that focuses on the sale and servicing of employee benefit plans. Finally, in the first quarter of 2006, through NISC, we purchased a 24% interest in Pacific Wealth Advisors, LLC (“PWA”), an investment advisory and wealth management business located in Seattle, Washington.

 

The Company is regulated by the Board of Governors of the Federal Reserve System, and the Bank is regulated by the Federal Deposit Insurance Corporation (“FDIC”), and the State of Alaska Department of Community and Economic Development, Division of Banking, Securities and Corporations. We began banking operations in Anchorage in December 1990, and formed the Company in connection with our reorganization into a holding company structure; that reorganization was completed effective December 31, 2001. We make our Securities Exchange Act reports available free of charge on our Internet web site, www.northrim.com. Our reports can also be obtained through the Securities and Exchange Commission’s EDGAR database at www.sec.gov.

 

We opened for business in 1990 shortly after the dramatic consolidation of the Alaska banking industry in the late 1980s that left three large commercial banks with over 93% of commercial bank deposits in greater Anchorage. Through the successful implementation of our “Customer First Service” philosophy of providing our customers with the highest level of service, we capitalized on the opportunity presented by this consolidation and carved out a market niche among small business and professional customers seeking more responsive and personalized service.

 

We grew substantially in 1999 when we completed a public stock offering in which we raised $18.5 million and acquired eight branches from Bank of America. The Bank of America branch acquisition was completed in June 1999 and increased our outstanding loans by $114 million, our deposits by $124 million, and provided us fixed assets valued at $2 million, for a purchase price of $5.9 million, in addition to the net book value of the loans and fixed assets. The stock offering allowed us to achieve the Bank of America acquisition while remaining well-capitalized under bank regulatory guidelines.

 

We have grown to be the third largest commercial bank in Anchorage and Alaska in terms of deposits, with $794.9 million in total deposits and $925.6 million in total assets at December 31, 2006. Through our 10 branches, we are accessible by approximately 65% of the Alaska population.

 

 

Elliott Cove Capital Management LLC

 

As of December 31, 2006, the Company owned a 47% equity interest in Elliott Cove, an investment advisory services company, through its wholly — owned subsidiary, NISC. Elliott Cove began active operations in the fourth quarter of 2002 and has had start-up losses since that time as it continues to build its assets under management. In addition to its ownership interest, the Company provides Elliott Cove with a line of credit that has a committed amount of $750,000 and an outstanding balance of $617,000 as of December 31, 2006.

 

As of December 31, 2006, there are 11 Northrim Bank employees who are licensed as IAR’s and actively selling the Elliott Cove product. We plan to continue to use the Elliott Cove products to strengthen our existing customer relationships and bring new customers into the Bank. In addition, as Elliott Cove builds its assets under management, we expect that it will reach a break-even point on a monthly basis on its operations in 2008.

 

Northrim Funding Services

 

In the third quarter of 2004, we formed Northrim Funding Services (“NFS”) as a division of the Bank. NFS is based in Bellevue, Washington and provides short-term working capital to customers in the states of Washington and Oregon by purchasing their accounts receivable. During its second full year of operations in 2006, the employees of NFS expanded the base of their operations. In 2007, we expect NFS to continue to penetrate its market and increase its market share in the purchased receivables business.

 

High Performance Checking

 

In the first part of 2005, we launched our High Performance Checking (“HPC”) product consisting of several consumer checking accounts tailored to the needs of specific segments of our market, including a totally free checking product. We supported the new products with a targeted marketing program and extensive branch sales promotions. Through the concentrated efforts of our branch employees, we increased the number of our deposit accounts and the balances in them.

 

In the fourth quarter of 2006, we introduced HPC for our business checking accounts. In 2007, we plan to continue to support the HPC consumer and business checking products with the same program of targeted marketing and branch promotions in an effort to continue to expand our core deposits.

 

Business Strategies

 

In addition to our acquisition strategy, we are pursuing a strategy of aggressive internal growth. Our success will depend on our ability to manage our credit risks and control our costs while providing competitive products and services. To achieve our objectives, we are pursuing the following business strategies:

 

 

 

Services

 

We provide a wide range of banking services in South Central and Interior Alaska to businesses, professionals, and individuals with high service expectations.

 

Deposit Services: Our deposit services include noninterest-bearing checking accounts and interest-bearing time deposits, checking accounts, and savings accounts. Our interest-bearing accounts generally earn interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. We have two deposit products that are indexed to specific U.S. Treasury rates.

 

Several of our innovative deposit services and products are:

 

 

Lending Services: We are an active lender with an emphasis on commercial and real estate lending. We also believe we have a significant niche in construction and land development lending in Anchorage, Fairbanks, and the Matanuska Valley (near Anchorage). To a lesser extent, we provide consumer loans. See “— Lending Activities.”

 

Other Customer Services: In addition to our deposit and lending services, we offer our customers several 24-hour services: Telebanking, faxed account statements, Internet banking for individuals and businesses, and automated teller services. Other special services include personalized checks at account opening, overdraft protection from a savings account, extended banking hours (Monday through Friday, 9 a.m. to 6 p.m. for the lobby, and 8 a.m. to 7 p.m. for the drive-up, and Saturday 10 a.m. to 3 p.m.), commercial drive-up banking with coin service, automatic transfers and payments, wire transfers, direct payroll deposit, electronic tax payments, Automated Clearing House origination and receipt, cash management programs to meet the specialized needs of business customers, and courier agents who pick up noncash deposits from business customers.

 

Directors and Executive Officers: The following table presents the names and occupations of our directors and executive officers.

 

 

*Indicates individual serving as both director and executive officer.

 

 

 

Reconciliation of Selected Financial Data to GAAP Financial Measures⁽²⁾

 

 

 

Overview

 

We are a publicly traded bank holding company with four wholly-owned subsidiaries: the Bank, a state chartered, full-service commercial bank; NISC, a company formed to invest in both Elliott Cove, an investment advisory services company, and PWA, an investment advisory and wealth management business located in Seattle, Washington; and NCT1 and NST2, entities formed to facilitate two trust preferred securities offerings. The Bank in turn has a wholly-owned subsidiary, NCIC, which has an interest in RML Holding Company, a residential mortgage holding company and NBG, an insurance brokerage company that provides employee benefits plans to businesses throughout Alaska. We are headquartered in Anchorage and have 10 branch locations, seven in Anchorage, and one each in Fairbanks, Eagle River, and Wasilla. The Bank also operates Northrim Funding Services, a division headquartered in Bellevue, Washington with operations in the Washington and Oregon markets. We offer a wide array of commercial and consumer loan and deposit products, investment products, and electronic banking services over the Internet.

 

We opened the Bank for business in Anchorage in 1990. The Bank became the wholly-owned subsidiary of the Company effective December 31, 2001, when we completed our bank holding company reorganization. We opened our first branch in Fairbanks in 1996, and our second location in Anchorage in 1997. During the second quarter of 1999, we purchased eight branches located in Anchorage, Eagle River and Wasilla from Bank of America. This acquisition resulted in us acquiring $114 million in loans, $124 million in deposits and $2 million in fixed assets for a purchase price of $5.9 million.

 

One of our major objectives is to increase our market share in Anchorage, Fairbanks, and the Matanuska Valley, Alaska’s three largest urban areas. We estimate that we hold a 21% share of the commercial bank deposit market in Anchorage, a 9% share of the Fairbanks market, and a 10% share of the Matanuska Valley market as of June 30, 2006.

 

Our growth and operations depend upon the economic conditions of Alaska and the specific markets we serve. The economy of Alaska is dependent upon the natural resources industries, in particular oil production, as well as tourism, government, and U.S. military spending. According to the State of Alaska Department of Revenue, approximately 86% of the Alaska state government is funded through various taxes and royalties on the oil industry. Any significant changes in the Alaska economy and the markets we serve eventually could have a positive or negative impact on the Company.

 

During the second quarter of 1999, we sold 1,842,900 shares of our common stock in an underwritten common stock offering that generated $18.5 million in net proceeds. We used the proceeds to purchase the Bank of America branches and to provide capital for additional growth.

 

At December 31, 2006, we had assets of $925.6 million and gross loans of $717.1 million, an increase of 3% and 2%, respectively, over assets of $895.6 million and gross loans of $705.1 million at December 31, 2005. Our net income and diluted earnings per share for 2006 were $13 million and $2.09, respectively, an increase of 16% and 22%, respectively, from $11.2 million and $1.72 at year end 2005. During the same time period, our net interest income increased by $3.6 million, or 8%, to $47.5 million, from $43.9 million for the year ended 2005. Our provision for loan losses in 2006 increased by $1.4 million, or 119% to $2.6 million, from $1.2 million in 2005, as our nonperforming loans increased by $561,000, or 9% for 2006, from $6.1 million in 2005 to $6.6 million for 2006. In contrast, for 2006 our other operating income increased by $2.8 million, or 58%, to $7.7 million from $4.8 million in 2005. The growth in our net interest income combined with the positive effects of the increases in our other operating income was offset in part by an increase in other operating expenses of $1.9 million, or 6%, to $31.4 million in 2006 from $29.5 million for 2005, which resulted in an increase in our net income and earnings per share.

 

Results of Operations

 

Net Income

 

We earned net income of $13 million in 2006, compared to net income of $11.2 million in 2005, and $10.7 million in 2004. During these periods, net income per diluted share was $2.09, $1.72, and $1.63, respectively.

 

Net Interest Income

 

Our results of operations are dependent to a large degree on our net interest income. We also generate other income, primarily through service charges and fees, earnings from our mortgage affiliate and purchased receivables products, and other sources. Our operating expenses consist in large part of compensation, employee benefits expense, occupancy, and marketing expense. Interest income and cost of funds are affected significantly by general economic conditions, particularly changes in market interest rates, and by government policies and the actions of regulatory authorities.

 

Net interest income is the difference between interest income, from loan and investment securities portfolios, and interest expense, on customer deposits and borrowings. Net interest income in 2006 was $47.5 million compared to $43.9 million in 2005, and $41.3 million in 2004, reflecting an increase in our interest-earning assets and the general level of interest rates. Average interest-earning assets increased $32.3 million, or 4%, in 2006 compared to an increase in average interest-bearing liabilities in 2006 of $36 million, or 6%. Average interest-earning assets increased $74.1 million, or 11%, in 2005 compared to an increase in average interest-bearing liabilities in 2005 of $76.1 million, or 15%.

 

Changes in net interest income result from changes in volume and spread, which in turn affect our margin. For this purpose, volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets. Changes in net interest income are influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities. During the fiscal years ended December 31, 2006, 2005, and 2004, average interest-earning assets were $810.9 million, $778.6 million, and $704.5 million, respectively. During these same periods, net interest margins were 5.86%, 5.64%, and 5.86%, respectively, which reflect our balance sheet mix and premium pricing on loans compared to other community banks and an emphasis on construction lending, which has a higher fee base. Our average yield on earning-assets was 8.57% in 2006, 7.55% in 2005, and 6.89% in 2004, while the average cost of interest-bearing liabilities was 3.63% in 2006, 2.61% in 2005, and 1.48% in 2004.

 

Our net interest margin increased in 2006 from 2005 due to the interaction of several factors. First, in 2006, the cost of interest-bearing liabilities increased by 102 basis points while the yield on interest-earning assets also increased by 102 basis points. During this time, the average balance of our interest-bearing demand deposits increased by $13 million to $78.9 million at December 31, 2006 from $65.9 million at December 31, 2005. The average balance of our demand deposits and other noninterest-bearing liabilities also increased by $5.5 million to $193.5 million at December 31, 2006 from $188 million at December 31, 2005. The increase in these lower cost deposits in 2006 helped to contain the rate of growth in the cost of interest-bearing liabilities. Second, the 102 basis point increase in the yield on earning assets in 2006 had a larger effect on net interest income because it was applied to earning assets with an average balance of $810.9 million versus the 102 basis point increase in the cost of interest-bearing liabilities that was applied to an average balance of $605.6 million. Finally, in 2006, earning assets increased by $32.3 million, or 4% compared to growth of $74.1 million, or 11% in 2005. However, during these same time periods, net interest income increased by $3.6 million, or 8% and $2.6 million, or 6%, respectively in 2006 and 2005. The growth rate of net interest income increased in 2006 while the rate of growth in earning assets decreased, which contributed to the increase in the net interest margin.

 

The following table sets forth for the periods indicated, information with regard to average balances of assets and liabilities, as well as the total dollar amounts of interest income from interest-earning assets and interest expense on interest-bearing liabilities. Resultant yields or costs, net interest income, and net interest margin are also presented:

 

 

 

The following table sets forth the changes in consolidated net interest income attributable to changes in volume and to changes in interest rates. Changes attributable to the combined effect of volume and interest rate have been allocated proportionately to the changes due to volume and the changes due to interest rate.

 

 

Other Operating Income

 

Total other operating income increased $2.8 million, or 59%, in 2006, after increasing $1 million, or 27%, in 2005, and decreasing $2.3 million, or 38%, in 2004. The following table separates the more routine (operating) sources of other income from those that can fluctuate significantly from period to period:

 

Total operating sources of other operating income in 2006 increased $2.8 million, or 59% over 2005 levels. In 2005, this income increased $1.2 million, or 32%, and in 2004, it decreased $2.1 million, or 37% as compared to 2003 levels. The main reason for the increase in other operating income in 2006 was the increase in income from purchased receivables and the consolidation of NBG into the Company’s financial statements.

 

Deposit service charges increased $175,000, or 10%, in 2006 as compared to 2005, and they increased $118,000, or 5%, in 2005 as compared to 2004 due to the increased personal account base that resulted from the marketing of the HPC deposit product. The Company began to market this product in the second quarter of 2005. As a result, the increase in deposit service charges was larger in 2006 than it was in 2005 since 2006 reflected a full year of activity with the HPC product.

 

Income from the Company’s purchased receivable products increased by $862,000, or 87%, in 2006 as compared to 2005, and this income increased $792,000, or 394%, in 2005 as compared to 2004. The Company uses these products to purchase accounts receivable from its customers and provide them with working capital for their businesses. While the customers are responsible for collecting these receivables, the Company mitigates this risk with extensive monitoring of the customers’ transactions and control of the proceeds from the collection process. The Company earns income from the purchased receivable product by charging finance charges to its customers for the purchase of their accounts receivable. The income from this product has grown as the Company has used it to purchase more receivables from its customers. The Company expects the income level from this product to show growth on a year-over-year comparative basis as the Company increases this line of business at NFS as it continues to increase its market share.

 

In December of 2005, the Company, through its wholly-owned subsidiary NCIC, purchased an additional 40.1% interest in NBG, which brought its ownership interest in this company to 50.1%. As a result of this increase in ownership, the Company now consolidates the balance sheet and income statement of NBG into its financial statements. In 2006, the Company included employee benefit plan income from NBG of $1.1 million in its other operating income. In contrast, the Company did not record any income for this item in its other operating income in 2005 as it purchased a 10% interest in NBG in March of 2005 and accounted for this interest according to the equity method in 2005.

 

The Company’s electronic banking fees increased by $158,000, or 25%, in 2006 as compared to 2005, and these fees increased by $24,000, or 4%, in 2005 as compared to 2004. As the Company increased the number of its deposit accounts through the marketing of the HPC product, it also sold additional services to these new accounts, which helped it to increase its electronic banking fees.

 

Included in operating sources of other operating income in 2006, 2005, and 2004 were $649,000, $493,000, and $438,000, respectively, of income from our share of the earnings from RML. RML was formed in 1998 and has offices throughout Alaska. During the third quarter of 2004, RML reorganized and became a wholly-owned subsidiary of a newly formed holding company, RML Holding Company. In this process, RML Holding Company acquired another mortgage company, Pacific Alaska Mortgage Company (“PAM”). In the first quarter of 2005, PAM was merged into RML. Prior to the reorganization, the Company, through Northrim Bank’s wholly-owned subsidiary, NCIC, owned a 30% interest in the profits and losses of RML. Following the reorganization, the Company’s interest in RML Holding Company decreased to 24%.

 

Earnings from RML and RML Holding Company have fluctuated with activity in the housing market, which has been affected by local economic conditions and changes in mortgage interest rates. In 2003, and 2002, declining mortgage interest rates generated a significant increase in the demand for mortgage loans by consumers both for the refinance of existing loans and the purchase of new homes. Mortgage rates began to increase in the third quarter of 2003 from the historic lows reached in the second quarter. As a result, the refinance activity in the mortgage industry began to decrease in the latter part of 2003. Due to this trend of increasing long-term mortgage interest rates and the costs associated with the merger of RML and PAM, our share of the earnings from RML declined in 2004. In 2005 and 2006, RML Holding Company began to realize some efficiencies from its merger and increased its income from its combined operations.

 

Merchant credit card transaction fees increased by $87,000, or 20% in 2006 as compared to 2005, and these fees increased by $30,000, or 7%, in 2005 as compared to 2004 as the Company increased the sales volume of this product to its larger account base.

 

Loan service fees increased by $157,000, or 42% in 2006 as compared to 2005 as the Company increased the collection of late fees on its loan portfolio. In contrast, loan service fees decreased by $5,000, or 1%, in 2005 as compared to 2004.

 

Our share of the loss from Elliott Cove decreased to $230,000 in 2006, as compared to losses of $424,000 and $457,000, respectively, in 2005 and 2004 as Elliott Cove increased its assets under management, which provided it with increased revenues.

 

Other income decreased by $81,000, or 27%, to $217,000 at December 31, 2006 from $298,000 at December 31, 2005. In the first quarter of 2006, through our subsidiary, NISC, the Company purchased a 24% interest in PWA. PWA is a holding company that owns Pacific Portfolio Consulting, LLC (“PPC”) and Pacific Portfolio Trust Company (“PPTC”). PPC is an investment advisory company with an existing client base while PPTC is a start-up operation. In 2006, the Company incurred a loss of $126,000 on its investment in PWA. The losses from PWA were partially offset by increases in commissions that the Company receives for its sales of

the Elliott Cove investment products, which were accounted for as other operating income. Finally, the Company expects to incur losses over the next several years as PWA builds the customer base of its combined operations.

 

Included in other sources of income is gain on sale of other real estate owned and gain on available for sale securities. No net security gains were recorded in 2006, whereas $9,000 of net gains was recorded in 2005, and $151,000 was recorded in 2004. In 2005, this income decreased $142,000, or 94%; and in 2004, it decreased $204,000, or 57%.

 

Expenses

 

Provision for Loan Losses: The provision for loan losses in 2006 was $2.6 million, compared to $1.2 million in 2005 and $1.6 million in 2004. We increased the provision for loan losses in 2006 due to overall loan growth and an increase in our nonperforming loans. In 2006, nonperforming loans increased to $6.6 million from a balance of $6.1 million at December 31, 2005. In addition, net loan charge-offs were $1.1 million, or 0.16% of average loans, in 2006 as compared to $1.2 million, or 0.18% of average loans, in 2005 and $1 million, or 0.16% of average loans, in 2004. The allowance for loan losses also increased in 2006 as a result of the increases in nonperforming loans and was $12.1 million, or 1.69% of portfolio loans as compared to $10.7 million, or 1.52% of portfolio loans at December 31, 2005 and $10.8 million, or 1.59% of portfolio loans, at December 31, 2004. Likewise, the coverage ratio of the allowance for loan losses versus nonperforming loans increased to 183% in 2006 as compared to a coverage ratio of 176% in 2005 and 163% in 2004.

 

Other Operating Expense: Other operating expense increased $1.9 million, or 6%, in 2006, $2.9 million, or 11%, in 2005, and $1.8 million, or 7%, in 2004. The following table breaks out the other operating expense categories:

 

 

Salaries and other personnel expense increased $1.6 million, or 9%, in 2006, $1.9 million, or 12%, in 2005, and $1.5 million, or 11%, in 2004, reflecting increases in salary and benefit costs throughout this time due in part to ongoing competition for our employees, which placed upward pressure on our salary structure. In 2006, the increase in the Company’s salary costs was partially offset by a $357,000 decrease in its health care costs. The Company does not expect continuing declines in its health care costs. Moreover, due to the tight labor market in the Company’s major markets and ongoing competition for its employees, the Company expects further increases in salaries and benefits. In addition, as noted above, the Company now accounts for NBG on a consolidated basis. In 2006, the Company included $446,000 of NBG’s salary and benefit costs in its own salary and benefit costs. Also, in the first quarter of 2006, the Company adopted FASB Statement 123R, Share-Based Payment. As a result, in 2006 the Company recorded $256,000 in additional expense associated with its stock options.

 

Between 2006 and 2004, our occupancy expenses increased by $373,000, or 18%, to $2.5 million from $2.1 million, as we incurred higher costs in our new branch locations and occupied additional space at our main Financial Center.

 

Marketing costs decreased by $16,000, or 1%, in 2006, increased by $456,000, or 38%, in 2005, and decreased $4,000, or less than 1%, in 2004. The main reason for the increase in marketing expenses in 2005 was the costs associated with marketing our HPC product. Although the Company has incurred additional marketing expenses due to promoting its HPC Program in 2006, those costs have been offset by a decrease in other marketing expenses such as advertising for some of the Company’s other products. The Company plans to continue to market its HPC Program as it has since the second quarter of 2005. Moreover, the company expects to incur increased marketing costs for the HPC for business product that it will begin marketing in 2007. The Company expects that the Bank will increase its deposit accounts and balances as it continues to implement the HPC Program over the next year. Furthermore, the Company expects that the additional deposit accounts will continue to generate increased fee income that will offset a majority of the increased marketing costs associated with the HPC Program.

 

Intangible asset amortization increased by $114,000 or 31% to $482,000 at December 31, 2006 from $368,000 at December 31, 2005, as the Company began to amortize the customer relationship intangible asset associated with NBG. As noted

above, the Company purchased an additional 40.1% interest in NBG in December of 2005, which increased its ownership interest in this company to 50.1%. The Company has invested $1.1 million in NBG since its initial investment in the first quarter of 2005 and has attributed all of this investment to an intangible asset represented by the value of the customer relationships of NBG. The Company is amortizing the NBG intangible asset over a ten-year period on a straight-line basis. In 2006, the amortization expense on the NBG intangible asset was $115,000, which accounts for the increase in amortization expense in that year. Prior to the Company’s additional investment in NBG in December of 2005, the Company accounted for its investment in NBG according to the equity method and did not record its amortization expense on the NBG investment on a separate basis. The other portion of intangible asset amortization at December 31, 2006 pertains to the core deposit intangible that was created when the Bank purchased branches from Bank of America in 1999. The amortization on the core deposit intangible will end in June 2007.

 

Other expenses, which includes professional fees, software expenses, ATM and Visa processing fees and other operational expenses, increased $107,000, or 2%, in 2006 as compared to 2005 and increased $252,000, or 4%, in 2005 as compared to 2004 due to changes in a variety of expense accounts.

 

Income Taxes: The provision for income taxes increased $1.1 million, or 15%, to $8 million in 2006, increased $697,000, or 11%, to $6.9 million in 2005, and decreased $289,000, or 4%, to $6.2 million in 2004. The effective tax rate for 2006 and 2005 was 38%, compared to 37% in 2004. The effective tax rate in 2004 was lower than that for 2005 due in part to the favorable resolution of a dispute on a prior year’s tax return recorded in 2004.

 

Financial Condition

 

Assets

 

Loans and Lending Activities

 

General: Our loan products include short and medium-term commercial loans, commercial credit lines, construction and real estate loans and consumer loans. We emphasize providing financial services to small and medium-sized businesses and to individuals. From our inception, we have emphasized commercial, land development and home construction, and commercial real estate lending. These types of lending have provided us with needed market opportunities and higher net interest margins than other types of lending. However, they also involve greater risks, including greater exposure to changes in local economic conditions, than certain other types of lending.

 

Loans are the highest yielding component of earning assets. Average loans were $13.9 million, or 2% greater in 2006 than in 2005. Average loans were $69.4 million, or 11% greater in 2005 than in 2004. Loans comprised 88% of total earning assets on average in 2006, 90% in 2005 and 89% in 2004. The yield on loans averaged 9.18% in 2006, 8.00% in 2005, and 7.30% in 2004.

 

Growth in the loan portfolio during 2006 was $12 million, or 2%. Commercial loans decreased $336,000, or less than 1%, commercial real estate loans decreased $14.8 million, or 6%, and construction loans increased $21.5 million, or 16%, in 2006. Installment and consumer loans increased $5.6 million, or 15%. Funding for the growth in loans in 2006 came from an increase in interest-bearing liabilities and from noninterest-bearing sources of funds and capital.

 

Nonperforming Loans; Real Estate Owned: Nonperforming assets consist of nonaccrual loans, accruing loans that are 90 days or more past due, restructured loans, and real estate owned. We had real estate owned property of $717,000 at December 31, 2006. The following table sets forth information regarding our nonperforming loans and total nonperforming assets:

 

 

Nonaccrual, Accruing Loans 90 Days or More Past Due, and Restructured Loans: The Company’s financial statements are prepared on the accrual basis of accounting, including recognition of interest income on its loan portfolio, unless a loan is placed on a nonaccrual basis. Loans are placed on a nonaccrual basis when management believes serious doubt exists about the collectability of principal or interest. Our policy generally is to discontinue the accrual of interest on all loans 90 days or more past due unless they are well secured and in the process of collection. Cash payments on nonaccrual loans are directly applied to the principal balance. The amount of unrecognized interest on nonaccrual loans was $437,000, $353,000, and $658,000, in 2006, 2005, and 2004, respectively.

 

Restructured loans are those for which concessions, including the reduction of interest rates below a rate otherwise available to that borrower, have been granted due to the borrower’s weakened financial condition. Interest on restructured loans will be accrued at the restructured rates when it is anticipated that no loss of original principal will occur, and the interest can be collected.

 

Total nonperforming loans at December 31, 2006, were $6.6 million, or 0.92% of portfolio loans, an increase of $561,000 from $6.1 million at December 31, 2005, and an increase of $42,000 from $6.6 million at December 31, 2004.

 

Potential Problem Loans: At December 31, 2006, management had identified potential problem loans of $6.4 million as compared to potential problem loans of $9.1 million at December 31, 2005. Loans in the amount of $4.1 million were reported as potential problem loans at December 31, 2005 and December 31, 2006. Potential problem loans are loans which are currently performing and are not included in nonaccrual, accruing loans 90 days or more past due, or restructured loans that have developed negative indications that the borrower may not be able to comply with present payment terms and which may later be included in nonaccrual, past due, or restructured loans.

 

Analysis of Allowance for Loan Losses: The allowance for loan losses is maintained at a level considered adequate by management to provide for inherent loan losses based on management’s assessment of various factors affecting the loan portfolio, including a review of problem loans, business conditions, estimated collateral values, loss experience, credit concentrations, and an overall evaluation of the quality of the underlying collateral, and holding and disposal costs. The allowance is increased by provisions charged to operations and reduced by loans charged off, net of recoveries. Management believes that at December 31, 2006, the allowance is adequate to cover losses that are probable in light of our current loan portfolio and existing economic conditions.

 

While management believes that it uses the best information available to determine the allowance for loan losses, unforeseen market conditions and other events could result in adjustment to the allowance for loan losses, and net income could be significantly affected, if circumstances differed substantially from the assumptions used in making the final determination.

 

The following table shows the allocation of the allowance for loan losses for the periods indicated:

 

 

 

The following table sets forth for the periods indicated information regarding changes in our allowance for loan losses:

 

 

Credit Authority and Loan Limits: All of our loans and credit lines are subject to approval procedures and amount limitations. These limitations apply to the borrower’s total outstanding indebtedness and commitments to us, including the indebtedness of any guarantor.

 

Generally, we are permitted to make loans to one borrower of up to 15% of the unimpaired capital and surplus of the Bank. The loan-to-one-borrower limitation for the Bank was $16.5 million at December 31, 2006. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Provision for Loan Losses.”

 

Loan Policy: Our lending operations are guided by loan policies, which outline the basic policies and procedures by which lending operations are conducted. Generally, the policies address our desired loan types, target markets, underwriting and collateral requirements, terms, interest rate and yield considerations, and compliance with laws and regulations. The policies are reviewed and approved annually by the Board of Directors. We supplement our own supervision of the loan underwriting and approval process with periodic loan reviews by experienced officers who examine quality, loan documentation, and compliance with laws and regulations.

 

Loans Receivable: Loans receivable increased to $717.1 million at December 31, 2006, compared to $705.1 million and $678.3 million at December 31, 2005 and 2004, respectively. At December 31, 2006, 78% of the portfolio was scheduled to mature or reprice in 2007 with 19% scheduled to mature or reprice between 2008 and 2011. Future growth in loans is generally dependent on new loan demand and deposit growth, constrained by our policy of being “well-capitalized” as determined by the FDIC.

 

Loan Portfolio Composition: The following table sets forth at the dates indicated our loan portfolio composition by type of loan:

 

 

The following table presents at December 31, 2006, the aggregate maturity and repricing data of our loan portfolio:

 

Commercial Loans: Our commercial loan portfolio includes both secured and unsecured loans for working capital and expansion. Short-term working capital loans generally are secured by accounts receivable, inventory, or equipment. We also make longer-term commercial loans secured by equipment and real estate. We also make commercial loans that are guaranteed in large part by the Small Business Administration or the Bureau of Indian Affairs and commercial real estate loans that are participated with the Alaska Industrial Development and Export Authority (“AIDEA”). Commercial loans represented 40% of our total loans outstanding as of December 31, 2006 and reprice more frequently than other types of loans, such as real estate loans. More frequent repricing means that commercial loans are more sensitive to changes in interest rates. In a rising interest rate environment, our philosophy is to emphasize the pricing of loans on a floating rate basis, which allows these loans to reprice more frequently and to contribute positively to our net interest margin.

 

Construction Loans:

 

Land Development: We believe we are a major land development and residential construction lender. At December 31, 2006, we had $46.8 million of residential subdivision land development loans outstanding, or 7% of total loans.

 

One-to-Four-Family Residences: We financed approximately one-third of the single-family houses constructed in Anchorage in 2006. We originated one-to-four-family residential construction loans to builders for construction of homes. At December 31, 2006, we had $86.2 million of one-to-four-family residential and condominium construction loans, or 12% of total loans. Of the homes under construction at December 31, 2006, for which these loans had been made, 36% were subject to sale contracts between the builder and homebuyers who were pre-qualified for loans, usually with other financial institutions.

 

Commercial Construction: We also provide construction lending for commercial real estate projects. Such loans generally are made only when there is a firm take-out commitment upon completion of the project by a third party lender.

 

Real Estate Loans for Sale: In 1998, our wholly-owned subsidiary, NCIC, purchased a 30% profits and losses interest of RML, a mortgage company with offices throughout Alaska, in order for us to obtain a presence in the residential mortgage market. As noted above, in the third quarter of 2004, RML merged with PAM, another mortgage company. As a result, we now own 24% of RML Holding Company, the holding company for RML and PAM.

 

Commercial Real Estate: We believe we are an active lender in the commercial real estate market. At December 31, 2006, our commercial real estate loans were $237.6 million, or 33% of our loan portfolio. These loans are typically secured by office buildings, apartment complexes or warehouses. Loan maturities range from 10 to 25 years, ordinarily subject to our right to call the loan within 10 to 15 years of its origination. The interest rate for approximately 49% of these loans originated by Northrim resets every one to five years based on the spread over an index rate, normally prime or the respective Treasury rate.

 

We often sell all or a portion of our commercial real estate loans to two State of Alaska entities that were established to provide long-term financing in the State, AIDEA, and the Alaska Housing Finance Corporation (“AHFC”). We often sell up to a 90% loan participation to AIDEA. AIDEA’s portion of the participated loan typically features a maturity twice that of the portion retained by us and bears a lower interest rate. The blend of our and AIDEA’s loan terms allows us to provide competitive long-term financing to our customers, while reducing the risk inherent in this type of lending. We also originate and sell to AHFC loans secured by multifamily residential units. Typically, 100% of these loans are sold to AHFC and we provide ongoing servicing of the loans for a fee. AIDEA and AHFC make it possible for us to originate these commercial real estate loans and enhance fee income while reducing our exposure to risk.

 

Consumer Loans: We provide personal loans for automobiles, recreational vehicles, boats, and other larger consumer purchases. We provide both secured and unsecured consumer credit lines to accommodate the needs of our individual customers, with home equity lines of credit serving as the major product in this area.

 

Off-Balance Sheet Arrangements — Commitments and Contingent Liabilities: In the ordinary course of business, we enter into various types of transactions that include commitments to extend credit that are not reflected on our balance sheet. We apply the same credit standards to these commitments as in all of our lending activities and include these commitments in our lending risk evaluations. Our exposure to credit loss under commitments to extend credit is represented by the amount of these commitments. See Note 18 to “Notes to Consolidated Financial Statements” in our Annual Report for the year ended December 31, 2006. See also “Liquidity and Capital Resources.”

 

Investments and Investment Activities

 

General: Our investment portfolio consists primarily of U.S. Treasury and government sponsored entity securities, and municipal securities. Investment securities totaled $100.3 million at December 31, 2006, an increase of $45.4 million, or 83%, from year-end 2005. The average maturity of the investment portfolio was approximately two years at December 31, 2006.

 

Investment securities designated as available for sale comprised 87% of the portfolio and are available to meet liquidity requirements. Both available for sale and held to maturity securities may be pledged as collateral to secure public deposits. At December 31, 2006, $15.7 million in securities were pledged for deposits and borrowings.

 

Investment Portfolio Composition: Our investment portfolio is divided into two classes:

 

Securities Available For Sale: These are securities we may hold for indefinite periods of time. These securities include those that management intends to use as part of our asset/liability management strategy and that may be sold in response to changes in interest rates and/or significant prepayment risks. We carry these securities at market value with any unrealized gains or losses reflected as an adjustment to shareholders’ equity.

 

Securities Held To Maturity: These are securities that we have the ability and the intent to hold to maturity. Events that may be reasonably anticipated are considered when determining our intent to hold investment securities to maturity. These securities are carried at amortized cost.

 

The following tables set forth the composition of our investment portfolio at the dates indicated:

 

For the periods ending December 31, 2006, 2005, and 2004, we held Federal Home Loan Bank (“FHLB”) stock with a book value approximately equal to its market value in the amounts of $1.6 million, $1.6 million, and $1.3 million, respectively.

 

Market Value, Maturities and Weighted Average Yields: The following table sets forth the market value, maturities and weighted average yields of our investment portfolio for the periods indicated as of December 31, 2006:

 

 

At December 31, 2006, we held no securities of any single issuer (other than government sponsored entities) that exceeded 10% of our shareholders’ equity.

 

Purchased Receivables

 

General: We purchase accounts receivable from our business customers and provide them with short-term working capital. We provide this service to our customers in Alaska with our Business Manager^® and MedCash Manager^® products and in Washington and Oregon through NFS.

 

Our purchased receivable balances increased in 2006 to $21.2 million, as compared to $12.2 million in 2005. The funding for this growth in purchased receivables came from an increase in interest-bearing liabilities and from noninterest-bearing sources of funds and capital.

 

Policy and Authority Limits: Our purchased receivable activity is guided by policies that outline risk management, documentation, and approval limits. The policies are reviewed and approved annually by the Board of Directors.

 

Liabilities

 

Deposits

 

General: Deposits are our primary source of funds. Total deposits increased 2% to $794.9 million at December 31, 2006, compared with $779.9 million at December 31, 2005, and $699.1 million at December 31, 2004. Our deposits generally are expected to fluctuate according to the level of our market share, economic conditions, and normal seasonal trends.

 

Average Balances and Rates: The following table sets forth the average balances outstanding and average interest rates for each major category of our deposits, for the periods indicated:

 

 

Certificates of Deposit: The only deposit category with stated maturity dates is certificates of deposit. At December 31, 2006, we had $85.9 million in certificates of deposit, of which $59.4 million, or 69%, are scheduled to mature in 2007.

 

Alaska Certificates of Deposit: The Alaska Certificate of Deposit (“Alaska CD”) is a savings deposit product with an open-ended maturity, interest rate that adjusts to an index that is tied to the two-year United States Treasury Note, and limited withdrawals. The total balance in the Alaska CD at December 31, 2006, was $207.5 million, an increase of $9.5 million as compared to the balance of $198 million at December 31, 2005.

 

Alaska Permanent Fund: The Alaska Permanent Fund may invest in certificates of deposit at Alaska banks in an aggregate amount with respect to each bank, not to exceed its capital and at specified rates and terms. The depository bank must collateralize the deposit. At December 31, 2006, we did not hold any certificates of deposit for the Alaska Permanent Fund.

 

Borrowings

 

FHLB: At December 31, 2006, our maximum borrowing line from the FHLB was equal to $107 million, approximately 12% of the Company’s assets. At December 31, 2006, there was $2.2 million outstanding on the line. At December 31, 2005, there was $2.6 million outstanding on the line and an additional $15.5 million of the borrowing line was committed to secure public deposits. FHLB advances are secured by a blanket pledge of the Company’s assets.

 

Other Short-term Borrowing: At December 31, 2006, there were no short-term (original maturity of one year or less) borrowings that exceeded 30% of shareholders’ equity.

 

Contractual Obligations

 

The following table references contractual obligations of the Company for the periods indicated: