NORTHRIM BANCORP INC - Annual Report: 2007 (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, 2007

 

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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

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, 2007, was $152,994,008.

 

The number of shares of registrant’s common stock outstanding at March 1, 2008, was 6,311,807.

 

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 1, 2008, 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 (“NFS”), 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, trust 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.

 

In October 2007, we acquired 100% of the outstanding shares of Alaska First Bank & Trust, N.A. (“Alaska First”) for a purchase price of $6.3 million and merged it into Northrim Bank. The Company did not acquire Alaska First’s subsidiary, Hagen Insurance, Inc., nor did it retain the two Alaska First branches. The Alaska First acquisition increased our cash by $18.8 million, investments by $23.8 million, outstanding loans by $13.2 million and other assets by $1.6 million. We assumed $47.7 million of deposits, $5.1 million of borrowings and $900,000 of other liabilities. See “Note 1 — Organization and Summary of Significant Accounting Policies” and “Note 2 — Alaska First Acquisition” for additional information about the Alaska First acquisition.

 

We have grown to be the third largest commercial bank in Anchorage and Alaska in terms of deposits, with $867.4 million in total deposits and over $1 billion in total assets at December 31, 2007. Through our 10 branches, we are accessible by approximately 65% of the Alaska population.

 

 

 

Elliott Cove Capital Management LLC

 

As of December 31, 2007, the Company owned a 48% 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 $665,000 as of December 31, 2007.

 

As of December 31, 2007, there are eight Northrim Bank employees who are licensed as Investment Advisor Representatives and actively selling the Elliott Cove investment products. 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 2009.

 

Northrim Funding Services

 

In the third quarter of 2004, we formed 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 third full year of operations in 2007, the employees of NFS expanded the base of their operations. In 2008, we expect NFS to continue to penetrate its market and increase its market share in the purchased receivables business and to continue to contribute to the Company’s net income.

 

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 continued to market the HPC products through a targeted mailing program and branch promotions, which helped us to increase the number of these accounts. In 2008, we plan to continue to support the HPC consumer and business checking products with a similar marketing and sales program 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 Southcentral 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, trust 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 benefit 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. Then, in October of 2007, we acquired 100% of the outstanding stock of another local bank, Alaska First. This acquisition resulted in us acquiring cash equivalents and investments of $42.6 million, outstanding loans of $13.2 million, deposits of $47.7 million of deposits and borrowings of $5.1 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. In accordance with this objective, the Company acquired 100% of the outstanding shares of Alaska First for $6.3 million in an all cash transaction at the close of business on October 19, 2007. Prior to this acquisition, we estimate that we held a 22% share of the commercial bank deposit market in Anchorage, a 9% share of the Fairbanks market, and an 11% share of the Matanuska Valley market as of June 30, 2007, the latest date for which such information is available.

 

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 89% 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.

 

At December 31, 2007, we had assets of over $1 billion, an increase of 9.6% over $925.6 million in 2006. Also, we had gross loans of $714.8 million, a decrease of less than 1% from $717.1 million at December 31, 2006. Our net income and diluted earnings per share for 2007 were $11.7 million and $1.80, respectively, a decrease of 10% each, respectively, from $13 million and $1.99 at year end 2006. During the same time period, our net interest income increased by $2.3 million, or 5%, to $49.8 million, from $47.5 million for the year ended 2006. Our provision for loan losses in 2007 increased by $2.9 million, or 115% to $5.5 million, from $2.6 million in 2006, as our nonperforming loans increased by $4.7 million, or 71% for 2007, from $6.6 million in 2006 to $11.3 million for 2007. In contrast, for 2007 our other operating income increased by $2.2 million, or 28%, to $9.8 million from $7.7 million in 2006. The growth in our net interest income combined with the positive effects of the increases in our other operating income was offset by an increase in other operating expenses of $3.6 million, or 11%, to $34.9 million in 2007 from $31.4 million for 2006, and the increase in our provision for loan losses which resulted in a decrease in our net income and earnings per share.

 

Results of Operations

 

Net Income

 

We earned net income of $11.7 million in 2007, compared to net income of $13 million in 2006, and $11.2 million in 2005. During these periods, net income per diluted share was $1.80, $1.99, and $1.64, 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, employee benefit plan income, 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 2007 was $49.8 million compared to $47.5 million in 2006, and $43.9 million in 2005, reflecting an increase in our interest-earning assets and the general level of interest rates. Average interest-earning assets increased $38.3 million, or 5%, in 2007 compared to an increase in average interest-bearing liabilities in 2007 of $27.4 million, or 5%. 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%.

 

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, 2007, 2006, and 2005, average interest-earning assets were $849.3 million, $810.9 million, and $778.6 million, respectively. During these same periods, net interest margins were 5.87%, 5.86%, and 5.64%, 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 8.60% in 2007, 8.57% in 2006, and 7.55% in 2005, while the average cost of interest-bearing liabilities was 3.66% in 2007, 3.63% in 2006, and 2.61% in 2005.

 

Our net interest margin increased in 2007 from 2006 due to the interaction of several factors. First, in 2007, the cost of interest-bearing liabilities increased by 3 basis points while the yield on interest-earning assets also increased by 3 basis points. During this time, the average balance of our interest-bearing demand deposits increased by $6.3 million to $85.2 million at December 31, 2007 from $78.9 million at December 31, 2006. The average balance of our demand deposits and other noninterest-bearing liabilities also increased by $15.2 million to $208.7 million at December 31, 2007 from $193.5 million at December 31, 2006. The increase in these lower cost deposits in 2007 helped to contain the rate of growth in the cost of interest-bearing liabilities. Second, the 3 basis point increase in the yield on earning assets in 2007 had a larger effect on net interest income because it was applied to earning assets with an average balance of $849.3 million versus the 3 basis point increase in the cost of interest-bearing liabilities that was applied to an average balance of $633.0 million. Finally, in 2007, earning assets increased by $38.3 million, or 5% compared to growth of $32.3 million, or 4% in 2006.

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 $2.2 million, or 28%, in 2007, after increasing $2.8 million, or 59%, in 2006, and increasing $1 million, or 27%, in 2005. 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 2007 increased $2.1 million, or 27% over 2006 levels. In 2006, this income increased $2.8 million, or 59%, and in 2005, it increased $1.2 million, or 32% as compared to 2004 levels. The main reason for the increase in operating income in 2007 was the increase in income from deposit service charges.

 

Deposit service charges increased $1.1 million, or 58%, in 2007 as compared to 2006, and they increased $175,000, or 10%, in 2006 as compared to 2005. The increase in 2007 is primarily from the April 2007 implementation of non-sufficient funds (“NSF”) fees on point-of-sale transactions. The new point-of-sale NSF fees represent $1.1 million of the increase in service charges.

 

Income from the Company’s purchased receivable products increased by $664,000, or 36%, in 2007 as compared to 2006, and this income increased $862,000, or 87%, in 2006 as compared to 2005. 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 decline on a year-over-year comparative basis as the Company expects that some of its customers will move into different products to meet their working capital needs.

 

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. The Company included employee benefit plan income from NBG for the first time in its other operating income in 2006. In 2007, the Company recorded an $81,000 increase for this item, or 7%, compared to the initial $1.1 million income recorded in 2006. 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 $124,000, or 16%, in 2007 as compared to 2006, and these fees increased by $158,000, or 25%, in 2006 as compared to 2005. 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 2007, 2006, and 2005 were $454,000, $649,000, and $493,000, respectively, of income from our share of the earnings from RML, which we account for according to the equity method. 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 2005 and 2006, RML Holding Company began to realize some efficiencies from its merger and increased its income from its combined operations. However, the decline in mortgage applications due to the slowdown in the Alaskan housing market had a direct effect on RML’s operating income in 2007. The Company expects that its share of RML’s income will decline further in 2008 as the slowdown that affected the residential construction market in 2007 carries over into 2008.

 

Merchant credit card transaction fees decreased by $22,000, or 4% in 2007 as compared to 2006 due to decreased sales, and these fees increased by $87,000, or 20%, in 2006 as compared to 2005 as the Company increased the sales volume of this product to its larger account base and switched to a revenue sharing program.

 

Loan service fees decreased by $15,000, or 3% in 2007 as compared to 2006 primarily due to the collection of past due late fees in 2006 on non performing loans that paid off in 2006. In contrast, loan service fees increased by $157,000, or 42%, in 2006 as compared to 2005 due to the increased collection of late fees and the collection of late fees on non performing loans that paid off.

 

Our share of the loss from Elliott Cove decreased to $93,000 in 2007, as compared to losses of $230,000 and $424,000, respectively, in 2006 and 2005 as Elliott Cove continued to increase its assets under management, which provided it with increased revenues.

 

Other income increased by $97,000, or 45%, to $314,000 at December 31, 2007 from $217,000 at December 31, 2006. 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. The Company incurred losses of $105,000 and $126,000 in

2007 and 2006, respectively, on its investment in PWA, which it accounts for according to the equity method. The losses from PWA were more than offset by increases in commissions that the Company receives for its sales of the Elliott Cove investment products, which totaled $294,000 and $210,000 in 2007 and 2006, respectively, and were accounted for as other operating income. Finally, the Company expects PWA to break even in 2008 as it 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. At December 31, 2007, the gain on sale of other real estate owned was $110,000 compared to a loss of less than $1,000 at the end of 2006. Additionally, there is $432,000 of deferred gain on the sale of other real estate owned included in other liabilities at December 31, 2007. This gain will be recognized using the installment method. No net security gains were recorded in 2007 or 2006, whereas $9,000 of net gains was recorded in 2005.

 

Expenses

 

Provision for Loan Losses: The provision for loan losses in 2007 was $5.5 million, compared to $2.6 million in 2006 and $1.2 million in 2005. We increased the provision for loan losses in 2007 due to an increase in our nonperforming loans and net loan charge-offs. In 2007, nonperforming loans increased to $11.3 million from a balance of $6.6 million at December 31, 2006. In addition, net loan charge-offs were $6.1 million, or 0.86% of average loans, in 2007 as compared to $1.1 million, or 0.16% of average loans, in 2006 and $1.2 million, or 0.18% of average loans, in 2005. The allowance for loan losses decreased in 2007 as a result of the increase in net loan charge-offs and paydowns of certain problem credits. At December 31, 2007, the allowance was $11.7 million, or 1.64% of portfolio loans as compared to $12.1 million, or 1.69% of portfolio loans at December 31, 2006 and $10.7 million, or 1.52% of portfolio loans, at December 31, 2005. Likewise, the coverage ratio of the allowance for loan losses versus nonperforming loans decreased to 104% in 2007 as compared to a coverage ratio of 183% in 2006 and 176% in 2005. Although the allowance for loan losses decreased in 2007 along with the coverage ratio for nonperforming loans, the Company expects that net loan charge-offs will decrease in the future as a result of its efforts to improve its credit quality. In addition, forty percent of the net loan charge-offs in 2007 were related to one borrowing relationship and are not representative of the Company’s historical loan charge-offs.

 

Other Operating Expense: Other operating expense increased $3.6 million, or 11%, in 2007, $1.9 million, or 6%, in 2006, and $2.9 million, or 11%, in 2005. The following table breaks out the other operating expense categories:

 

 

Salaries and other personnel expense increased $1.4 million, or 7%, in 2007, $1.6 million, or 9%, in 2006, and $1.9 million, or 12%, in 2005, 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. 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 2007, NBG’s salary and benefit costs included in the Company’s own salary and benefit costs increased by $82,000 to $528,000 from $446,000 in 2006. The acquisition of Alaska First in the fourth quarter added salary and benefits costs. Also, stock-based compensation expense increased to $578,000 in 2007 from $390,000 in 2006 and $68,000 in 2005. In the first quarter of 2006, the Company adopted FASB 123R, Share-Based Payment. As a result, in 2006, the Company recorded $256,000 in additional expense associated with its stock options. Prior to 2006, the Company’s stock-based compensation expense was associated with the fair value of restricted stock units granted to its employees and expensed over the required service period.

 

During 2007, our occupancy expenses increased by $320,000, or 13%, to $2.8 million from $2.5 million, as we incurred higher costs in repair and maintenance as well as increased utility expenses. In addition to this, the Company incurred a $233,000 increase in rent expense due to expenses associated with the Alaska First buildings, as well as an overall increase in rents. In 2006, occupancy expense increased by $86,000, or 4%, to $2.5 million from $2.4 million as we incurred higher costs in one of our branch locations.

Marketing costs decreased by $24,000, or 1%, in 2007, decreased by $16,000, or 1%, in 2006, and increased $456,000, or 38%, in 2005. 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 2007 and 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. 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 decreased by $145,000 or 30% to $337,000 during 2007 from $482,000 during 2006, as the Company finished amortizing the core deposit intangible related to the accounts it acquired in 1999 from the Bank of America transaction. In 2006, amortization expense increased by $114,000, or 31%, to $482,000 from $368,000 in 2005. In 2007 and 2006, the amortization expense on the NBG intangible asset was $115,000. 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. In the fourth quarter of 2007, the Company recognized $60,000 in amortization expense on the core deposit intangible associated with the Alaska First acquisition in 2007.

 

Other expenses, which includes professional fees, software expenses, ATM and debit card processing fees and other operational expenses, increased $2.0 million, or 32%, in 2007 as compared to 2006 and increased $107,000, or 2%, in 2006 as compared to 2005 due to changes in a variety of expense accounts. The largest increases in 2007 can be attributed to a $327,000 increase in professional services as well as a $473,000 increase in operational losses of which $245,000 is tied to purchased receivable losses. In addition, the amortization expense associated with the Company’s investments in partnerships that develop low-income housing increased by $361,000 as a result of two additional investments in these partnerships in the amount of $3 million each in the third and fourth quarters of 2006. Internet banking expense also increased by $266,000 in 2007 as a result of a new internet banking product that the Company brought on line in the fourth quarter of 2006.

 

Income Taxes: The provision for income taxes decreased $718,000, or 9%, to $7.3 million in 2007, increased $1.1 million, or 15%, to $8 million in 2006, and decreased $697,000, or 11%, to $6.9 million in 2005. The effective tax rate for 2007, 2006 and 2005 was 38%.

 

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 $1.2 million, or less than 1% lower in 2007 than in 2006. Average loans were $13.9 million, or 2% greater in 2006 than in 2005. Loans comprised 84% of total earning assets on average in 2007, 88% in 2006 and 90% in 2005. The yield on loans averaged 9.35% in 2007, 9.18% in 2006, and 8.00% in 2005.

 

Reduction in the loan portfolio during 2007 was $2.3 million, or less than 1%. Commercial loans decreased $2.3 million, or less than 1%, commercial real estate loans increased $5.6 million, or 2%, and construction loans decreased $15.0 million, or 10%, in 2007. Installment and consumer loans increased $9.1 million, or 22%.

Nonperforming Loans; Other Real Estate Owned: Nonperforming assets consist of nonaccrual loans, accruing loans that are 90 days or more past due, restructured loans, and other real estate owned. We had other real estate owned property of $4.4 million at December 31, 2007, as compared to $717,000 at December 31, 2006. The Company expects to expend $2.8 million during 2008 to complete these projects with an estimated completion date of June 30, 2008. 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 $865,000, $437,000, and $353,000, in 2007, 2006, and 2005, 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, 2007, were $11.3 million, or 1.59% of portfolio loans, an increase of $4.7 million from $6.6 million at December 31, 2006, and an increase of $561,000 from $6.1 million at December 31, 2005. The increase in nonperforming loans at December 31, 2007 as compared to December 31, 2006 is due in large part to the addition of $3.9 million in nonaccrual loans tied to a lending relationship with one residential construction builder in the Anchorage area. These loans were used to finance a single-family residential housing development.

 

Potential Problem Loans: At December 31, 2007, management had identified potential problem loans of $13.5 million as compared to potential problem loans of $6.4 million at 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.

 

At December 31, 2007, nonperforming loans increased to $11.3 million, or 1.59% of portfolio loans as compared to $6.6 million, or 0.92% of portfolio loans in 2006. The coverage ratio of the allowance for loan losses verses nonperforming loans decreased to 104% in 2007 as compared to a coverage ratio of 183% in 2006. As previously noted, a majority of the increase in the nonperforming loans in 2007 is associated with loans to one borrower. The increase in nonperforming loans and potential problem loans has been factored into the Company’s methodology for analyzing its allowance on a consistent basis. The relation of the

allowance to the Company’s nonperforming loans is within the expectation and ranges established by policy. The Company’s allowance was decreased by $6.1 million in net charge-offs that it incurred in 2007 with forty percent of these charge-offs associated with one borrower. This level of charge-offs is not representative of the Company’s historical loan charge-offs. The Company has also taken steps to improve its credit quality including the formation of a Quality Assurance department to provide independent, detailed financial analysis of its largest, most complex loans, which it believes will help to improve its credit quality in the future. Management believes that at December 31, 2007, 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 $18.6 million at December 31, 2007. 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. Our Quality Assurance department also provides independent, detailed financial analysis of our largest, most complex loans. In addition, the department, along with the Chief Lending Officer and others in the Loan Administration department, has developed processes to analyze and manage various concentrations of credit within the overall loan portfolio. The Loan Administration department has also enhanced the procedures and processes for the analysis and reporting of problem loans along with the development of strategies to resolve them.

 

Loans Receivable: Loans receivable decreased to $714.8 million at December 31, 2007, compared to $717.1 million and $705.1 million at December 31, 2006 and 2005, respectively. At December 31, 2007, 76% of the portfolio was scheduled to mature or reprice in 2008 with 17% scheduled to mature or reprice between 2009 and 2012. 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, 2007, 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, 2007 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. The majority of these loans reprice to an index based upon the prime rate of interest.

Construction Loans:

 

Land Development: We believe we are a major land development and residential construction lender. At December 31, 2007, we had $46.9 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 2007. We originated one-to-four-family residential construction loans to builders for construction of homes. At December 31, 2007, we had $71.5 million of one-to-four-family residential and condominium construction loans, or 10% of total loans. Of the homes under construction at December 31, 2007, for which these loans had been made, 33% 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.

 

Commercial Real Estate: We believe we are an active lender in the commercial real estate market. At December 31, 2007, our commercial real estate loans were $243.2 million, or 34% 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 43% 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 20 to “Notes to Consolidated Financial Statements” in our Annual Report for the year ended December 31, 2007. 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 $161.7 million at December 31, 2007, an increase of $61.4 million, or 61%, from year-end 2006. The purchase of Alaska First resulted in an addition of $14.9 million in available for sale securities after the sale of $8.9 million in mortgage back securities originally acquired from Alaska First. The average maturity of the investment portfolio was approximately two years at December 31, 2007.

 

Investment securities designated as available for sale comprised 91% 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, 2007, $32.4 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 fair 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, 2007, 2006, and 2005, we held Federal Home Loan Bank (“FHLB”) stock with a book value approximately equal to its market value in the amounts of $2.0 million, $1.6 million, and $1.6 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, 2007:

 

 

At December 31, 2007, 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 decreased in 2007 to $19.4 million, as compared to $21.2 million in 2006 primarily due to a $4.6 million decrease in purchased receivables related to Business Manager^®. This decrease is the result of, among other factors, the migration of several customers into loans from purchased receivables. The Company expects that this trend will continue in 2008.

 

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 9% to $867.4 million at December 31, 2007, compared with $794.9 million at December 31, 2006, and $779.9 million at December 31, 2005. Our deposits generally are expected to fluctuate according to the level of our market share, economic conditions, and normal seasonal trends. The Company assumed $47.7 million of deposits in the Alaska First purchase in the fourth quarter of 2007.

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, 2007, we had $103.5 million in certificates of deposit, of which $71.1 million, or 69%, are scheduled to mature in 2008.

 

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, 2007, was $171.3 million, a decrease of $36.2 million as compared to the balance of $207.5 million at December 31, 2006. Some of this decrease can be attributed to product movement to our premium CD accounts due to swings in the interest rate environment.

 

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, 2007, we did not hold any certificates of deposit for the Alaska Permanent Fund.

 

Borrowings

 

FHLB: At December 31, 2007, our maximum borrowing line from the FHLB was equal to $113 million, approximately 11% of the Company’s assets. FHLB advances are subject to collateral criteria that require the Company to pledge assets under a blanket pledge arrangement as collateral for its borrowings from the FHLB. At December 31, 2007 and 2006 there was $1.8 million and $2.2 million outstanding on the line respectively.

 

Federal Reserve Bank: The Company entered into a note agreement with the Federal Reserve Bank on the payment of tax deposits. The Federal Reserve has the option to call the note at any time. The balance at December 31, 2007, and 2006, was $1 million which was secured by investment securities.

 

The Federal Reserve Bank is holding $69.2 million of loans as collateral to secure advances made through the discount window on December 31, 2007. There were no discount window advances outstanding at December 31, 2007 and 2006.

 

Other Short-term Borrowing: At December 31, 2007, 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:

 

 

 

Long-term debt obligations consist of (a) $1.8 million advance from the FHLB that was originated on May 7, 2002, matures on May 7, 2012, and bears interest at 5.46%, (b) $8.2 million junior subordinated debentures that were originated on May 8, 2003, mature on May 15, 2033, and bear interest at a rate of 90-day LIBOR plus 3.15%, adjusted quarterly, and (c) $10.3 million junior subordinated debentures that were originated on December 16, 2005, mature on March 15, 2036, and bear interest at a rate of 90-day LIBOR plus 1.37%, adjusted quarterly. The operating lease obligations are more fully described in Note 19 of the Company’s annual report. Other long-term liabilities consist of amounts that the Company owes for its investments in Delaware limited partnerships that develop low-income housing projects throughout the United States. The Company purchased a $3 million interest in CharterMac Corporate Partners XXXIII, L.P., (“CharterMac”), in September 2006. The Company also purchased a $3 million interest in U.S.A. Institutional Tax Credit Fund LVII L.P. (“USA 57”) in December 2006. CharterMac changed its name to Centerline in April 2007 and the investment was subsequently renamed Centerline XXXIII, L.P., (“Centerline”). The investments in Centerline and USA 57 will be fully funded in 2009 and 2010, respectively.

 

Liquidity and Capital Resources

 

Our primary sources of funds are customer deposits and advances from the Federal Home Loan Bank of Seattle. These funds, together with loan repayments, loan sales, other borrowed funds, retained earnings, and equity are used to make loans, to acquire securities and other assets, and to fund deposit flows and continuing operations. The primary sources of demands on our liquidity are customer demands for withdrawal of deposits and borrowers’ demands that we advance funds against unfunded lending commitments. Our total unfunded lending commitments at December 31, 2007, were $187 million, and we do not expect that all of these loans are likely to be fully drawn upon at any one time. Additionally, as noted above, our total deposits at December 31, 2007, were $867.4 million.

 

The sources by which we meet the liquidity needs of our customers are current assets and borrowings available through our correspondent banking relationships and our credit lines with the Federal Reserve Bank and the FHLB. At December 31, 2007, our current assets were $469.4 million and our funds available for borrowing under our existing lines of credit were $183.4 million. Given these sources of liquidity and our expectations for customer demands for cash and for our operating cash needs, we believe our sources of liquidity to be sufficient in the foreseeable future.

In September 2002, our Board of Directors approved a plan whereby we would periodically repurchase for cash up to approximately 5%, or 306,372, of our shares of common stock in the open market. In August of 2004, the Board of Directors amended the stock repurchase plan and increased the number of shares available under the program by 5% of total shares outstanding, or 304,283 shares. In June of 2007, the Board of Directors amended the stock repurchase plan and increased the number of shares available under the program by 5% of total shares outstanding, or 305,029 shares. We have purchased 688,442 shares of our stock under this program through December 31, 2007 at a total cost of $14.2 million at an average price of $20.65, which leaves a balance of 227,242 shares available under the stock repurchase program. We intend to continue to repurchase our stock from time to time depending upon market conditions, but we can make no assurances that we will continue this program or that we will repurchase all of the authorized shares.

 

The stock repurchase program had an effect on earnings per share because it decreased the total number of shares outstanding in 2007, 2006, 2005, and 2003, by 137,500, 17,500, 308,642, and 155,800 shares respectively. The Company did not repurchase any of its shares in 2004. The table below shows this effect on diluted earnings per share as adjusted for the 5% stock dividend in 2007.

 

 

On May 8, 2003, the Company’s newly formed subsidiary, Northrim Capital Trust 1, issued trust preferred securities in the principal amount of $8 million. These securities carry an interest rate of 90-day LIBOR plus 3.15% per annum that was initially set at 4.45% adjusted quarterly. The securities have a maturity date of May 15, 2033, and are callable by the Company on or after May 15, 2008. These securities are treated as Tier 1 capital by the Company’s regulators for capital adequacy calculations. The interest cost to the Company of the trust preferred securities was $689,000 in 2007. At December 31, 2007, the securities had an interest rate of 8.02%.

 

On December 16, 2005, the Company’s newly formed subsidiary, Northrim Statutory Trust 2, issued trust preferred securities in the principal amount of $10 million. These securities carry an interest rate of 90-day LIBOR plus 1.37% per annum that was initially set at 5.86% adjusted quarterly. The securities have a maturity date of March 15, 2036, and are callable by the Company on or after March 15, 2011. These securities are treated as Tier 1 capital by the Company’s regulators for capital adequacy calculations. The interest cost to the Company of these securities was $689,000 in 2007. At December 31, 2007, the securities had an interest rate of 6.36%.

 

Our shareholders’ equity at December 31, 2007, was $101.4 million, as compared to $95.4 million at December 31, 2006. The Company earned net income of $11.7 million during 2007, issued 23,000 shares through the exercise of stock options, and repurchased 137,500 shares of its common stock under the Company’s publicly announced repurchase program. In addition, on October 5, 2007, the Company paid a 5% stock dividend to shareholders of record as of September 21, 2007. As a result, the Company issued 300,729 of its shares along with a cash dividend of $2,000 to pay for fractional shares. At December 31, 2007, the Company had 6.3 million shares of its common stock outstanding.

 

We are subject to minimum capital requirements. Federal banking agencies have adopted regulations establishing minimum requirements for the capital adequacy of banks and bank holding companies. The requirements address both risk-based capital and leverage capital. We believe as of December 31, 2007, that the Company and Northrim Bank met all applicable capital adequacy requirements.

 

The FDIC has in place qualifications for banks to be classified as “well-capitalized.” As of June 15, 2007, the most recent notification from the FDIC categorized Northrim Bank as “well-capitalized.” There were no conditions or events since the FDIC notification that we believe have changed Northrim Bank’s classification.

The table below illustrates the capital requirements for the Company and the Bank and the actual capital ratios for each entity that exceed these requirements. The capital ratios for the Company exceed those for the Bank primarily because the $8 million trust preferred securities offering that the Company completed in the second quarter of 2003 and another offering of $10 million completed in the fourth quarter of 2006 are included in the Company’s capital for regulatory purposes although they are accounted for as a long-term debt in our financial statements. The trust preferred securities are not accounted for on the Bank’s financial statements nor are they included in its capital. As a result, the Company has $18 million more in regulatory capital than the Bank, which explains most of the difference in the capital ratios for the two entities.

 

(See Note 20 of the Consolidated Financial Statements for a detailed discussion of the capital ratios.)

 

Effects of Inflation and Changing Prices

 

The primary impact of inflation on our operations is increased operating costs. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on a financial institution’s performance than the effects of general levels of inflation. Although interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services, increases in inflation generally have resulted in increased interest rates, which could affect the degree and timing of the repricing of our assets and liabilities. In addition, inflation has an impact on our customers’ ability to repay their loans.

 

Market for Common Stock

 

Our common stock trades on the Nasdaq Stock Market under the symbol, “NRIM.” We are aware that large blocks of our stock are held in street name by brokerage firms. At December 31, 2007, the number of shareholders of record of our common stock was 187.

 

We began paying regular cash dividends of $0.05 per share in the second quarter of 1996. In the second quarters of 2007, 2006, and 2005, we paid cash dividends of $0.15, $0.125, and $0.11 per share, respectively. Cash dividends totaled $3.6 million, $2.8 million, and $2.6 million in 2007, 2006, and 2005, respectively. On January 10, 2008, the Board of Directors approved payment of a $0.15 per share dividend on February 8, 2008, to shareholders of record on January 28, 2008. On September 6, 2007, the Board of Directors approved payment of a stock dividend equal to 5% of the shares of the Company’s common stock outstanding as of the close of business September 21, 2007 (the “Record Date”). The stock dividend was payable on October 5, 2007 to shareholders of record on the Record Date. The Company and the Bank are subject to restrictions on the payment of dividends pursuant to applicable federal and state banking regulations.

 

The following are high and low sales prices as reported by Nasdaq. Prices do not include retail markups, markdowns or commissions. Prices have been adjusted for applicable stock dividends.

 

Market Price of and Dividends on the Registrant’s Common Equity and Related Stockholder Matters

 

Stock Performance Graph

 

The graph shown below depicts the total return to shareholders during the period beginning after December 31, 2002, and ending December 31, 2007. The definition of total return includes appreciation in market value of the stock, as well as the actual cash and stock dividends paid to shareholders. The comparable indices utilized are the Russell 3000 Index, representing approximately 98% of the U.S. equity market, and the SNL Financial Bank Stock Index, comprised of publicly traded banks with assets of $500 million to $1 billion, which are located in the United States. The graph assumes that the value of the investment in the Company’s common stock and each of the three indices was $100 on December 31, 2002, and that all dividends were reinvested.

 

Total Return Performance

 

 

Repurchase of Securities

 

The Company purchased 25,000 shares of its common stock, in the aggregate, during the fourth quarter of 2007 as indicated below:

 

 

 

Equity Compensation Plan Information

 

 

Recent Accounting Pronouncements

 

Between December of 2006 and December of 2007, the Financial Accounting Standards Board (“FASB”) issued Statement No. 141R, Business Combinations (Revised 2007), Statement No. 157, Fair Value Measurements, and Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51. The Company believes the adoption of these Statements will not have a significant impact on its financial statements.

 

In December 2004, the FASB issued Statement No. 123R, Share-Based Payment, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services primarily in share-based payment transactions with its employees. This Statement supersedes the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance.

 

As of January 1, 2006, the Company adopted FASB No. 123R according to the modified prospective method, which requires measurement of compensation cost from January 1, 2006 for all unvested stock-based awards at fair value on the date of

grant and recognition of the compensation associated with these stock-based awards over the service period for the awards that are expected to vest. In accordance with the modified prospective transition method, results for prior periods have not been restated.

 

The fair value of restricted stock units is determined based on the number of shares granted and the quoted price of the Company’s stock on the date of grant, and the fair value of stock options is determined using the Black-Scholes valuation model, which is consistent with the Company’s valuation techniques previously utilized for options in footnote disclosures required under FASB 123R. The Company recognizes the fair value of the restricted stock units and stock options as expense over the required service period, net of estimated forfeitures, using the straight line attribution method for stock-based payment grants previously granted but not fully vested at January 1, 2006 as well as grants made after January 1, 2006 as prescribed in FASB 123R.

 

Prior to January 1, 2006, the Company accounted for stock-based awards using the intrinsic value method, which followed the recognition and measurement principles of APB Opinion No. 25. Outlined below are valuation assumptions used in the Black-Scholes valuation model for stock options that were used in estimating the fair value for each stock option granted in November of 2007, 2006 and 2005.

 

 

The expected life represents the weighted average period of time that options granted are expected to be outstanding when considering vesting periods and the exercise history of the Company. The risk free rate is based upon the equivalent yield of a United States Treasury zero-coupon issue with a term equivalent to the expected life of the option. The expected dividends are based on projected dividends for the Company at the date of the option grant taking into account projected net income growth, dividend pay-out ratios, and other factors. The expected volatility is based upon the historical price volatility of the Company’s stock. See “Note 18 Options” for additional information.

 

Fair Value Disclosures — Prior to FASB 123R Adoption

 

Stock-based compensation for the period prior to January 1, 2006 was determined using the intrinsic value method. The following table illustrates the effect on net income and earnings per share as if the fair value based method under FASB 123R had been applied to all outstanding and unvested awards in periods prior to January 1, 2006:

 

 

Prior to the adoption of FASB 123R, the Company presented any tax benefits of deductions resulting from the exercise of stock options within operating cash flows in the condensed consolidated statements of cash flow. FASB 123R requires tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (“excess tax benefits”) to be classified and reported as both an operating cash outflow and a financing cash inflow upon adoption of FASB 123R. Accordingly, the Company has recognized these excess tax benefits in the condensed statement of cash flow for the year ended December 31, 2007.

FASB Staff Position No. FAS No. 123(R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards” (“FSP 123R-3”), effective November 10, 2005, provides for a practical transition method that may be elected to calculate the pool of excess tax benefits available to absorb tax deficiencies upon the adoption of FASB 123R. The method comprises a computational component that establishes the beginning balance of the additional paid in capital (“APIC”) pool related to employee compensation and a simplified method to determine the subsequent impact on the APIC pool of awards that are fully vested and outstanding upon the adoption of FASB 123R. The Company has elected to use the long haul method to calculate the beginning balance of the APIC pool as opposed to electing this simplified method.

 

Quantitative and Qualitative Disclosure About Market Risk

 

Our results of operations depend substantially on our net interest income. Like most financial institutions, our interest income and cost of funds are affected by general economic conditions, levels of market interest rates, and by competition, and in addition, our community banking focus makes our results of operations particularly dependent on the Alaska economy.

 

The purpose of asset/liability management is to provide stable net interest income growth by protecting our earnings from undue interest rate risk, which arises from changes in interest rates and changes in the balance sheet mix, and by managing the risk/return relationships between liquidity, interest rate risk, market risk, and capital adequacy. We maintain an asset/liability management policy that provides guidelines for controlling exposure to interest rate risk by setting a target range and minimum for the net interest margin and running simulation models under different interest rate scenarios to measure the risk to earnings over the next 12-month period.

 

In order to control interest rate risk in a rising interest rate environment, our philosophy is to shorten the average maturity of the investment portfolio and emphasize the pricing of new loans on a floating rate basis in order to achieve a more asset sensitive position, therefore, allowing quicker repricings and maximizing net interest margin. Conversely, in a declining interest rate environment, our philosophy is to lengthen the average maturity of the investment portfolio and emphasize fixed rate loans, thereby becoming more liability sensitive. In each case, the goal is to exceed our targeted net interest margin range without exceeding earnings risk parameters.

 

Our excess liquidity not needed for current operations has generally been invested in short-term assets or securities, primarily securities issued by government sponsored entities. The securities portfolio contributes to our profits and plays an important part in the overall interest rate management. The primary tool used to manage interest rate risk is determination of mix, maturity, and repricing characteristics of the loan portfolios. The loan and securities portfolios must be used in combination with management of deposits and borrowing liabilities and other asset/liability techniques to actively manage the applicable components of the balance sheet. In doing so, we estimate our future needs, taking into consideration historical periods of high loan demand and low deposit balances, estimated loan and deposit increases, and estimated interest rate changes.

 

Although analysis of interest rate gap (the difference between the repricing of interest-earning assets and interest-bearing liabilities during a given period of time) is one standard tool for the measurement of exposure to interest rate risk, we believe that because interest rate gap analysis does not address all factors that can affect earnings performance, such as early withdrawal of time deposits and prepayment of loans, it should not be used as the primary indicator of exposure to interest rate risk and the related volatility of net interest income in a changing interest rate environment. Interest rate gap analysis is primarily a measure of liquidity based upon the amount of change in principal amounts of assets and liabilities outstanding, as opposed to a measure of changes in the overall net interest margin.

The following table sets forth the estimated maturity or repricing, and the resulting interest rate gap, of our interest-earning assets and interest-bearing liabilities at December 31, 2007. The amounts in the table are derived from internal data based upon regulatory reporting formats and, therefore, may not be wholly consistent with financial information appearing elsewhere in the audited financial statements that have been prepared in accordance with generally accepted accounting principles. The amounts shown below could also be significantly affected by external factors such as changes in prepayment assumptions, early withdrawals of deposits, and competition.