10-Q


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x
QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2007

OR

¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM _____________________ TO ________________.

Commission File Number.....0-20800

STERLING FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)

Washington
91-1572822
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification No.)

111 North Wall Street, Spokane, Washington 99201
(Address of principal executive offices) (Zip Code)


(509) 458-3711
(Registrant's telephone number, including area code)

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

Indicate by check mark whether the registrant 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 x Accelerated Filer ¨ Non-accelerated filer ¨

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

Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date:
 
Class
Outstanding as of November 1, 2007
   
Common Stock ($1.00 par value)
51,431,361
 



 
STERLING FINANCIAL CORPORATION

FORM 10-Q
For the Quarter Ended SEPTEMBER 30, 2007

TABLE OF CONTENTS
 
   
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32
     
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33
 

 
PART I - Financial Information
Item 1 - Financial Statements 
STERLING FINANCIAL CORPORATION
Consolidated Balance Sheets
(Unaudited)
 
   
September 30,
 
December 31,
 
   
2007
 
2006
 
   
(Dollars in thousands)
 
ASSETS:
          
Cash and cash equivalents:
          
Interest bearing
 
$3,492
 
$13,846
 
Non-interest bearing and vault
   
163,764
   
164,719
 
Total cash and cash equivalents
   
167,256
   
178,565
 
Restricted cash
   
1,100
   
1,150
 
Investment securities and mortgage-backed securities ("MBS"):
             
Available for sale
   
1,788,911
   
1,820,583
 
Held to maturity
   
115,518
   
93,063
 
Loans receivable, net
   
8,747,430
   
7,021,241
 
Loans held for sale
   
54,460
   
91,469
 
Accrued interest receivable
   
65,676
   
55,519
 
Real estate owned and other collateralized assets, net
   
3,427
   
4,052
 
Office properties and equipment, net
   
94,939
   
93,796
 
Bank-owned life insurance ("BOLI")
   
149,136
   
139,206
 
Goodwill
   
453,294
   
247,244
 
Other intangible assets, net
   
32,852
   
28,570
 
Mortgage servicing rights, net
   
9,970
   
7,335
 
Prepaid expenses and other assets, net
   
62,946
   
52,699
 
Total assets
 
$
11,746,915
 
$
9,834,492
 
LIABILITIES:
             
Deposits
 
$
7,766,392
 
$
6,746,028
 
Advances from Federal Home Loan Bank ("FHLB")
   
1,462,132
   
1,308,617
 
Repurchase agreements and federal funds
   
941,143
   
616,354
 
Other borrowings
   
273,467
   
240,226
 
Cashiers checks issued and payable
   
5,976
   
18,144
 
Borrowers' reserves for taxes and insurance
   
3,223
   
2,348
 
Accrued interest payable
   
39,172
   
39,863
 
Accrued expenses and other liabilities
   
96,692
   
79,496
 
Total liabilities
   
10,588,197
   
9,051,076
 
Commitments and Contingencies
             
SHAREHOLDERS' EQUITY:
             
Preferred stock, $1 par value; 10,000,000 shares authorized;
             
no shares issued and outstanding
   
0
   
0
 
Common stock, $1 par value; 100,000,000 shares authorized;
             
51,422,336 and 42,042,740 shares issued and outstanding
   
51,422
   
42,043
 
Additional paid-in capital
   
891,518
   
590,218
 
Accumulated other comprehensive loss:
             
Unrealized losses on investment securities and MBS available-for-sale,
             
net of deferred income taxes of $18,793 and $19,531
   
(32,067
)
 
(33,350
)
Retained earnings
   
247,845
   
184,505
 
Total shareholders' equity
   
1,158,718
   
783,416
 
Total liabilities and shareholders' equity
 
$
11,746,915
 
$
9,834,492
 
               
               
The accompanying notes are an integral part of the consolidated financial statements.
             

 
STERLING FINANCIAL CORPORATION
Consolidated Statements of Income
(Unaudited)
 
   
Three Months Ended
 
Nine Months Ended
 
   
September 30,
 
September 30,
 
   
2007
 
2006
 
2007
 
2006
 
   
(Dollars in thousands, except per share data)
 
Interest income:
                 
Loans
 
$
179,132
 
$
125,554
 
$
504,720
 
$
321,021
 
MBS
   
18,882
   
21,626
   
58,706
   
67,444
 
Investments and cash equivalents
   
1,904
   
1,028
   
5,455
   
2,642
 
Total interest income
   
199,918
   
148,208
   
568,881
   
391,107
 
Interest expense:
                         
Deposits
   
71,489
   
51,653
   
205,875
   
127,372
 
Short-term borrowings
   
6,690
   
10,055
   
26,095
   
25,301
 
Long-term borrowings
   
28,075
   
16,467
   
73,591
   
48,396
 
Total interest expense
   
106,254
   
78,175
   
305,561
   
201,069
 
Net interest income
   
93,664
   
70,033
   
263,320
   
190,038
 
Provision for losses on loans
   
(3,888
)
 
(4,698
)
 
(12,088
)
 
(13,998
)
Net interest income after provision for losses on loans
   
89,776
   
65,335
   
251,232
   
176,040
 
Non-interest income:
                         
Fees and service charges
   
14,966
   
11,526
   
40,852
   
31,220
 
Mortgage banking operations
   
7,314
   
5,572
   
25,979
   
10,568
 
Loan servicing fees
   
366
   
473
   
1,459
   
1,224
 
Real estate owned and other collateralized assets operations
   
223
   
(138
)
 
85
   
247
 
BOLI
   
1,553
   
1,225
   
4,817
   
3,611
 
Other
   
(215
)
 
(207
)
 
(759
)
 
(372
)
Total non-interest income
   
24,207
   
18,451
   
72,433
   
46,498
 
Non-interest expenses
   
74,104
   
55,302
   
209,664
   
146,531
 
Income before income taxes
   
39,879
   
28,484
   
114,001
   
76,007
 
Income tax provision
   
(13,349
)
 
(9,145
)
 
(37,569
)
 
(24,321
)
Net income
 
$
26,530
 
$
19,339
 
$
76,432
 
$
51,686
 
Earnings per share - basic
 
$
0.52
 
$
0.52
 
$
1.55
 
$
1.45
 
Earnings per share - diluted
 
$
0.51
 
$
0.52
 
$
1.54
 
$
1.44
 
Weighted average shares outstanding - basic
   
51,279,114
   
36,891,986
   
49,257,951
   
35,645,887
 
Weighted average shares outstanding - diluted
   
51,660,186
   
37,273,560
   
49,768,308
   
35,992,764
 
                           
                           
The accompanying notes are an integral part of the consolidated financial statements.

 
STERLING FINANCIAL CORPORATION
Consolidated Statements of Cash Flows
(Unaudited)
 
   
Nine Months Ended
 
   
September 30,
 
   
2007
 
2006
 
   
(Dollars in thousands)
 
Cash flows from operating activities:
         
Net income
 
$
76,432
 
$
51,686
 
Adjustments to reconcile net income to net cash provided by operating activities:
             
Provisions for losses on loans and real estate owned
   
12,088
   
14,168
 
Accretion of deferred gain on sale of branches
   
(536
)
 
(151
)
Net gain on sales of loans, investment securities and MBS
   
(16,499
)
 
(4,832
)
Stock based compensation
   
1,013
   
182
 
Excess tax benefit from stock based compensation
   
(1,419
)
 
(1,638
)
Stock issuances relating to 401(k) match
   
1,637
   
1,203
 
Other gains and losses
   
3,024
   
888
 
Increase in cash surrender value of BOLI
   
(4,817
)
 
(3,611
)
Depreciation and amortization
   
18,184
   
14,084
 
Change in:
             
Accrued interest receivable
   
(3,117
)
 
(8,770
)
Prepaid expenses and other assets
   
(10,027
)
 
1,217
 
Cashiers checks issued and payable
   
(16,867
)
 
721
 
Accrued interest payable
   
(2,664
)
 
16,307
 
Accrued expenses and other liabilities
   
7,094
   
(2,910
)
Proceeds from sales of loans originated for sale
   
988,255
   
304,302
 
Loans originated for sale
   
(975,871
)
 
(299,639
)
Net cash provided by operating activities
   
75,910
   
83,207
 
Cash flows from investing activities:
             
Change in restricted cash
   
50
   
(501
)
Loans funded and purchased
   
(3,702,199
)
 
(3,169,552
)
Loan principal received
   
3,122,955
   
2,120,741
 
Proceeds from sales of other loans
   
112,651
   
51,144
 
Purchase of investment securities
   
(79,941
)
 
(44,416
)
Proceeds from maturities of investment securities
   
38,580
   
11,400
 
Proceeds from sale of investments
   
5,609
   
0
 
Net change in cash and cash equivalents from acquisitions
   
92,419
   
(5,983
)
Purchase of mortgage-backed securities
   
(120,419
)
 
0
 
Principal payments on mortgage-backed securities
   
183,899
   
208,160
 
Purchase of office properties and equipment
   
(10,806
)
 
(11,742
)
Sales of office properties and equipment
   
3,810
   
18,882
 
Improvements and other changes to real estate owned
   
30
   
(248
)
Proceeds from sales and liquidation of real estate owned
   
1,348
   
1,353
 
Net cash used in investing activities
   
(352,014
)
 
(820,762
)
               
               
The accompanying notes are an integral part of the consolidated financial statements.
             

 
STERLING FINANCIAL CORPORATION
Consolidated Statements of Cash Flows
(Unaudited)
 
   
Nine Months Ended
 
   
September 30,
 
   
2007
 
2006
 
   
(Dollars in thousands)
 
Cash flows from financing activities:
         
Net change in transaction and savings deposits
 
$
105,673
 
$
224,549
 
Proceeds from issuance of time deposits
   
3,010,268
   
2,803,087
 
Payments for maturing time deposits
   
(3,280,346
)
 
(2,437,358
)
Interest credited to deposits
   
190,115
   
110,760
 
Advances from FHLB
   
1,517,744
   
1,985,866
 
Repayment of advances from FHLB
   
(1,630,642
)
 
(2,055,766
)
Net change in securities sold subject to repurchase agreements
             
and funds purchased
   
324,789
   
11,936
 
Proceeds from other borrowings
   
69,392
   
130,000
 
Repayments of other borrowings
   
(36,403
)
 
(25,000
)
Proceeds from stock purchases
   
3,546
   
4,774
 
Excess tax benefit from stock based compensation
   
1,419
   
1,638
 
Cash dividends paid to shareholders
   
(11,635
)
 
(6,670
)
Other
   
875
   
2,044
 
Net cash provided by financing activities
   
264,795
   
749,860
 
Net change in cash and cash equivalents
   
(11,309
)
 
12,305
 
Cash and cash equivalents, beginning of period
   
178,565
   
131,307
 
Cash and cash equivalents, end of period
 
$
167,256
 
$
143,612
 
Supplemental disclosures:
             
Cash paid during the period for:
             
Interest
 
$
306,252
 
$
184,122
 
Income taxes
   
35,902
   
28,732
 
Noncash financing and investing activities:
             
Loans converted into real estate owned and other collateralized assets
   
753
   
4,406
 
Common stock issued upon business combination
   
8,927
   
50,565
 
Common stock cash dividends accrued
   
4,611
   
2,594
 
Deferred gain on sale of branches
   
804
   
9,029
 
               
               
The accompanying notes are an integral part of the consolidated financial statements.
             

 
STERLING FINANCIAL CORPORATION
Consolidated Statements of Comprehensive Income
(Unaudited)
 
   
Three Months Ended
 
Nine Months Ended
 
   
September 30,
 
September 30,
 
   
2007
 
2006
 
2007
 
2006
 
   
(Dollars in thousands)
 
(Dollars in thousands)
 
                   
Net income
 
$
26,530
 
$
19,339
 
$
76,432
 
$
51,686
 
                           
Other comprehensive income:
                         
Change in unrealized gains (losses) on investment
                         
securities and MBS available-for-sale
   
20,482
   
39,170
   
2,021
   
(1,650
)
Less deferred income taxes
   
(7,575
)
 
(14,490
)
 
(738
)
 
620
 
Net other comprehensive income (loss)
   
12,907
   
24,680
   
1,283
   
(1,030
)
Comprehensive income
 
$
39,437
 
$
44,019
 
$
77,715
 
$
50,656
 
                           
                           
The accompanying notes are an integral part of the consolidated financial statements.

 
STERLING FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
 
1. Basis of Presentation:

The foregoing unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X as promulgated by the Securities and Exchange Commission. Accordingly, these financial statements do not include all of the disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements as disclosed in the annual report on Form 10-K for the year ended December 31, 2006. In the opinion of management, the unaudited interim consolidated financial statements furnished herein include all adjustments, all of which are of a normal recurring nature, necessary for a fair statement of the results for the interim periods presented.

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities known to exist as of the date the financial statements are published, and the reported amounts of revenues and expenses during the reporting period. Uncertainties with respect to such estimates and assumptions are inherent in the preparation of Sterling Financial Corporation's ("Sterling's") consolidated financial statements; accordingly, it is possible that the actual results could differ from these estimates and assumptions, which could have a material effect on the reported amounts of Sterling's consolidated financial position and results of operations.

2. Other Borrowings:

The components of other borrowings are as follows (in thousands):
 
   
September 30,
 
December 31,
 
   
2007
 
2006
 
            
Junior Subordinated Debentures
 
$
270,013
 
$
236,772
 
Other
   
3,454
   
3,454
 
Total
 
$
273,467
 
$
240,226
 
 
Sterling raises capital from time to time through the formation of trusts ("Capital Trusts"), which issue capital securities ("Trust Preferred Securities") to investors. Sterling has also acquired Capital Trusts in connection with business acquisitions. These Capital Trusts are business trusts in which Sterling owns all of the common equity. The proceeds from the sale of the Trust Preferred Securities are used to purchase junior subordinated deferrable interest debentures ("Junior Subordinated Debentures") issued by Sterling. Sterling's obligations under the Junior Subordinated Debentures and related documents, taken together, constitute a full and unconditional guarantee by Sterling of the Capital Trusts' obligations under the Trust Preferred Securities. The Trust Preferred Securities are treated as debt of Sterling. The Junior Subordinated Debentures and related Trust Preferred Securities generally mature 30 years after issuance and are redeemable at the option of Sterling under certain conditions, including, with respect to certain of the Trust Preferred Securities, payment of call premiums. Interest is paid quarterly or semi-annually. Details of the Trust Preferred Securities are as follows:

 
 
Subsidiary Issuer
 
Issue
Date
 
Maturity
Date
 
Call Date
 
Rate at
September 30, 2007
 
Carrying Value
(in thousands)
 
Sterling Capital Trust IX
   
July 2007
   
Oct 2037
   
N/A
   
Floating
   
6.76
%
$
46,392
 
Sterling Capital Trust VIII
   
Sept 2006
   
Sept 2036
   
N/A
   
Floating
   
7.32
   
51,547
 
Sterling Capital Trust VII
   
June 2006
   
June 2036
   
N/A
   
Floating
   
7.22
   
56,702
 
Lynnwood Financial Statutory Trust II
   
June 2005
   
June 2035
   
N/A
   
Floating
   
7.49
   
10,310
 
Sterling Capital Trust VI
   
June 2003
   
Sept 2033
   
Sept 2008
   
Floating
   
8.89
   
10,310
 
Sterling Capital Statutory Trust V
   
May 2003
   
May 2033
   
June 2008
   
Floating
   
8.45
   
20,619
 
Sterling Capital Trust IV
   
May 2003
   
May 2033
   
May 2008
   
Floating
   
8.71
   
10,310
 
Sterling Capital Trust III
   
April 2003
   
April 2033
   
April 2008
   
Floating
   
8.61
   
14,433
 
Lynnwood Financial Statutory Trust I
   
Mar 2003
   
Mar 2033
   
Mar 2007
   
Floating
   
8.35
   
9,478
 
Klamath First Capital Trust I
   
July 2001
   
July 2031
   
June 2006
   
Floating
   
9.06
   
15,169
 
Sterling Capital Trust II
   
July 2001
   
July 2031
   
June 2006
   
Fixed
   
10.25
   
24,743
 
                            7.88
%*
$
270,013
 
                                       

*
weighted average rate

Sterling has a $40.0 million revolving credit agreement (the "Credit Facility") through August 2008 with Wells Fargo Bank, N.A., with amounts advanced on the Credit Facility included in the "Other" caption of other borrowings. As of September 30, 2007 and December 31, 2006, no amount was drawn on the Credit Facility. Amounts loaned pursuant to the Credit Facility bear interest, at Sterling's election, either floating at two percent below prime or fixed at LIBOR plus 90 basis points. The Credit Facility contains representations and warranties, and negative and affirmative covenants by Sterling, including financial covenants and restrictions on certain actions by Sterling, such as Sterling's ability to incur debt, make investments and merge into or consolidate with other entities. The Credit Facility may be terminated and loans under the Credit Facility may be accelerated if an event of default occurs, as defined in the Credit Facility.

In April 2007, Sterling elected to exercise its early redemption right to call the Klamath First Capital Trust II debenture in the amount of $13.0 million. The redemption occurred on April 23, 2007.

On July 25, 2007, Sterling's wholly owned subsidiary, Sterling Capital Trust IX, sold $45.0 million of Trust Preferred Securities. The rate payable on these securities will be the 90-day LIBOR plus 1.40% and is adjustable and payable quarterly. These securities mature in 2037.

 
-7-


3. Income Taxes:

In July 2006, the FASB issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes" ("FIN No. 48"). This pronouncement requires a certain methodology for measuring and reporting uncertain tax positions, as well as disclosures regarding such tax positions. FIN No. 48 became effective for Sterling as of January 1, 2007. The following were estimated amounts as of the effective date:
 
   
January 1, 2007
 
   
(Dollars in thousands)
 
Unrecognized Tax Benefit
 
$
1,553
 
Potential Effective Tax Rate Impact
   
1,245
 
Recognized Penalties and Interest
   
308
 
 
Sterling does not expect unrecognized tax benefits to significantly change within the next twelve months. Sterling's tax positions for the years 2003 through 2006 remain subject to review by the Internal Revenue Service. Penalties and interest associated with any potential estimate variances would be included in income tax expense on the Consolidated Statement of Income.

4. Earnings Per Share:

The following table presents the basic and diluted earnings per share computations.


   
Three Months Ended September 30,
 
   
2007
 
2006
 
   
Net
 
Weighted
 
Per Share
 
Net
 
Weighted
 
Per Share
 
   
Income
 
Avg. Shares
 
Amount
 
Income
 
Avg. Shares
 
Amount
 
   
(Dollars in thousands, except per share amounts)
 
                           
Basic computations
 
$
26,530
   
51,279,114
 
$
0.52
 
$
19,339
   
36,891,986
 
$
0.52
 
                                       
Effect of dilutive securities:
                                     
Common stock options and
                                     
restricted shares
   
0
   
381,072
   
(0.01
)
 
0
   
369,570
   
0.00
 
Contingently issuable shares
   
0
   
0
   
0.00
   
0
   
12,004
   
0.00
 
Diluted computations
 
$
26,530
   
51,660,186
 
$
0.51
 
$
19,339
   
37,273,560
 
$
0.52
 
Antidilutive options not included
                                     
in diluted earnings per share
         
735,749
               
0
       
                                       
                                       
 
   
Nine Months Ended September 30,
 
   
2007
 
2006
 
   
Net
 
Weighted
 
Per Share
 
Net
 
Weighted
 
Per Share
 
   
Income
 
Avg. Shares
 
Amount
 
Income
 
Avg. Shares
 
Amount
 
   
(Dollars in thousands, except per share amounts)
 
                           
Basic computations
 
$
76,432
   
49,257,951
 
$
1.55
 
$
51,686
   
35,645,887
 
$
1.45
 
                                       
Effect of dilutive securities:
                                     
Common stock options and
                                     
restricted shares
   
0
   
510,357
   
(0.01
)
 
0
   
334,873
   
(0.01
)
Contingently issuable shares
   
0
   
0
   
0.00
   
0
   
12,004
   
0.00
 
Diluted computations
 
$
76,432
   
49,768,308
 
$
1.54
 
$
51,686
   
35,992,764
 
$
1.44
 
Antidilutive options not included
                                     
in diluted earnings per share
         
281,396
               
0
       
                                       

 
 
-8-


5. Non-Interest Expenses:

The following table details the components of Sterling's total non-interest expenses:
 
   
Three Months Ended
 
Nine Months Ended
 
   
September 30,
 
September 30,
 
   
2007
 
2006
 
2007
 
2006
 
   
(Dollars in thousands)
 
                   
Employee compensation and benefits
 
$
41,114
 
$
31,479
 
$
118,348
 
$
82,278
 
Occupancy and equipment
   
10,767
   
8,755
   
32,915
   
23,046
 
Data processing
   
4,833
   
3,746
   
13,206
   
10,601
 
Depreciation
   
3,387
   
2,662
   
9,923
   
7,377
 
Advertising
   
3,289
   
2,900
   
9,245
   
7,155
 
Travel and entertainment
   
2,022
   
1,454
   
5,663
   
4,040
 
Goodwill litigation costs
   
1,525
   
25
   
2,837
   
245
 
Insurance
   
1,338
   
364
   
2,246
   
963
 
Amortization of core deposit intangibles
   
1,225
   
586
   
3,492
   
1,697
 
Legal and accounting
   
591
   
622
   
1,814
   
1,861
 
Merger and acquisition costs
   
263
   
191
   
1,883
   
191
 
Other
   
3,750
   
2,518
   
8,092
   
7,077
 
Total
 
$
74,104
 
$
55,302
 
$
209,664
 
$
146,531
 
                           
6. Segment Information:

For purposes of measuring and reporting financial results, Sterling is divided into five business segments:

·
The Community Banking segment consists of the operations conducted by Sterling's subsidiary, Sterling Savings Bank.

·
The Residential Mortgage Banking segment originates and sells servicing-retained and servicing-released residential loans through loan production offices of Sterling's subsidiary, Golf Savings Bank and Sterling Savings Bank's subsidiary, Action Mortgage Company ("Action Mortgage").

·
The Commercial Mortgage Banking segment originates, sells and services commercial real estate loans and participation interests in commercial real estate loans through offices in the western region primarily through Sterling Savings Bank's subsidiary INTERVEST-Mortgage Investment Company ("INTERVEST").

·
The Retail Brokerage segment markets fixed income and equity products, mutual funds, fixed and variable annuities, insurance and other financial products within the Sterling Savings Bank financial service center network through sales representatives of Sterling Savings Bank's subsidiary Harbor Financial Services, Inc.

·
The Other and Eliminations segment represents the parent company expenses and intercompany eliminations of revenue and expenses.

 
-9-


The following table presents certain financial information regarding Sterling's segments and provides a reconciliation to Sterling's consolidated totals for the periods presented:
 
   
As of and for the Three Months Ended September 30, 2007    
 
   
Community
Banking
 
Residential
Mortgage Banking
 
Commercial
Mortgage Banking
  Retail Brokerage   
Other and
Eliminations 
 
Total
 
   
(Dollars in thousands)    
 
                             
Interest income
 
$
183,366
 
$
14,178
 
$
2,309
 
$
0
 
$
65
 
$
199,918
 
Interest expense
   
(97,636
)
 
(3,908
)
 
0
   
0
   
(4,710
)
 
(106,254
)
Net interest income (expense)
   
85,730
   
10,270
   
2,309
   
0
   
(4,645
)
 
93,664
 
Provision for loan losses
   
(3,775
)
 
(113
)
 
0
   
0
   
0
   
(3,888
)
Noninterest income
   
19,982
   
6,190
   
1,751
   
1,458
   
(5,174
)
 
24,207
 
Noninterest expense
   
(58,966
)
 
(10,572
)
 
(2,881
)
 
(1,140
)
 
(545
)
 
(74,104
)
Income before income taxes
 
$
42,971
 
$
5,775
 
$
1,179
   
318
 
$
(10,364
)
$
39,879
 
Total assets
 
$
11,429,438
 
$
407,668
 
$
10,370
 
$
1,160
 
$
(101,721
)
$
11,746,915
 
                                       
 
   
As of and for the Three Months Ended September 30, 2006    
 
   
Community
Banking
 
Residential
Mortgage Banking
 
Commercial
Mortgage Banking
  Retail Brokerage    Other and Eliminations   
Total
 
   
(Dollars in thousands)    
 
                             
Interest income
 
$
136,616
 
$
10,870
 
$
2,407
 
$
0
 
$
(1,685
)
$
148,208
 
Interest expense
   
(72,246
)
 
(3,886
)
 
0
   
0
   
(2,043
)
 
(78,175
)
Net interest income (expense)
   
64,370
   
6,984
   
2,407
   
0
   
(3,728
)
 
70,033
 
Provision for loan losses
   
(4,650
)
 
(45
)
 
0
   
0
   
(3
)
 
(4,698
)
Noninterest income
   
14,398
   
6,173
   
1,129
   
759
   
(4,008
)
 
18,451
 
Noninterest expense
   
(40,546
)
 
(11,016
)
 
(2,272
)
 
(726
)
 
(742
)
 
(55,302
)
Income before income taxes
 
$
33,572
 
$
2,096
 
$
1,264
 
$
33
 
$
(8,481
)
$
28,484
 
Total assets
 
$
8,669,081
 
$
354,447
 
$
10,660
 
$
897
 
$
(117,410
)
$
8,917,675
 
                                       

 
 
-10-

 
   
As of and for the Nine Months Ended September 30, 2007    
 
   
Community
Banking
 
Residential
Mortgage Banking
 
Commercial
Mortgage Banking
  Retail Brokerage   
Other and
Eliminations 
 
Total
 
   
(Dollars in thousands)
 
                             
Interest income
 
$
524,903
 
$
37,355
 
$
6,544
 
$
0
 
$
79
 
$
568,881
 
Interest expense
   
(281,837
)
 
(10,159
)
 
0
   
0
   
(13,565
)
 
(305,561
)
Net interest income (expense)
   
243,066
   
27,196
   
6,544
   
0
   
(13,486
)
 
263,320
 
Provision for loan losses
   
(11,825
)
 
(263
)
 
0
   
0
   
0
   
(12,088
)
Noninterest income
   
58,101
   
20,965
   
5,925
   
3,281
   
(15,839
)
 
72,433
 
Noninterest expense
   
(165,158
)
 
(30,896
)
 
(8,210
)
 
(2,979
)
 
(2,421
)
 
(209,664
)
Income before income taxes
 
$
124,184
 
$
17,002
 
$
4,259
 
$
302
 
$
(31,746
)
$
114,001
 
Total assets
 
$
11,429,438
 
$
407,668
 
$
10,370
 
$
1,160
   
(101,721
)
$
11,746,915
 
                                       
 
   
As of and for the Nine Months Ended September 30, 2006    
 
   
Community
Banking
 
Residential
Mortgage Banking
 
Commercial
Mortgage Banking
 
Retail
Brokerage 
 
Other and
Eliminations 
 
Total
 
   
(Dollars in thousands)
 
                             
Interest income
 
$
367,562
 
$
18,112
 
$
6,670
 
$
0
 
$
(1,237
)
$
391,107
 
Interest expense
   
(190,402
)
 
(3,886
)
 
0
   
0
   
(6,781
)
 
(201,069
)
Net interest income (expense)
   
177,160
   
14,226
   
6,670
   
0
   
(8,018
)
 
190,038
 
Provision for loan losses
   
(13,953
)
 
(45
)
 
0
   
0
   
0
   
(13,998
)
Noninterest income
   
39,330
   
10,725
   
3,612
   
2,602
   
(9,771
)
 
46,498
 
Noninterest expense
   
(117,393
)
 
(18,791
)
 
(6,195
)
 
(2,197
)
 
(1,955
)
 
(146,531
)
Income before income taxes
 
$
85,144
 
$
6,115
 
$
4,087
 
$
405
 
$
(19,744
)
$
76,007
 
Total assets
 
$
8,669,081
 
$
354,447
 
$
10,660
 
$
897
 
$
(117,410
)
$
8,917,675
 
                                       
7. Stock Based Compensation:

On January 1, 2006, Statement of Financial Accounting Standard No. 123 (R), "Share Based Payment," became effective for Sterling. As a result, stock options issued as compensation are recorded as an expense at their estimated fair value.

During the nine months ended September 30, 2007, stock option activity and related information was as follows:
 
   
Number
 
Weighted Average Exercise Price
 
Weighted Average Remaining Contractual Life (in years)
 
Aggregate Intrinsic Value (in thousands)
 
Outstanding, December 31, 2006
   
1,485,661
 
$
19.72
             
Granted
   
340,000
   
32.37
             
Exercised
   
(314,155
)
 
11.48
             
Acquisitions
   
573,212
   
12.67
             
Cancelled
   
(11,623
)
 
18.74
             
Outstanding, September 30, 2007
   
2,073,095
 
$
21.10
   
4.90
 
$
12,048
 
Exercisable, September 30, 2007
   
1,734,095
 
$
18.90
   
4.58
 
$
13,897
 
 
On April 24, 2007, Sterling adopted the 2007 Long-Term Incentive Plan, which allows for the issuance of up to an aggregate of 2.0 million options to purchase shares of Sterling's common stock. As of September 30, 2007, a total of 2,011,249 shares remained available for grant under Sterling's 2001, 2003 and 2007 Long-Term Incentive Plans. The options granted under these plans have terms of four, six, eight or ten years.

 
-11-


During the nine months ended September 30, 2007 and 2006, the fair value of options granted were $3.4 million and $171,000, respectively, and the intrinsic value of options exercised were $6.2 million and $4.9 million, respectively. The Black-Scholes option-pricing model was used in estimating the fair value of option grants. The weighted average assumptions used are presented in the table below.
 
   
Nine Months Ended
 
   
September 30,
 
   
2007
 
2006
 
Expected volatility
   
26% - 29
%
 
31
%
Expected term (in years)
   
4.7 - 6.0
   
5.5
 
Expected dividend yield
   
0.90% - 1.47
%
 
0.87
%
Risk free interest rate
   
4.65% - 4.80
%
 
4.36
%
 
Other stock based compensation during the nine months ended September 30, 2007 included the issuance to management of 85,000 shares of restricted stock, with a grant date fair value of $2.8 million. These shares vest evenly over a four year period. Stock compensation expense recognized during the nine months ended September 30, 2007 and 2006 was $1.0 million and $146,000, respectively.

8. New Accounting Pronouncements:

In February 2007, the Financial Accounting Standards Board ("FASB") issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS No. 159"). SFAS No. 159 provides a fair value measurement election for many financial instruments, on an instrument by instrument basis. SFAS No. 159 will be effective for Sterling as of January 1, 2008. Sterling is currently assessing the impact of this standard and does not expect SFAS No. 159 to have a material effect on Sterling.

In September 2006, the Emerging Issues Task Force ("EITF") reached a consensus on Issue No. 06-4, "Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements." Under the provisions of EITF Issue No. 06-4, Sterling will recognize the amount, if any, that is owed current or former employees under split dollar BOLI. EITF 06-4 is effective January 1, 2008. Sterling is currently assessing the potential impact of this standard.

In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" ("SFAS No. 157"). SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 will be effective for Sterling as of January 1, 2008. Sterling is currently assessing the impact of this standard and does not expect SFAS No. 157 to have a material effect on Sterling.

9. Derivatives and Hedging:

As part of its mortgage banking activities, Sterling issues interest rate lock commitments ("rate locks") to prospective borrowers on residential one-to-four family mortgage loan applications. Pricing for the sale of these loans is fixed with various qualified investors, such as Fannie Mae, under both non-binding ("best-efforts") and binding ("mandatory") delivery programs at or near the time the interest rate is locked with the borrowers.  For mandatory delivery programs, Sterling hedges Interest Rate Risk ("IRR") by entering into offsetting forward sale agreements on MBS with third parties. Risks inherent in mandatory delivery programs include the risk that if Sterling does not close the loans subject to rate locks, it is nevertheless obligated to deliver MBS to the counterparty under the forward sale agreement. Sterling could incur significant costs in acquiring replacement loans or MBS and such costs could have a material adverse effect on mortgage banking operations in future periods.

Rate lock commitments to borrowers and best-effort loan delivery commitments from investors are off-balance-sheet commitments that are considered to be derivatives. Sterling accounts for these commitments by recording their estimated fair value on its balance sheet. As of September 30, 2007, Sterling had entered into best efforts forward commitments to sell $189.3 million of mortgage loans, with the estimated fair value of rate locks issued and delivery commitments received on the unfunded portion valued as an offsetting asset and liability of approximately $1.1 million. As of December 31, 2006, these rate locks and delivery commitments were valued at $482,000. As of

 
-12-


September 30, 2007, Sterling had loans locked with investors under mandatory delivery programs valued at $18,000, and held offsetting forward sale agreements on MBS valued at $20,000, with a net position reflected in mortgage banking income. As of December 31, 2006, Sterling did not have any loans subject to rate locks under mandatory delivery programs.

Sterling enters into interest rate swap derivative contracts with customers. The IRR on these contracts is offset by entering comparable broker dealer swaps. These contracts are carried as an offsetting asset and liability at fair value, and as of September 30, 2007 and December 31, 2006, were $706,000 and $404,000, respectively.

10. Cash Dividends:

The board of directors of Sterling from time to time evaluates the payment of cash dividends. The timing and amount of any future dividends will depend upon earnings, cash and capital requirements, the financial condition of Sterling and its subsidiaries, applicable government regulations and other factors deemed relevant by Sterling's board of directors. During 2006 and 2007, Sterling paid the following cash dividends:
 
Date Paid
 
Per Share Amount
 
Total
 
January 2006
 
$
0.055
 
$
1.9 million
 
April 2006
   
0.060
   
2.1 million
 
July 2006
   
0.065
   
2.3 million
 
October 2006
   
0.070
   
2.6 million
 
January 2007
   
0.075
   
3.2 million
 
April 2007
   
0.080
   
4.1 million
 
July 2007
   
0.085
   
4.3 million
 
October 2007
   
0.090
   
4.6 million
 
 
11. Business Combinations:

On April 11, 2007, Sterling announced the signing of a definitive agreement (the "Merger Agreement") to acquire North Valley Bancorp ("North Valley"), headquartered in Redding, California. This pending acquisition required approval by the North Valley shareholders, which was received at a special meeting of the North Valley shareholders on July 31, 2007, and remains subject to regulatory approval and satisfaction of other customary closing conditions. On October 26, 2007, Sterling announced that it appears unlikely that the pending merger between Sterling and North Valley will be completed during the fourth quarter of 2007 as previously intended. Sterling has revised its expectation for regulatory approval of the merger based upon recent conversations between Sterling and the FDIC. Sterling has been asked by the FDIC to strengthen its internal regulatory compliance program to ensure that Sterling's infrastructure is keeping pace with its growth rate. The FDIC has also informed Sterling that, at this time, it cannot advise Sterling when or if the pending application to merge Sterling Savings Bank with North Valley Bank will be approved. Sterling and North Valley are currently in discussions regarding an amendment to the Merger Agreement to extend the date after which either party may terminate the Merger Agreement if the merger has not been consummated, which is currently November 30, 2007; however, no agreement to amend the Merger Agreement has yet been reached. The integration of North Valley into Sterling is expected to increase Sterling's total assets by approximately $900 million, and would complement the recent growth of its business in northern California, increasing its presence there by 25 depository branches. The transaction was valued at $196.2 million as of the date the parties agreed to merge.

On February 28, 2007, Sterling completed its acquisition of Northern Empire Bancshares ("Northern Empire"), a California corporation by issuing $30.0 million in cash, and 8,914,815 shares of Sterling common stock valued at $290.4 million in exchange for all outstanding Northern Empire shares. Northern Empire options totaling 646,018 were converted into options to purchase an aggregate of 573,212 shares of Sterling's common stock, valued at $12.3 million. The total value of the transaction was $332.8 million. Northern Empire merged with and into Sterling, with Sterling being the surviving corporation in the merger. Northern Empire's financial institution subsidiary, Sonoma National Bank, merged with and into Sterling's subsidiary, Sterling Savings Bank, with Sterling Savings Bank being the surviving institution. The Sonoma National Bank acquisition provided Sterling Savings

 
-13-


Bank entry into the northern California market, enhanced the products and services available to the customers of both companies and strengthened Sterling’s leadership position in the West.

The following summarizes the fair values of the assets acquired and liabilities assumed as of the date of acquisition (in thousands):
 
   
February 28, 2007
 
Cash and cash equivalents
 
$
110,775
 
Investments and MBS
   
22,574
 
Loans receivable, net
   
1,228,816
 
Goodwill
   
208,944
 
Core deposit intangible
   
7,775
 
Other assets
   
19,523
 
Total assets acquired
 
$
1,598,407
 
         
Deposits
 
$
987,694
 
Other borrowings
   
266,853
 
Other liabilities
   
11,093
 
Total liabilities assumed
   
1,265,640
 
Net assets acquired
 
$
332,767
 
 
The following summarizes the unaudited pro forma results of operations as if Sterling acquired Northern Empire on January 1, 2006 (in thousands, except per share amounts):
 
   
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
   
2007
 
2006
 
2007
 
2006
 
Pro forma interest income
 
$
199,918
 
$
173,438
 
$
585,859
 
$
461,380
 
Pro forma interest expense
   
106,254
   
91,363
   
314,562
   
235,510
 
Pro forma net interest income
   
93,664
   
82,075
   
271,297
   
225,870
 
Pro forma net income
   
26,530
   
23,492
   
75,337
   
64,565
 
Pro forma earnings per share - basic
 
$
0.52
 
$
0.51
 
$
1.48
 
$
1.45
 
Pro forma earnings per share - diluted
 
$
0.51
 
$
0.50
 
$
1.47
 
$
1.43
 
                           
12. Subsequent Event:

In October 2007, Sterling announced a quarterly cash dividend of $0.095 per share, payable on January 11, 2008 to shareholders of record as of December 31, 2007.

 
PART I - Financial Information (continued)
Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operation

STERLING FINANCIAL CORPORATION
September 30, 2007
 
 
This report contains forward-looking statements. For a discussion about such statements, including the risks and uncertainties inherent therein, see "Forward-Looking Statements." Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes presented elsewhere in this report and in Sterling's 2006 annual report on Form 10-K.

General

Sterling Financial Corporation ("Sterling") is a bank holding company, the significant operating subsidiaries of which are Sterling Savings Bank and Golf Savings Bank. The principal operating subsidiaries of Sterling Savings Bank are Action Mortgage Company ("Action Mortgage"), INTERVEST-Mortgage Investment Company ("INTERVEST") and Harbor Financial Services, Inc. ("Harbor Financial"). Sterling Savings Bank commenced operations in 1983 as a Washington State-chartered federally insured stock savings and loan association headquartered in Spokane, Washington. On July 8, 2005, Sterling Savings Bank converted to a Washington State-chartered commercial bank. The main focus of Golf Savings Bank, a Washington State-chartered savings bank acquired by Sterling in July 2006, is the origination and sale of residential mortgage loans.

Sterling provides personalized, quality financial services and "Perfect Fit" banking products to its customers consistent with its "Hometown Helpful" philosophy. Sterling believes that its dedication to personalized service has enabled it to grow both its retail deposit base and its lending portfolio in the western United States. With $11.75 billion in total assets at September 30, 2007, Sterling originates loans and attracts Federal Deposit Insurance Corporation ("FDIC") insured deposits from the general public through 171 financial service centers throughout Washington, Oregon, California, Idaho and Montana. In addition, Sterling originates loans through Golf Savings Bank and Action Mortgage residential loan production offices and through INTERVEST commercial real estate lending offices in the western United States. Sterling also markets fixed income and equity products, mutual funds, fixed and variable annuities and other financial products through Harbor Financial service representatives located throughout Sterling's financial service center network.

Sterling continues to implement its strategy to become the leading community bank in the western United States by increasing its commercial real estate, commercial banking, consumer and construction lending, which generally produce higher yields than residential loans, as well as increasing its retail deposits, particularly transaction accounts. Such loans generally involve a higher degree of risk than financing residential real estate. Management believes that a community bank mix of assets and liabilities will enhance its net interest income ("NII") (the difference between the interest earned on loans and investments and the interest paid on deposits and borrowings) and will increase other fee income, although there can be no assurance in this regard. Sterling's revenues are derived primarily from interest earned on loans and mortgage-backed securities ("MBS"), fees and service charges, and mortgage banking operations ("MBO"). The operations of Sterling, and banking institutions generally, are influenced significantly by general economic conditions and by policies of its primary regulatory authorities, the Board of Governors of the Federal Reserve System ("FRB"), the FDIC and the Washington State Department of Financial Institutions ("Washington Supervisor").

 
Executive Summary and Highlights

During 2006 and 2007, Sterling completed the acquisitions of Lynnwood Financial Group, Inc. and its subsidiary, Golf Savings Bank on July 5, 2006; FirstBank NW Corp. and its subsidiary, FirstBank Northwest on November 30, 2006; and Northern Empire Bancshares and its subsidiary, Sonoma National Bank on February 28, 2007. On July 31, 2006, Sterling also acquired certain assets of Mason-McDuffie Financial Corporation. As a result, comparability among periods may be affected. The increase in net income over 2006 was mainly due to the increase in net interest income from growth in loan balances causing a change in the mix of interest earning assets.

During the third quarter of 2007, disruptions in the mortgage market impacted many financial institutions, including Sterling.  Although Sterling's total assets, total loans receivable and total deposits have increased on an annualized basis, on a linked quarter basis these market conditions have contributed to Sterling experiencing a decrease in loan originations, a lower level of income from mortgage banking operations and a decline in asset quality.  The lower level of income from mortgage banking operations is primarily the result of the declining volume and prices for loan sales into the secondary market, while residential construction loans are the primary source of the decline in asset quality.

Highlights for the third quarter of 2007 as compared to the second quarter of 2007 were as follows:
 
 
·
Net interest margin was 3.50 percent, a 9 basis point improvement over last quarter.

 
·
Total assets were a record $11.75 billion, representing a 10 percent growth on an annualized basis over last quarter.

 
·
Net income was $26.5 million, slightly below the $27.0 million last quarter.

 
·
Non-interest income was $24.2 million, compared to $24.8 million last quarter.

 
·
Total loans receivable increased to a record $8.75 billion, representing an 11 percent growth on an annualized basis over last quarter.

 
·
Total deposits increased to a record $7.77 billion, representing an 8 percent growth on an annualized basis over last quarter.

 
·
Total nonperforming assets increased to 0.49 percent of total assets, up from 0.27 percent of total assets last quarter.

Company Growth

Sterling intends to continue to pursue an aggressive growth strategy to become the leading community bank in the western United States. This strategy may include acquiring other financial businesses or branches thereof, or other substantial assets or deposit liabilities. Sterling may not be successful in identifying further acquisition candidates, integrating acquisitions or preventing such acquisitions from having an adverse effect on Sterling. There is significant competition for acquisitions in Sterling's market area, and Sterling may not be able to acquire other businesses on attractive terms. Furthermore, the success of Sterling's growth strategy will depend on increasing and maintaining sufficient levels of regulatory capital, obtaining necessary regulatory approvals, generating appropriate growth and the existence of favorable economic and market conditions. There can be no assurance that Sterling will be successful in implementing its growth strategy.

On April 11, 2007, Sterling announced the signing of a definitive agreement (the "Merger Agreement") to acquire North Valley Bancorp ("North Valley"), headquartered in Redding, California. This pending acquisition required approval by the North Valley shareholders, which was received at a special meeting of the North Valley shareholders on July 31, 2007, and remains subject to regulatory approval and satisfaction of other customary

 
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closing conditions. On October 26, 2007, Sterling announced that it appears unlikely that the pending merger between Sterling and North Valley will be completed during the fourth quarter of 2007 as previously intended. Sterling has revised its expectation for regulatory approval of the merger based upon recent conversations between Sterling and the FDIC. Sterling has been asked by the FDIC to strengthen its internal regulatory compliance program to ensure that Sterling's infrastructure is keeping pace with its growth rate. The FDIC has also informed Sterling that, at this time, it cannot advise Sterling when or if the pending application to merge Sterling Savings Bank with North Valley Bank will be approved. Sterling and North Valley are currently in discussions regarding an amendment to the Merger Agreement to extend the date after which either party may terminate the Merger Agreement if the merger has not been consummated, which is currently November 30, 2007; however, no agreement to amend the Merger Agreement has yet been reached. The integration of North Valley into Sterling is expected to increase Sterling's total assets by approximately $900 million, and would complement the recent growth of its business in California, increasing its presence there by 25 depository branches.

On February 28, 2007, Sterling completed its acquisition of Northern Empire Bancshares, a California corporation ("Northern Empire") by issuing $30.0 million in cash, and 8,914,815 shares of Sterling common stock valued at $290.4 million in exchange for all outstanding Northern Empire shares. Northern Empire options totaling 646,018 were converted into 573,212 Sterling options, valued at $12.3 million. The total value of the transaction was $332.8 million. Northern Empire merged into Sterling, with Sterling being the surviving corporation in the merger. Northern Empire's financial institution subsidiary, Sonoma National Bank, merged with and into Sterling's subsidiary, Sterling Savings Bank, with Sterling Savings Bank being the surviving institution.

On November 30, 2006, Sterling completed its acquisition of FirstBank NW Corp., a Washington corporation ("FirstBank"), by issuing cash of $15.6 million and 4,821,913 shares of Sterling common stock valued at $145.3 million in exchange for all outstanding FirstBank shares. The total value of the transaction, including options converted, was $165.4 million. FirstBank was merged with and into Sterling, with Sterling being the surviving corporation in the merger. FirstBank's financial institution subsidiary, FirstBank Northwest, was merged with and into Sterling's subsidiary, Sterling Savings Bank, with Sterling Savings Bank being the surviving institution.

On July 31, 2006, a wholly owned subsidiary of INTERVEST acquired the mortgage banking operations, including the commercial servicing portfolio, brand name and investor/customer list, of Mason-McDuffie Financial Corporation ("Mason-McDuffie"), located in northern California. INTERVEST's mortgage banking business in northern California is now being conducted by Mason-McDuffie. The transaction was valued at $2.7 million, including $1.8 million in cash paid at closing, with the remainder to be paid in Sterling common stock, subject to the terms of a three-year earnout. Mason-McDuffie is dedicated to commercial loan originations and loan servicing.

On July 5, 2006, Sterling completed its acquisition of Lynnwood Financial Group, Inc. ("Lynnwood"), the parent company of Golf Savings Bank, by issuing $15.8 million in cash and 1,799,961 shares of Sterling common stock valued at $48.8 million in exchange for all outstanding Lynnwood shares. The total value of the transaction, including options converted, was $66.3 million. Lynnwood merged with and into Sterling, with Sterling being the surviving entity in the merger. Lynnwood's wholly owned subsidiaries, Golf Savings Bank and Golf Escrow Corporation, have become subsidiaries of Sterling.

Critical Accounting Policies

The accounting and reporting policies of Sterling conform to accounting principles generally accepted in the United States of America ("GAAP") and to general practices within the banking industry. The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Sterling's management has identified the accounting policies described below as those that, due to the judgments, estimates and assumptions inherent in those policies are critical to an understanding of Sterling's Consolidated Financial Statements and Management's Discussion and Analysis.

Income Recognition. Sterling recognizes interest income by methods that conform to general accounting practices within the banking industry. In the event management believes collection of all or a portion of contractual interest

 
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on a loan has become doubtful, which generally occurs after the loan is 90 days past due, Sterling discontinues the accrual of interest and any previously accrued interest recognized in income deemed uncollectible is reversed. Interest received on nonperforming loans is included in income only if principal recovery is reasonably assured. A nonperforming loan is restored to accrual status when it is brought current, has performed in accordance with contractual terms for a reasonable period of time, and the collectibility of the total contractual principal and interest is no longer in doubt.

Allowance for Loan Losses. In general, determining the amount of the allowance for loan losses requires significant judgment and the use of estimates by management. Sterling maintains an allowance for loan losses to absorb probable losses in the loan portfolio based on a quarterly analysis of the portfolio and expected future losses. This analysis is designed to determine an appropriate level and allocation of the allowance for losses among loan types by considering factors affecting loan losses, including specific losses, levels and trends in impaired and nonperforming loans, historical loan loss experience, current national and local economic conditions, volume, growth and composition of the portfolio, regulatory guidance and other relevant factors. Management monitors the loan portfolio to evaluate the adequacy of the allowance. The allowance can increase or decrease each quarter based upon the results of management's analysis.

The amount of the allowance for the various loan types represents management's estimate of expected losses from existing loans based upon specific allocations for individual lending relationships and historical loss experience for each category of homogeneous loans. The allowance for loan losses related to impaired loans is based on discounted cash flows using the loan's initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. This evaluation requires management to make estimates of the amounts and timing of future cash flows on impaired loans, which consist primarily of non-accrual and restructured loans.

Individual loan reviews are based upon specific quantitative and qualitative criteria, including the size of the loan, loan quality ratings, value of collateral, repayment ability of borrowers, and historical experience factors. The historical experience factors utilized and allowances for homogeneous loans (such as residential mortgage loans, personal loans, etc.) are collectively evaluated based upon historical loss experience, trends in losses and delinquencies, growth of loans in particular markets, and known changes in economic conditions in each particular lending market.

While management uses available information to provide for loan losses, the ultimate collectibility of a substantial portion of the loan portfolio and the need for future additions to the allowance will be influenced by changes in economic conditions and other relevant factors. A slowdown in economic activity could adversely affect cash flows for both commercial and individual borrowers, which may result in increases in nonperforming assets, delinquencies and losses on loans. There can be no assurance that the allowance for loan losses will be adequate to cover all losses, but management believes the allowance for loan losses was adequate at September 30, 2007.

Investment Securities and MBS. Assets in the investment securities and MBS portfolios are initially recorded at cost, which includes any premiums and discounts. Sterling amortizes premiums and discounts as an adjustment to interest income using the level interest yield method over the estimated life of the security. The cost of investment securities sold, and any resulting gain or loss, is based on the specific identification method.

The loans underlying Sterling's MBS are subject to the prepayment of principal. The rate at which prepayments are expected to occur in future periods impacts the amount of premium to be amortized in the current period. If prepayments in a future period are higher or lower than expected, then Sterling will need to amortize a larger or smaller amount of the premium to interest income in that future period.

Management determines the appropriate classification of investment securities at the time of purchase. Held-to-maturity securities are those securities that Sterling has the positive intent and ability to hold to maturity and are recorded at amortized cost. Available-for-sale securities are those securities that would be available to be sold in the future in response to Sterling's liquidity needs, changes in market interest rates, and asset-liability management strategies, among others. Available-for-sale securities are reported at fair value, with unrealized holding gains and losses reported in shareholders' equity as a separate component of other comprehensive income, net of applicable deferred income taxes.

 
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Management evaluates investment securities for other-than-temporary declines in fair value on a quarterly basis. If the fair value of investment securities falls below their amortized cost and the decline is deemed to be other-than-temporary, the securities will be written down to current market value, resulting in a loss recorded in the income statement and the establishment of a new basis. During the six months ended September 30, 2007, there were no investment securities that management identified to be other-than-temporarily impaired, because the decline in fair value was attributable to changes in interest rates and not credit quality, and because Sterling has the ability and intent to hold these investments until a recovery in market price occurs, or until maturity. Realized losses could occur in future periods due to a change in management's intent to hold the investments to recovery, a change in management's assessment of credit risk, or a change in regulatory or accounting requirements.

Goodwill and Other Intangible Assets. Goodwill arising from business combinations represents the value attributable to unidentifiable intangible elements in the business acquired. Sterling's goodwill relates to value inherent in the banking business and the value is dependent upon Sterling's ability to provide quality, cost effective services in a competitive market place. As such, goodwill value is supported ultimately by revenue that is generated by the volume of business transacted. A decline in earnings as a result of a lack of growth or the inability to deliver cost effective services over sustained periods can lead to impairment of goodwill that could adversely impact earnings in future periods.

Sterling's management performed an annual test of its goodwill and other intangible assets as of June 30, 2007, and concluded that the recorded values were not impaired. There are many assumptions and estimates underlying the determination of impairment. Another estimate using different but still reasonable assumptions could produce a significantly different result. Additionally, future events could cause management to conclude that Sterling's goodwill is impaired, which would result in Sterling recording an impairment loss. Any resulting impairment loss could have a material adverse impact on Sterling's financial condition and results of operations. Other intangible assets consisting of core-deposit intangibles with definite lives are amortized over the estimated life of the acquired depositor relationships (generally eight to ten years).

Real Estate Owned and Other Collateralized Assets. Property and other assets acquired through foreclosure of defaulted mortgage or other collateralized loans are carried at the lower of cost or fair value, less estimated costs to sell. Development and improvement costs relating to such property are capitalized to the extent they are deemed to be recoverable.

An allowance for losses on real estate and other assets owned includes amounts for estimated losses as a result of impairment in value of the property after repossession. Sterling reviews its real estate owned and other collateralized assets for impairment in value whenever events or circumstances indicate that the carrying value of the property or other assets may not be recoverable. In performing the review, if expected future undiscounted cash flow from the use of the property or other assets, or the fair value, less selling costs, from the disposition of the property or other assets is less than its carrying value, an impairment loss is recognized.

Income Taxes. Sterling estimates income taxes payable based on the amount it expects to owe various taxing authorities. Accrued income taxes represent the net estimated amount due to, or to be received from, taxing authorities. In estimating accrued income taxes, Sterling assesses the relative merits and risks of the appropriate tax treatment of transactions, taking into account the applicable statutory, judicial and regulatory guidance in the context of Sterling's tax position. Sterling also considers recent audits and examinations, as well as its historical experience in making such estimates. Although Sterling uses available information to record income taxes, underlying estimates and assumptions can change over time as a result of unanticipated events or circumstances.

Sterling uses an estimate of future earnings to support its position that the benefit of its net deferred tax assets will be realized. If future taxable income should prove nonexistent or less than the amount of temporary differences giving rise to the net deferred tax assets within the tax years to which they may be applied, the assets will not be realized and Sterling's net income will be reduced.
 
 
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Results of Operations
 
Overview. Sterling recorded net income of $26.5 million, or $0.51 per diluted share, for the three months ended September 30, 2007, compared with net income of $19.3 million, or $0.52 per diluted share, for the three months ended September 30, 2006, and $27.0 million, or $0.52 per diluted share, for the three months ended June 30, 2007. Net income for the nine months ended September 30, 2007 was $76.4 million, or $1.54 per diluted share compared with net income of $51.7 million, or $1.44 per diluted share for the nine months ended September 30, 2006. The year over year increase in net income mainly reflected an increase in net interest income generated by margin expansion and growth in interest earnings assets, while the linked quarter decrease primarily reflected disruption in the mortgage market.

The annualized return on average assets ("ROA") was 0.91% and 0.89% for the three months ended September 30, 2007 and 2006, respectively, and 0.93% and 0.85% for the nine months ended September 30, 2007 and 2006, respectively. The annualized return on average equity ("ROE") was 9.3% and 13.4% for the three months ended September 30, 2007 and 2006, respectively, and 9.7% and 12.9% for the nine months ended September 30, 2007 and 2006, respectively. The increase in ROA compared to 2006 was due to growth of net income outpacing the increase in assets, while dilution from recent acquisitions drove the decrease in ROE.

Net Interest Income. The most significant component of earnings for a financial institution typically is NII, which is the difference between interest income, primarily from loan, MBS and investment securities portfolios, and interest expense, primarily on deposits and borrowings. During the three months ended September 30, 2007 and 2006, NII was $93.7 million and $70.0 million, respectively, an increase of 33.7%. During the nine months ended September 30, 2007 and 2006, NII was $263.3 million and $190.0 million, respectively, an increase of 38.6%. The increase in NII was mainly influenced by the increase in loans as a percentage of interest earning assets.

Changes in Sterling's NII are a function of changes in both rates and volumes of interest-earning assets and interest-bearing liabilities. Volume refers to the dollar level of interest-earning assets and interest-bearing liabilities. Net interest spread refers to the difference between the yield on interest-earning assets and the rate paid on interest-bearing liabilities. Net interest margin refers to NII divided by total average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities.

The following table presents the composition of the change in NII, on a tax equivalent basis, for the periods presented. Municipal loan and bond interest income are presented gross of their applicable tax savings. For each category of interest-earning assets and interest-bearing liabilities, the following table provides information on changes attributable to:

·
Volume - changes in volume multiplied by comparative period rate;
·
Rate - changes in rate multiplied by comparative period volume; and
·
Rate/volume - changes in rate multiplied by changes in volume.
 
   
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
   
2007 vs. 2006
 
2007 vs. 2006
 
   
Increase (Decrease) Due to:
 
Increase (Decrease) Due to:
 
           
Rate/
             
Rate/
     
   
Volume
 
Rate
 
Volume
 
Total
 
Volume
 
Rate
 
Volume
 
Total
 
Rate/volume analysis:
 
(Dollars in thousands)
 
Interest income:
                                 
Loans
 
$
53,037
 
$
443
 
$
141
 
$
53,621
 
$
160,583
 
$
15,431
 
$
7,793
 
$
183,807
 
MBS
   
(2,855
)
 
126
   
(16
)
 
(2,745
)
 
(8,888
)
 
173
   
(23
)
 
(8,738
)
Investments and cash equivalents
   
(303
)
 
1,803
   
(369
)
 
1,131
   
452
   
2,760
   
332
   
3,544
 
Total interest income
   
49,879
   
2,372
   
(244
)
 
52,007
   
152,147
   
18,364
   
8,102
   
178,613
 
Interest expense:
                                                 
Deposits
   
15,363
   
3,461
   
1,012
   
19,836
   
48,997
   
21,337
   
8,169
   
78,503
 
Borrowings
   
6,652
   
1,272
   
319
   
8,243
   
13,216
   
10,830
   
1,943
   
25,989
 
Total interest expense
   
22,015
   
4,733
   
1,331
   
28,079
   
62,213
   
32,167
   
10,112
   
104,492
 
Net changes in NII
 
$
27,864
 
$
(2,361
)
$
(1,575
)
$
23,928
 
$
89,934
 
$
(13,803
)
$
(2,010
)
$
74,121
 
                                                   

 
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Net interest margin for each of the last five quarters was as follows:
 
Three Months Ended
 
Tax Equivalent Net Interest Margin
 
       
September 30, 2007
   
3.50
%
June 30, 2007
   
3.41
%
March 31, 2007
   
3.41
%
December 31, 2006
   
3.37
%
September 30, 2006
   
3.34
%
 
Average interest-earning assets for the three and nine months ended September 30, 2007 were $10.70 billion and $10.30 billion, respectively, reflecting growth of $2.31 billion and $2.57 billion, respectively, over the comparative 2006 amounts. The growth in the loan portfolio is driving the increase in interest earning assets, resulting in an increase in net interest margin as loans are becoming a larger percentage of earning assets. Another positive influence on the net interest margin was the drop in the cost of wholesale funding in anticipation of a Federal Reserve rate cut in September 2007.

Provision for Losses on Loans. Management's policy is to establish valuation allowances for estimated losses by charging corresponding provisions against income. The evaluation of the adequacy of specific and general valuation allowances is an ongoing process. This process includes information derived from many factors, including historical loss trends and trends in classified assets, delinquency and nonaccrual loans, and portfolio volume, diversification as to type of loan, size of individual credit exposure, current and anticipated economic conditions, as well as loan policies, collection policies and effectiveness, quality of credit personnel, effectiveness of policies, procedures and practices, and recent loss experience of peer banking institutions.

Sterling recorded provisions for losses on loans of $3.9 million and $4.7 million for the three months ended September 30, 2007 and 2006, respectively. The current provision reflects the analysis and assessment of the relevant factors mentioned in the preceding paragraph, growth in the allowance as a percentage of loans, as well as the decrease for the three month comparative period in loan originations. Management anticipates that its provision for losses on loans may increase, reflecting, among other factors, market conditions surrounding residential construction lending.

The following table summarizes loan loss allowance activity for the periods indicated:
 
   
Nine Months Ended
September 30,
 
   
2007
 
2006
 
   
(Dollars in thousands)
 
           
Allowance - loans, January 1
 
$
77,849
 
$
52,034
 
Acquired
   
15,294
   
4,552
 
Provision
   
11,838
   
13,998
 
Charge offs, net of recoveries
   
(2,733
)
 
(2,570
)
Transfers
   
(206
)
 
(1,509
)
Allowance - loans, September 30
   
102,042
   
66,505
 
Allowance - unfunded commitments, January 1