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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, 2011

OR

 

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

For the transition period from             to             .

Commission File Number.....001-34696

 

 

STERLING FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

Washington		91-1572822
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer 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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer		¨		Accelerated filer		¨
Non-accelerated filer		x (Do not check if a smaller reporting company)		Smaller reporting company		¨

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date:

 

Class		Outstanding as of October 31, 2011
Common Stock		61,973,619

 

 

 

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TABLE OF CONTENTS

September 30, 2011

 

				Page
PART I - Financial Information					1
Item 1		Financial Statements (Unaudited)			1
		Consolidated Balance Sheets			2
		Consolidated Statements of Operations			3
		Consolidated Statements of Comprehensive Income			4
		Consolidated Statements of Cash Flows			5
		Notes to Consolidated Financial Statements			7
Item 2		Management’s Discussion and Analysis of Financial Condition and Results of Operations			31
Item 3		Quantitative and Qualitative Disclosures About Market Risk			47
Item 4		Controls and Procedures			47
PART II - Other Information					48
Item 1		Legal Proceedings			48
Item 1A		Risk Factors			49
Item 2		Unregistered Sales of Equity Securities and Use of Proceeds			49
Item 3		Defaults Upon Senior Securities			49
Item 4		(Removed And Reserved)			49
Item 5		Other Information			49
Item 6		Exhibits			49
Signatures					50

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STERLING FINANCIAL CORPORATION

CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(in thousands)

 

		September 30, 2011				December 31, 2010
ASSETS:
Cash and cash equivalents:
Interest bearing		$	372,650			$	341,425
Non-interest bearing			89,872				70,158
Total cash and cash equivalents			462,522				411,583
Restricted cash			19,195				15,681
Investments and mortgage-backed securities (“MBS”):
Available for sale			2,446,523				2,825,010
Held to maturity			1,900				13,464
Loans held for sale			241,039				222,216
Loans receivable, net			5,428,355				5,379,081
Accrued interest receivable			33,618				34,087
Other real estate owned, net (“OREO”)			111,566				161,653
Properties and equipment, net			84,380				81,094
Bank-owned life insurance (“BOLI”)			174,092				169,288
Core deposit intangible assets, net			13,290				16,929
Mortgage servicing rights, net			21,160				20,604
Prepaid expenses and other assets, net			138,234				142,479
Total assets		$	9,175,874			$	9,493,169
LIABILITIES:
Deposits:
Noninterest bearing		$	1,167,552			$	992,368
Interest bearing			5,311,688				5,918,639
Total deposits			6,479,240				6,911,007
Advances from Federal Home Loan Bank (“FHLB”)			407,000				407,211
Securities sold under repurchase agreements and funds purchased			1,056,352				1,032,512
Junior subordinated debentures			245,289				245,285
Accrued interest payable			21,152				17,259
Accrued expenses and other liabilities			107,348				109,128
Total liabilities			8,316,381				8,722,402
SHAREHOLDERS’ EQUITY:
Preferred stock, 10,000,000 shares authorized; no shares outstanding			0				0
Common stock, 151,515,151 shares authorized; 61,968,510 and 61,926,187 shares outstanding			1,963,820				1,960,871
Accumulated other comprehensive income (loss)			57,297				(4,179	)
Accumulated deficit			(1,161,624	)			(1,185,925	)
Total shareholders’ equity			859,493				770,767
Total liabilities and shareholders’ equity		$	9,175,874			$	9,493,169

See notes to consolidated financial statements.

 

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STERLING FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

(in thousands, except per share amounts)

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2011				2010				2011				2010
Interest income:
Loans		$	82,010			$	85,886			$	242,132			$	276,747
MBS			16,719				18,127				56,681				56,569
Investments and cash equivalents			2,650				2,641				8,150				8,039
Total interest income			101,379				106,654				306,963				341,355
Interest expense:
Deposits			14,135				22,639				46,645				75,153
Short-term borrowings			657				1,220				847				5,434
Long-term borrowings			11,751				15,360				36,085				45,348
Total interest expense			26,543				39,219				83,577				125,935
Net interest income			74,836				67,435				223,386				215,420
Provision for credit losses			6,000				60,892				26,000				220,229
Net interest income (expense) after provision for credit losses			68,836				6,543				197,386				(4,809	)
Noninterest income:
Fees and service charges			12,332				13,826				37,839				41,094
Mortgage banking operations			16,360				19,409				37,481				42,354
Loan servicing fees			(4,694	)			(1,120	)			(2,884	)			(382	)
BOLI			1,612				1,570				4,922				5,425
Gains on sales of securities, net			0				7,005				14,298				24,265
Other			3,502				(1,032	)			1,773				(6,573	)
Total noninterest income			29,112				39,658				93,429				106,183
Noninterest expense			86,620				94,223				266,515				287,515
Income (loss) before income taxes			11,328				(48,022	)			24,300				(186,141	)
Income tax expense			0				0				0				0
Net income (loss)			11,328				(48,022	)			24,300				(186,141	)
Preferred stock dividend			0				(2,715	)			0				(11,596	)
Benefit to common shareholders (1)			0				84,329				0				84,329
Net income (loss) available to common shareholders		$	11,328			$	33,592			$	24,300			$	(113,408	)
Earnings (loss) per share - basic (2)		$	0.18			$	7.05			$	0.39			$	(53.29	)
Earnings (loss) per share - diluted (2)		$	0.18			$	1.31			$	0.39			$	(53.29	)
Weighted average shares outstanding - basic (2)			61,958,183				4,764,875				61,944,392				2,128,059
Weighted average shares outstanding - diluted (2)			62,041,203				25,739,308				62,236,465				2,128,059

 

(1)	The August 26, 2010 conversion of Series C preferred stock into common stock resulted in an increase in income available to common shareholders.

(2)	Reflects the 1-for-66 reverse stock split in November 2010.

See notes to consolidated financial statements.

 

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STERLING FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (UNAUDITED)

(in thousands)

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2011				2010				2011				2010
Net income (loss)		$	11,328			$	(48,022	)		$	24,300			$	(186,141	)
Other comprehensive income:
Change in unrealized gains on investments and MBS available-for-sale			39,564				6,215				78,158				42,618
Less deferred income tax provision			0				2,561				(2,384	)			(1,504	)
Realized net gains reclassified from other comprehensive income			0				(7,005	)			(14,298	)			(24,265	)
Net other comprehensive income			39,564				1,771				61,476				16,849
Comprehensive income (loss)		$	50,892			$	(46,251	)		$	85,776			$	(169,292	)

See notes to consolidated financial statements.

 

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STERLING FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(in thousands)

 

		Nine Months Ended September 30,
		2011				2010
Cash flows from operating activities:
Net income (loss)		$	24,300			$	(186,141	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Provision for credit losses			26,000				220,229
Net gain on sales of loans			(38,007	)			(38,836	)
Net gain on sales of investments and MBS			(14,298	)			(24,265	)
Stock based compensation			2,949				813
Loss on OREO			61,617				66,274
Increase in cash surrender value of BOLI			(4,804	)			(5,425	)
Depreciation and amortization			30,161				22,082
Change in:
Accrued interest receivable			469				7,465
Prepaid expenses and other assets			4,246				42,083
Accrued interest payable			3,893				(4,171	)
Accrued expenses and other liabilities			(1,279	)			7,733
Proceeds from sales of loans originated for sale			1,394,273				1,678,816
Loans originated for sale			(1,399,822	)			(1,739,032	)
Net cash provided by operating activities			89,698				47,625
Cash flows from investing activities:
Change in restricted cash			(3,514	)			(14,677	)
Net (increase) decrease in loans			(298,315	)			865,544
Proceeds from sales of loans			39,320				310,155
Purchase of investment securities			(9,857	)			(20,857	)
Proceeds from maturities of investment securities			478				8,035
Proceeds from sale of investment securities			30,987				17,429
Purchase of MBS			(264,156	)			(1,711,340	)
Principal payments received on MBS			341,827				437,644
Proceeds from sales of MBS			353,444				763,437
Office properties and equipment, net			(13,069	)			(2,344	)
Improvements and other changes to OREO			(5,357	)			(2,887	)
Proceeds from sales of OREO			197,528				120,532
Net cash provided by investing activities			369,316				770,671

See notes to consolidated financial statements.

 

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STERLING FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)—cont.

(in thousands)

 

		Nine Months Ended September 30,
		2011				2010
Cash flows from financing activities:
Net change in deposits		$	(431,767	)		$	(865,976	)
Advances from FHLB			0				538,050
Repayment of advances from FHLB			(148	)			(1,037,643	)
Net change in securities sold under repurchase agreements and funds purchased			23,840				(14,201	)
Proceeds from stock issuance, net			0				684,412
Other			0				3,370
Net cash used in financing activities			(408,075	)			(691,988	)
Net change in cash and cash equivalents			50,939				126,308
Cash and cash equivalents, beginning of period			411,583				564,783
Cash and cash equivalents, end of period		$	462,522			$	691,091
Supplemental disclosures:
Cash paid on interest during the period		$	79,684			$	130,106
Cash received on income tax refunds during the period			0				49,340
Noncash financing and investing activities:
Loans converted into OREO			203,701				257,448
Preferred stock cash dividend accrued			0				10,349
Conversion of preferred stock into common stock			0				295,384
Conversion of preferred stock accrued dividend into common stock			0				19,865
Conversion of Treasury warrant			0				3,669

See notes to consolidated financial statements.

 

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STERLING FINANCIAL CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2011

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, 2010. 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.

In addition to other established accounting policies, the following is a discussion of recent accounting pronouncements:

In July 2010, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) 2010-20, “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.” This update amends codification topic 310 on receivables to improve the disclosures that an entity provides about the credit quality of its financing receivables and the related allowance for credit losses. As a result of these amendments, an entity is required to disaggregate by portfolio segment or class certain existing disclosures and provide certain new disclosures about its financing receivables and related allowance for credit losses. This guidance was phased in, with the new disclosure requirements for period end balances effective as of December 31, 2010, and the new disclosure requirements for activity during the reporting period effective March 31, 2011. The troubled debt restructuring disclosures in this ASU became effective September 30, 2011. See Note 3.

In April 2011, the FASB issued ASU 2011-2, “A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.” This update to codification topic 310 provides guidance for what constitutes a concession and whether a debtor is experiencing financial difficulties. The amendments in this update were effective for Sterling on July 1, 2011, with retrospective application from January 1, 2011. This update did not have a material effect on Sterling’s consolidated financial statements.

In April 2011, the FASB issued ASU 2011-3, “Reconsideration of Effective Control for Repurchase Agreements.” This update to codification topic 860 revises the assessment of effective control for purposes of determining if a reverse repurchase agreement should be accounted for as a sale, as compared with a secured borrowing. ASU 2011-3 will be effective for Sterling on January 1, 2012, and is not expected to have a material effect on Sterling’s consolidated financial statements.

In May 2011, the FASB issued ASU 2011-4, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.” This update to codification topic 820 clarifies the application of existing fair value measurement and disclosure requirements, and implements changes to the codification that align U.S. GAAP and IFRS. This update will be effective for Sterling on January 1, 2012, and is not expected to have a material effect on Sterling’s consolidated financial statements.

In June 2011, the FASB issued ASU 2011-5, “Presentation of Comprehensive Income.” This update to codification topic 220 eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders equity, and requires a presentation of comprehensive income either on the face of the

 

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income statement, or on a separate schedule immediately following the income statement. This update will be effective for Sterling on January 1, 2012, and is not expected to have a material effect on Sterling’s consolidated financial statements.

2. Investments and MBS:

The carrying and fair values of investments and MBS are summarized as follows:

 

		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Fair Value
		(in thousands)
September 30, 2011
Available for sale
MBS (1)			2,166,944			$	55,269			$	(265	)			2,221,948
Municipal bonds			196,486				10,395				(1,876	)			205,005
Other			24,897				2				(5,329	)			19,570
Total		$	2,388,327			$	65,666			$	(7,470	)		$	2,446,523
Held to maturity
Tax credits		$	1,900			$	0			$	0			$	1,900
Total		$	1,900			$	0			$	0			$	1,900
December 31, 2010
Available for sale
MBS (1)		$	2,598,086			$	30,017			$	(25,493	)		$	2,602,610
Municipal bonds			208,588				949				(8,394	)			201,143
Other			24,821				2				(3,566	)			21,257
Total		$	2,831,495			$	30,968			$	(37,453	)		$	2,825,010
Held to maturity
Tax credits		$	13,464			$	0			$	0			$	13,464
Total		$	13,464			$	0			$	0			$	13,464

 

(1)	Sterling’s MBS portfolio is comprised primarily of residential agency securities. As of September 30, 2011 and December 31, 2010, MBS also included $21.2 million and $48.4 million, respectively, of nonagency collateralized mortgage obligations.

Other available for sale securities primarily consist of a single issuer trust preferred security at both September 30, 2011 and December 31, 2010. During the second quarter of 2011, Sterling sold $10.5 million of tax credit investments in low income housing partnerships. Until recently, there was not a liquid market for these investments. The sale was driven by the absence of a current tax burden for Sterling, combined with monthly expenses associated with the tax credits. The tax credit investments carrying balance were being systematically reduced over their projected life. The sale resulted in a loss of $2.2 million. Total sales of Sterling’s securities during the periods ended September 30, 2011 and 2010 are summarized as follows:

 

		Proceeds from Sales				Gross Realized Gains				Gross Realized (Losses)
		(in thousands)
Nine months ended:
September 30, 2011		$	384,431			$	16,605			$	(2,307	)
September 30, 2010			780,866				30,686				(6,421	)

 

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The following table summarizes Sterling’s investments and MBS that had a market value below their amortized cost as of September 30, 2011 and December 31, 2010, segregated by those investments that have been in a continuous unrealized loss position for less than 12 months and those that have been in a continuous unrealized loss position for 12 months or longer:

 

		Less than 12 months								12 months or longer								Total
		Market Value				Unrealized Losses				Market Value				Unrealized Losses				Market Value				Unrealized Losses
		(in thousands)
September 30, 2011
Municipal bonds		$	0			$	0			$	17,543			$	(1,876	)		$	17,543			$	(1,876	)
MBS			57,931				(265	)			0				0				57,931				(265	)
Other			0				0				19,563				(5,329	)			19,563				(5,329	)
Total		$	57,931			$	(265	)		$	37,106			$	(7,205	)		$	95,037			$	(7,470	)
December 31, 2010
Municipal bonds		$	89,364			$	(3,193	)		$	47,101			$	(5,201	)		$	136,465			$	(8,394	)
MBS			1,460,173				(25,493	)			0				0				1,460,173				(25,493	)
Other			0				0				21,250				(3,566	)			21,250				(3,566	)
Total		$	1,549,537			$	(28,686	)		$	68,351			$	(8,767	)		$	1,617,888			$	(37,453	)

The following table presents the amortized cost and fair value of available-for-sale and held-to-maturity securities as of September 30, 2011, grouped by contractual maturity. Actual maturities for MBS will differ from contractual maturities as a result of the level of prepayments experienced on the underlying mortgages. As of September 30, 2011, the weighted average life of the MBS portfolio was 3.5 years, and its effective duration was 2.7%. This compares with a weighted average life of 5.0 years, and an effective duration of 3.6% at December 31, 2010.

 

		Held-to-maturity								Available-for-sale
		Amortized Cost				Estimated Fair Value				Amortized Cost				Estimated Fair Value
		(in thousands)
Due within one year		$	0			$	0			$	657			$	657
Due after one year through five years			0				0				0				0
Due after five years through ten years			0				0				208,652				213,278
Due after ten years			1,900				1,900				2,179,018				2,232,588
Total		$	1,900			$	1,900			$	2,388,327			$	2,446,523

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 are written down to current market value, resulting in a loss. There were no investment securities that management identified to be other than-temporarily impaired at September 30, 2011, because Sterling expects the return of all principal and interest on all securities within its investment and MBS portfolio pursuant to the contractual terms, has the ability and intent to hold these investments, has no intent to sell securities that are deemed to have a market value impairment, and believes it is unlikely that Sterling would be required to sell these investments before a recovery in market price occurs, or until maturity. As of September 30, 2011, Sterling held nonagency collateralized mortgage obligations with an amortized book value of $20.9 million, and a net unrealized gain of $310,000. All nonagency collateralized mortgage obligations are internally monitored monthly and independently stress-tested quarterly for both credit quality and collateral strength, and are AAA rated according to at least one major rating agency. The vintage, or year of issuance, for these nonagency securities ranges from 2003 to 2005. As of September 30, 2011, Sterling held municipal bonds with an amortized book value of $196.5 million, and a net unrealized gain of $8.5 million. Sterling reviews its municipal bonds for impairment at least quarterly. Approximately 90% of Sterling’s municipal bonds held as of September 30, 2011 were general obligation bonds. Additionally, as of September 30, 2011, Sterling held one single issuer trust preferred security with an amortized book value of $24.9 million, and a net unrealized loss of $5.3 million. The issuer is JP Morgan Chase, interest payments have not been deferred, and the security is rated A2 by Moody’s.

 

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3. Loans Receivable and Allowance for Credit Losses:

The following table presents the composition of Sterling’s loan portfolio as of the balance sheet dates:

 

		September 30, 2011				December 31, 2010
		(in thousands)
Residential real estate		$	701,921			$	758,410
Multifamily real estate			990,707				517,022
Commercial real estate (1)			1,287,381				1,314,657
Construction:
Residential			44,671				156,853
Multifamily			29,285				90,518
Commercial			147,655				278,297
Total construction			221,611				525,668
Consumer			683,972				744,068
Commercial banking (2)			1,729,626				1,770,426
Gross loans receivable			5,615,218				5,630,251
Deferred loan fees, net			(668	)			(4,114	)
Allowance for loan losses			(186,195	)			(247,056	)
Net loans receivable		$	5,428,355			$	5,379,081

 

(1)	Comprised of non owner-occupied commercial real estate (“CRE”).

(2)	Comprised of commercial and industrial (“C&I”), and owner-occupied CRE.

Gross loans pledged as collateral for borrowings from the FHLB and the Federal Reserve totaled $1.34 billion and $1.52 billion as of September 30, 2011 and December 31, 2010, respectively. As of September 30, 2011 and December 31, 2010, the unamortized portion of discounts on acquired loans was $4.5 million and $5.3 million, respectively.

 

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The following table sets forth details by segment for Sterling’s loan portfolio and related allowance as of the balance sheet dates:

 

		Real Estate																				Commercial
		Residential				Multifamily				Commercial				Construction				Consumer				Banking				Unallocated				Total
		(in thousands)
September 30, 2011
Loans receivable, gross:
Individually evaluated for impairment		$	19,477			$	4,912			$	57,318			$	106,434			$	1,196			$	92,400			$	0			$	281,737
Collectively evaluated for impairment			682,444				985,795				1,230,063				115,177				682,776				1,637,226				0				5,333,481
Total loans receivable, gross		$	701,921			$	990,707			$	1,287,381			$	221,611			$	683,972			$	1,729,626			$	0			$	5,615,218
Allowance for loan losses:
Individually evaluated for impairment		$	(1,723	)		$	(49	)		$	(3,685	)		$	(6,061	)		$	(31	)		$	(3,727	)		$	0			$	(15,276	)
Collectively evaluated for impairment			(18,327	)			(20,380	)			(39,137	)			(18,249	)			(12,580	)			(34,443	)			(27,803	)			(170,919	)
Total allowance for loan losses		$	(20,050	)		$	(20,429	)		$	(42,822	)		$	(24,310	)		$	(12,611	)		$	(38,170	)		$	(27,803	)		$	(186,195	)
December 31, 2010
Loans receivable, gross:
Individually evaluated for impairment		$	74,994			$	23,541			$	103,389			$	332,287			$	4,852			$	80,880			$	0			$	619,943
Collectively evaluated for impairment			683,416				493,481				1,211,268				193,381				739,216				1,689,546				0				5,010,308
Total loans receivable, gross		$	758,410			$	517,022			$	1,314,657			$	525,668			$	744,068			$	1,770,426			$	0			$	5,630,251
Allowance for loan losses:
Individually evaluated for impairment		$	(1,239	)		$	(1,158	)		$	(7,859	)		$	(20,676	)		$	(33	)		$	(6,689	)		$	0			$	(37,654	)
Collectively evaluated for impairment			(16,068	)			(8,510	)			(41,503	)			(45,201	)			(14,612	)			(50,262	)			(33,246	)			(209,402	)
Total allowance for loan losses		$	(17,307	)		$	(9,668	)		$	(49,362	)		$	(65,877	)		$	(14,645	)		$	(56,951	)		$	(33,246	)		$	(247,056	)

 

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The following tables present a roll forward by segment of the allowance for credit losses for the three and nine months ended September 30, 2011 and 2010:

 

		Real Estate																				Commercial Banking
		Residential				Multifamily				Commercial				Construction				Consumer								Unallocated				Total
		(in thousands)
2011 quarterly activity
Allowance for loan losses:
Beginning balance, July 1		$	20,826			$	11,251			$	46,449			$	44,907			$	13,800			$	46,602			$	28,253			$	212,088
Charge-offs			(4,204	)			(1,035	)			(11,189	)			(14,426	)			(2,554	)			(7,769	)			0				(41,177	)
Recoveries			178				684				31				6,066				463				3,862				0				11,284
Provisions			3,250				9,529				7,531				(12,237	)			902				(4,525	)			(450	)			4,000
Ending balance, September 30			20,050				20,429				42,822				24,310				12,611				38,170				27,803				186,195
Allowance for unfunded commitments:
Beginning balance, July 1			2,349				0				0				2,555				2,363				755				(591	)			7,431
Charge-offs			(55	)			0				0				0				0				0				0				(55	)
Recoveries			0				0				0				0				0				0				0				0
Provisions			710				0				0				(387	)			(638	)			783				1,532				2,000
Ending balance, September 30			3,004				0				0				2,168				1,725				1,538				941				9,376
Total credit allowance		$	23,054			$	20,430			$	42,822			$	26,478			$	14,336			$	39,707			$	28,744			$	195,571
2010 quarterly activity
Allowance for loan losses:
Beginning balance, July 1		$	15,392			$	5,036			$	55,524			$	103,750			$	16,053			$	61,622			$	7,473			$	264,850
Charge-offs			(10,708	)			(5,173	)			(12,739	)			(43,268	)			(3,696	)			(8,225	)			0				(83,809	)
Recoveries			187				146				627				4,592				511				601				0				6,664
Provisions			11,438				7,121				9,461				16,001				3,664				7,964				5,151				60,800
Ending balance, September 30			16,309				7,130				52,873				81,075				16,532				61,962				12,624				248,505
Allowance for unfunded commitments:
Beginning balance, July 1			1,494				1				1				6,776				1,115				1,444				120				10,951
Charge-offs			(26	)			0				0				0				0				0				0				(26	)
Recoveries			0				0				0				0				0				0				0				0
Provisions			377				(1	)			46				(1,493	)			63				(117	)			1,217				92
Ending balance, September 30			1,845				0				47				5,283				1,178				1,327				1,337				11,017
Total credit allowance		$	18,154			$	7,130			$	52,920			$	86,358			$	17,710			$	63,289			$	13,961			$	259,522

 

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		Real Estate																				Commercial Banking
		Residential				Multifamily				Commercial				Construction				Consumer								Unallocated				Total
		(in thousands)
2011 year to date
Allowance for loan losses:
Beginning balance, January 1		$	17,307			$	9,668			$	49,362			$	65,877			$	14,645			$	56,951			$	33,246			$	247,056
Charge-offs			(15,230	)			(1,703	)			(22,107	)			(42,785	)			(6,817	)			(21,261	)			0				(109,903	)
Recoveries			1,032				1,852				1,484				11,633				1,421				5,120				0				22,542
Provisions			16,941				10,612				14,083				(10,415	)			3,362				(2,640	)			(5,443	)			26,500
Ending balance, September 30			20,050				20,429				42,822				24,310				12,611				38,170				27,803				186,195
Allowance for unfunded commitments:
Beginning balance, January 1			3,103				0				31				4,127				1,112				1,306				1,028				10,707
Charge-offs			(831	)			0				0				0				0				0				0				(831	)
Recoveries			0				0				0				0				0				0				0				0
Provisions			732				0				(31	)			(1,959	)			613				232				(87	)			(500	)
Ending balance, September 30			3,004				0				0				2,168				1,725				1,538				941				9,376
Total credit allowance		$	23,054			$	20,429			$	42,822			$	26,478			$	14,336			$	39,708			$	28,744			$	195,571
2010 year to date
Allowance for loan losses:
Beginning balance, January 1		$	28,319			$	8,985			$	42,296			$	185,222			$	19,198			$	59,135			$	288			$	343,443
Charge-offs			(26,767	)			(17,119	)			(42,331	)			(220,889	)			(11,975	)			(17,426	)			0				(336,507	)
Recoveries			791				145				1,193				16,271				1,467				1,112				0				20,979
Provisions			13,966				15,119				51,715				100,471				7,842				19,141				12,336				220,590
Ending balance, September 30			16,309				7,130				52,873				81,075				16,532				61,962				12,624				248,505
Allowance for unfunded commitments:
Beginning balance, January 1			713				(1	)			0				9,228				1,481				1,665				(1,119	)			11,967
Charge-offs			(589	)			0				0				0				0				0				0				(589	)
Recoveries			0				0				0				0				0				0				0				0
Provisions			1,721				1				47				(3,945	)			(303	)			(338	)			2,456				(361	)
Ending balance, September 30			1,845				0				47				5,283				1,178				1,327				1,337				11,017
Total credit allowance		$	18,154			$	7,130			$	52,920			$	86,358			$	17,710			$	63,289			$	13,961			$	259,522

 

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In establishing its allowance for loan losses, Sterling groups its loan portfolio into standard portfolio segments for homogeneous loans. The groups are further segregated based on internal risk ratings. Both qualitative and quantitative data are considered in determining the probability of default and loss given default for each group of loans. The probability of default and loss given default are used to calculate an expected loss rate which is multiplied by the loan balance in each category to determine the general allowance for loan losses. If a loan is determined to be impaired, Sterling performs an individual evaluation of the loan. The individual evaluation compares the present value of the expected future cash flows or the fair value of the underlying collateral to the recorded investment in the loan. The results of the individual impairment evaluation could determine the need to record a confirmed loss or a specific reserve.

Sterling assigns risk rating classifications to its loans. These risk ratings are divided into the following groups:

 

•

Pass – asset is considered of sufficient quality to preclude a Special Mention or an adverse rating. Pass assets generally are well protected by the current net worth and paying capacity of the obligor or by the value of the asset or underlying collateral.

 

•

Special Mention – asset has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in Sterling’s credit position at some future date. Special Mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.

 

•

Substandard – asset is inadequately protected by the current net worth and paying capacity of the obligor or by the collateral pledged, if any. Assets so classified have well-defined weaknesses. They are characterized by the distinct possibility that Sterling will sustain some loss if the deficiencies are not corrected.

 

•

Doubtful/Loss – a Doubtful asset has the weaknesses of those classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. An asset classified Loss is considered uncollectible and/or of such little value that its continuance as an asset, without establishment of a specific valuation allowance or charge-off, is not warranted. This classification does not necessarily mean that an asset has absolutely no recovery or salvage value; but rather, it is not practical or desirable to defer writing off an asset that is no longer deemed to have financial value, even though partial recovery may be recognized in the future.

 

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The following table presents credit quality indicators for Sterling’s loan portfolio as of September 30, 2011 and December 31, 2010 grouped according to internally assigned risk ratings and payment activity:

 

		Real Estate																				Commercial Banking
		Residential				Multifamily				Commercial				Construction				Consumer								Total				% of total
		(in thousands)
September 30, 2011
Pass		$	648,931			$	958,001			$	1,126,590			$	64,987			$	672,854			$	1,502,954			$	4,974,317				89	%
Special mention			14,560				15,242				78,786				39,530				3,851				98,910				250,879				4	%
Substandard			36,707				17,415				78,319				111,033				7,236				122,568				373,278				7	%
Doubtful/Loss			1,723				49				3,686				6,061				31				5,194				16,744				0	%
Total		$	701,921			$	990,707			$	1,287,381			$	221,611			$	683,972			$	1,729,626			$	5,615,218				100	%
Restructured		$	18,561			$	0			$	4,368			$	39,557			$	0			$	20,511			$	82,997				1	%
Nonaccrual			30,600				5,296				55,594				69,348				5,705				73,599				240,142				4	%
Nonperforming			49,161				5,296				59,962				108,905				5,705				94,110				323,139				5	%
Performing			652,760				985,411				1,227,419				112,706				678,267				1,635,516				5,292,079				95	%
Total		$	701,921			$	990,707			$	1,287,381			$	221,611			$	683,972			$	1,729,626			$	5,615,218				100	%
December 31, 2010
Pass		$	638,273			$	446,363			$	1,047,239			$	68,099			$	718,831			$	1,474,312			$	4,393,117				78	%
Special mention			15,670				29,566				91,870				89,524				7,074				89,680				323,384				6	%
Substandard			104,467				41,093				175,548				368,045				18,163				205,354				912,670				16	%
Doubtful/Loss			0				0				0				0				0				1,080				1,080				0	%
Total		$	758,410			$	517,022			$	1,314,657			$	525,668			$	744,068			$	1,770,426			$	5,630,251				100	%
Restructured		$	20,569			$	0			$	10,856			$	57,662			$	119			$	19,298			$	108,504				2	%
Nonaccrual			70,842				23,541				95,229				277,993				7,854				70,674				546,133				10	%
Nonperforming			91,411				23,541				106,085				335,655				7,973				89,972				654,637				12	%
Performing			666,999				493,481				1,208,572				190,013				736,095				1,680,454				4,975,614				88	%
Total		$	758,410			$	517,022			$	1,314,657			$	525,668			$	744,068			$	1,770,426			$	5,630,251				100	%

 

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Aging by class for Sterling’s loan portfolio as of September 30, 2011 and December 31, 2010 was as follows:

 

		Real Estate																				Commercial Banking
		Residential				Multifamily				Commercial				Construction				Consumer								Total				% of total
		(in thousands)
September 30, 2011
30 - 59 days past due		$	5,788			$	0			$	8,118			$	4,453			$	5,365			$	19,918			$	43,642				1	%
60 - 89 days past due			3,083				169				16,656				5,235				1,616				7,002				33,761				1	%
> 90 days past due			24,870				4,750				36,026				74,939				5,358				57,619				203,562				4	%
Total past due			33,741				4,919				60,800				84,627				12,339				84,539				280,965				6	%
Current			668,180				985,788				1,226,581				136,984				671,633				1,645,087				5,334,253				94	%
Total Loans		$	701,921			$	990,707			$	1,287,381			$	221,611			$	683,972			$	1,729,626			$	5,615,218				100	%
> 90 days and accruing		$	0			$	0			$	0			$	0			$	0			$	0			$	0
December 31, 2010
30 - 59 days past due		$	10,273			$	3,235			$	4,251			$	27,251			$	5,650			$	12,994			$	63,654				1	%
60 - 89 days past due			4,179				6,146				7,089				15,419				1,837				4,099				38,769				1	%
> 90 days past due			35,544				6,428				34,517				232,140				4,834				52,497				365,960				6	%
Total past due			49,996				15,809				45,857				274,810				12,321				69,590				468,383				8	%
Current			708,414				501,213				1,268,800				250,858				731,747				1,700,836				5,161,868				92	%
Total Loans		$	758,410			$	517,022			$	1,314,657			$	525,668			$	744,068			$	1,770,426			$	5,630,251				100	%
> 90 days and accruing		$	0			$	0			$	0			$	0			$	0			$	0			$	0

 

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Sterling considers its nonperforming loans to be impaired loans, which include $35.8 million and $34.7 million of homogeneous and small balance loans which were collectively evaluated for impairment on September 30, 2011 and December 31, 2010, respectively. Impaired loans by class were as follows at September 30, 2011 and December 31, 2010:

 

										Book Balance												Three Months Ended September 30, 2011								Nine Months Ended September 30, 2011
		Unpaid Principal Balance				Charge-Offs				Without Specific Reserve				With Specific Reserve				Specific Reserve				Average Book Balance				Interest Income Recognized				Average Book Balance				Interest Income Recognized
		(in thousands)
September 30, 2011
Residential real estate		$	62,020			$	12,859			$	40,441			$	8,720			$	1,723			$	51,786			$	247			$	70,286			$	567
Multifamily real estate			5,614				318				4,897				399				49				7,206				67				14,419				690
Commercial real estate			86,122				26,160				37,528				22,434				3,685				58,185				620				83,024				1,848
Construction			163,914				55,009				45,527				63,378				6,061				142,356				1,146				222,280				1,190
Consumer			6,794				1,089				5,560				145				31				5,635				0				6,839				—
Commercial banking			122,790				28,680				65,124				28,986				3,727				94,457				803				92,041				2,234
Total		$	447,254			$	124,115			$	199,077			$	124,062			$	15,276			$	359,624			$	2,883			$	488,889			$	6,529
December 31, 2010
Residential real estate		$	114,401			$	22,990			$	27,956			$	63,455			$	1,239
Multifamily real estate			30,464				6,923				8,326				15,215				1,158
Commercial real estate			135,366				29,281				30,400				75,685				7,859
Construction			539,331				203,676				65,618				270,037				20,676
Consumer			12,740				4,767				4,353				3,620				33
Commercial banking			142,110				52,138				46,948				43,024				6,689
Total		$	974,412			$	319,775			$	183,601			$	471,036			$	37,654

 

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The following tables present loans that were modified and recorded as troubled debt restructurings (“TDR’s”) during the three and nine months ended September 30, 2011:

 

		Three Months Ended September 30, 2011
		Number of Contracts				Pre-Modification Recorded Investment				Post-Modification Recorded Investment
		(in thousands, except number of contracts)
Residential real estate			0			$	0			$	0
Multifamily real estate			0				0				0
Commercial real estate			0				0				0
Construction			1				18,644				19,229
Consumer			0				0				0
Commercial banking			0				0				0
Total (1)			1			$	18,644			$	19,229

 

(1)	Amounts exclude specific loan loss reserves.

 

		Nine Months Ended September 30, 2011
		Number of Contracts				Pre-Modification Recorded Investment				Post-Modification Recorded Investment
		(in thousands, except number of contracts)
Residential real estate			0			$	0			$	0
Multifamily real estate			0				0				0
Commercial real estate			8				3,271				3,282
Construction			2				21,419				22,046
Consumer			0				0				0
Commercial banking			8				14,809				14,918
Total (1)			18			$	39,499			$	40,246

 

(1)	Amounts exclude specific loan loss reserves.

 

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The majority of TDRs are determined to be impaired prior to being restructured. As such, they are individually evaluated for impairment, unless they are considered homogeneous loans in which case they would be collectively evaluated for impairment. As of September 30, 2011, Sterling had specific reserves of $1.8 million on TDRs, which were restructured during the nine months ended September 30, 2011. The following table shows the post modification recorded investment for TDRs restructured during the nine months ended September 30, 2011 by the primary type of concession granted:

		Principal Deferral				Rate Reduction				Capitalized Interest into Principal Balance				Forgiveness of Principal and/or Interest				Total
		(in thousands)
Residential Real Estate		$	0			$	0			$	0			$	0			$	0
Multifamily Real Estate			0				0				0				0				0
Commercial Real Estate			0				1,856				1,426								3,282
Construction			2,816				0				0				19,230				22,046
Consumer			0				0				0				0				0
Commercial Banking			10,230				345				0				4,343				14,918
		$	13,046			$	2,201			$	1,426			$	23,573			$	40,246

Restructurings that result in the forgiveness of principal or interest are typically part of a bankruptcy settlement. TDR’s that were restructured during the 12 months ended September 30, 2011 and defaulted during the three and nine months ended September 30, 2011, were as follows:

During the three months ended September 30, 2011

 

		Number of Contracts				Recorded Investment at Default
Residential real estate			0			$	0
Multifamily real estate			0				0
Commercial real estate			2				366
Construction			0				0
Consumer			0				0
Commercial banking			0				0
Total			2			$	366

During the nine months ended September 30, 2011

 

		Number of Contracts				Recorded Investment at Default
Residential real estate			1			$	564
Multifamily real estate			0				0
Commercial real estate			3				588
Construction			0				0
Consumer			0				0
Commercial banking			1				377
Total			5			$	1,529

 

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At the applicable foreclosure date, OREO is recorded at the fair value of the real estate, less the estimated costs to sell. The carrying value of OREO is periodically evaluated and, if necessary, an allowance is established to reduce the carrying value to net realizable value. Changes in this allowance were as follows for the periods presented:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2011				2010				2011				2010
		(in thousands)
Allowance for OREO losses:
Balance, beginning of period		$	17,844			$	14,068			$	21,799			$	8,204
Provision			7,995				4,784				20,850				20,894
Charge-offs			(6,298	)			(5,643	)			(23,108	)			(15,889	)
Balance, end of period		$	19,541			$	13,209			$	19,541			$	13,209

The increase in charge-offs during the periods presented was due to the increase in OREO sales, which totaled $194.1 million for the nine months ended September 30, 2011 compared to $113.9 million during the same period in 2010.

4. Junior Subordinated Debentures:

Sterling has raised regulatory capital through the formation of trust subsidiaries and the assumption of similar obligations through mergers with other financial institutions. The trusts are business trusts in which Sterling owns all of the common equity. The proceeds from the sale of the securities were used to purchase 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 trusts’ obligations. The junior subordinated debentures are treated as debt of Sterling. The junior subordinated debentures generally mature 30 years after issuance and are redeemable at the option of Sterling under certain conditions, including, with respect to certain of the trusts, payment of call premiums. During the third quarter of 2009, Sterling elected to defer regularly scheduled interest payments on these securities, and has continued to defer these payments through September 30, 2011. As of September 30, 2011 and December 31, 2010, the accrued deferred interest was $14.0 million and $9.4 million, respectively. Sterling is allowed to defer payments of interest on the junior subordinated debentures for up to 20 consecutive quarterly periods without triggering an event of default. Details of the junior subordinated debentures are as follows:

 

Subsidiary Issuer

Issue Date

Maturity Date

Next Call Date

Rate at September 30, 2011

Amount

(in thousands)

Sterling Capital Trust IX

July 2007

Oct 2037

Oct 2012

Floating

1.70

%

$

46,392

Sterling Capital Trust VIII

Sept 2006

Sept 2036

Dec 2011

Floating

1.88

51,547

Sterling Capital Trust VII

June 2006

June 2036

Dec 2011

Floating

1.77

56,702

Lynnwood Capital Trust II

June 2005

June 2035

Dec 2011

Floating

2.05

10,310

Sterling Capital Trust VI

June 2003

Sept 2033

Dec 2011

Floating

3.45

10,310

Sterling Capital Statutory Trust V

May 2003

May 2033

Dec 2011

Floating

3.50

20,619

Sterling Capital Trust IV

May 2003

May 2033

Nov 2011

Floating

3.41

10,310

Sterling Capital Trust III

April 2003

April 2033

Oct 2011

Floating

3.52

14,433

Lynnwood Capital Trust I

Mar 2003

Mar 2033

Dec 2011

Floating

3.40

9,448

Klamath First Capital Trust I

July 2001

July 2031

Jan 2012

Floating

4.20

15,218

2.39

%*

$

245,289

 

*	Weighted average rate

 

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5. Earnings (Loss) Per Share:

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

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2011				2010				2011				2010
		(in thousands, except shares and per share amounts)
Numerator:
Net income (loss) available to common shareholders		$	11,328			$	33,592			$	24,300			$	(113,408	)
Denominator:
Weighted average shares outstanding - basic			61,958,183				4,764,875				61,944,392				2,128,059
Dilutive securities outstanding			83,020				20,974,433				292,073				0
Weighted average shares outstanding - diluted			62,041,203				25,739,308				62,236,465				2,128,059
Earnings (loss) per share - basic		$	0.18			$	7.05			$	0.39			$	(53.29	)
Earnings (loss) per share - diluted		$	0.18			$	1.31			$	0.39			$	(53.29	)
Antidilutive securities outstanding (weighted average):
Stock options			16,291				19,833				16,823				21,112
Warrants			2,625,000				0				0				359,016
Convertible preferred			0				0				0				6,709,291
Restricted shares			9,049				2,087				63,405				2,397
Total antidilutive securities outstanding			2,650,340				21,920				80,228				7,091,816

Prior period share and per share amounts disclosed in this footnote, as well as all other prior period share and per share amounts disclosed in these financial statements, have been restated to reflect the 1-for-66 reverse stock split that was effected in November 2010.

 

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6. Noninterest Expense:

The following table details the components of Sterling’s noninterest expense:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2011				2010				2011				2010
		(in thousands)
Employee compensation and benefits		$	43,828			$	42,561			$	129,514			$	125,875
OREO operations			10,739				10,456				36,591				38,585
Occupancy and equipment			9,580				9,562				29,558				29,306
Data processing			5,651				5,858				18,339				16,322
Insurance			3,914				6,632				12,589				29,508
Professional fees			3,161				8,303				9,571				17,469
Depreciation			3,000				3,326				9,026				10,266
Advertising			1,932				3,195				6,659				9,105
Travel and entertainment			1,336				895				3,931				2,570
Amortization of core deposit intangibles			1,190				1,225				3,639				3,674
Other			2,289				2,210				7,098				4,835
Total noninterest expense		$	86,620			$	94,223			$	266,515			$	287,515

7. Income Taxes:

Sterling uses an estimate of future earnings and an evaluation of its loss carryback ability and tax planning strategies to determine whether it is more likely than not that it will realize the benefit of its deferred tax asset. Sterling determined that it did not meet the required threshold as of September 30, 2011 and December 31, 2010, and accordingly, had a full valuation allowance against its net deferred tax assets. As of September 30, 2011, the reserved net deferred tax asset was approximately $335 million, including approximately $288 million of net operating loss and tax credit carry-forwards. This is compared with a reserved deferred tax asset of approximately $359 million, including approximately $263 million of net operating loss and tax credit carry-forwards, as of December 31, 2010. The primary reason for the decline in the net deferred tax asset since year end was due to the change in the unrealized gains on available for sale securities.

With regard to the deferred tax asset, the benefits of Sterling’s accumulated tax losses would be reduced in the event of an “ownership change,” as determined under Section 382 of the Internal Revenue Code. During 2010, in order to preserve the benefits of these tax losses, Sterling’s shareholders approved a protective amendment to the restated articles of incorporation and Sterling’s board adopted a tax preservation rights plan, both of which restrict certain stock transfers that would result in an investor acquiring more than 4.95% of Sterling’s total outstanding common stock.

 

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8. Stock-Based Compensation:

The following table presents a summary of stock option and restricted stock activity during the nine months ended September 30, 2011:

 

		Stock Options								Restricted Stock
		Number				Weighted Average Exercise Price				Number				Weighted Average Grant Price
Balance, January 1, 2011			18,920			$	1,357.97				368,805			$	18.24
Granted			0				0.00				116,230				17.40
Exercised/vested			0				0.00				(43,017	)			24.76
Cancelled/expired			(2,849	)			1,178.77				(24,125	)			16.39
Outstanding, September 30, 2011			16,071			$	1,389.74				417,893			$	17.44
Exercisable, September 30, 2011			14,244			$	1,502.18

Prior period share and per share amounts disclosed in this footnote, as well as all other prior period share and per share amounts disclosed in these financial statements, have been restated to reflect the 1-for-66 reverse stock split that was effected in November 2010. The following presents the weighted average remaining contractual life and the aggregate intrinsic value for stock options as of the dates indicated:

 

Stock Options

Outstanding

Exercisable

Weighted Average Life

Intrinsic Value

Weighted Average Life

Intrinsic Value

December 31, 2010

2.8 years

$

0

2.6 years

$

0

September 30, 2011

2.4 years

0

2.3 years

0

As of September 30, 2011, a total of 5,513,176 shares remained available for grant under Sterling’s 2003, 2007 and 2010 Long-Term Incentive Plans. The stock options granted under these plans have terms of four, six, eight and ten years. Restricted shares granted during 2011 have vesting schedules that vary, ranging from vesting immediately upon grant to vesting up to three years after the grant date.

Stock-based compensation expense recognized during the periods presented was as follows:

 

		Nine Months Ended September 30,
		2011				2010
		(in thousands)
Stock options		$	226			$	567
Restricted stock			2,723				246
Total		$	2,949			$	813

As of September 30, 2011, unrecognized equity compensation expense totaled $5.3 million, as the underlying outstanding awards had not yet been earned. This amount will be recognized over a weighted average period of 1.1 years. During the nine months ended September 30, 2011, 249 stock options were forfeited, and 24,125 shares of restricted stock were forfeited.

9. Derivatives and Hedging:

From time to time, Sterling may enter into interest rate swap transactions with loan customers. The interest rate risk on these swap transactions is managed by entering into offsetting interest rate swap agreements with various unaffiliated counterparties (“broker-dealers”). Both customer and broker-dealer related interest rate derivatives are carried at fair value by Sterling.

As part of its mortgage banking activities, Sterling makes commitments to prospective borrowers on residential mortgage loan applications, which may have the interest rates locked for a period of 10 to 60 days (“interest rate

 

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lock commitments”). These interest rate lock commitments, and loans held for sale that have not been committed to investors, give rise to interest rate risk. Sterling hedges the interest rate risk arising from these mortgage banking activities by entering into forward sales agreements on MBS with third parties (“forward commitments”).

Residential mortgage loans held for sale that were not committed to investors were $199.3 million and $207.0 million as of September 30, 2011 and December 31, 2010, respectively. The following table summarizes the off-balance sheet portions of Sterling’s mortgage banking operations, as well as Sterling’s interest rate swaps:

 

		September 30, 2011
						Fair Value
		Notional				Asset				Liability
		(in thousands)
Interest rate lock commitments		$	236,521			$	7,218			$	0
Forward commitments			373,079				0				4,656
Interest rate swaps - broker-dealer			44,195				0				4,777
Interest rate swaps - customer			46,814				4,987				0
		December 31, 2010
						Fair Value
		Notional				Asset				Liability
		(in thousands)
Interest rate lock commitments		$	118,589			$	1,869			$	0
Forward commitments			285,300				3,770				0
Interest rate swaps - broker-dealer			47,815				0				4,426
Interest rate swaps - customer			50,467				4,877				0

The fair value of these derivatives are included in other assets and liabilities, respectively. Gains and losses on Sterling’s mortgage banking derivative transactions are included in mortgage banking income, while gains and losses on Sterling’s interest rate swap transactions are included in other noninterest income. The following table sets forth these gains and losses:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2011				2010				2011				2010
		(in thousands)
Mortgage banking operations		$	(2,116	)		$	(686	)			(5,015	)		$	(3,448	)
Other noninterest income			1,191				(272	)			1,228				(195	)

10. Fair Value:

Fair value estimates are determined as of a specific date using quoted market prices, where available, or various assumptions and estimates. As the assumptions underlying these estimates change, the fair value of the financial instruments will change. The use of assumptions and various valuation techniques, as well as the absence of secondary markets for certain financial instruments, will likely reduce the comparability of fair value disclosures between financial institutions. Accordingly, the aggregate fair value amounts presented do not represent and should not be construed to represent the full underlying value of Sterling.

 

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The carrying amounts and fair values of financial instruments as of the periods indicated were as follows. Other assets are comprised of FHLB stock and derivatives, while other liabilities are comprised of derivatives:

 

		September 30, 2011								December 31, 2010
		Carrying Amount				Fair Value				Carrying Amount				Fair Value
		(in thousands)
Financial assets:
Cash and cash equivalents		$	481,717			$	481,717			$	427,264			$	427,264
Investments and MBS:
Available for sale			2,446,523				2,446,523				2,825,010				2,825,010
Held to maturity			1,900				1,900				13,464				13,464
Loans held for sale			241,039				241,039				222,216				222,216
Loans receivable, net			5,428,355				5,192,500				5,379,081				5,078,157
Accrued interest receivable			33,618				33,618				34,087				34,087
Other assets			111,484				111,484				110,487				110,487
Financial liabilities:
Non-maturity deposits			3,692,335				3,692,335				3,376,188				3,123,840
Deposits with stated maturities			2,786,905				2,838,301				3,534,819				3,588,051
Borrowings			1,708,641				1,719,609				1,685,008				1,660,387
Accrued interest payable			21,152				21,152				17,259				17,259
Other liabilities			10,007				10,007				6,176				6,176

Companies have the option of carrying financial assets and liabilities at fair value, which can be implemented on all or individually selected financial instruments. The framework for defining and measuring fair value requires that one of three valuation methods be used to determine fair market value: the market approach, the income approach or the cost approach. To increase consistency and comparability in fair value measurements and related disclosures, the standard also creates a fair value hierarchy to prioritize the inputs to these valuation methods into the following three levels:

 

•

Level 1 inputs are a select class of observable inputs, based upon the quoted prices for identical instruments in active markets that are accessible as of the measurement date, and are to be used whenever available.

 

•

Level 2 inputs are other types of observable inputs, such as quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are inactive; or other inputs that are observable or can be derived from or supported by observable market data. Level 2 inputs are to be used whenever Level 1 inputs are not available.

 

•

Level 3 inputs are substantially unobservable, reflecting the reporting entity’s own assumptions regarding what market participants would assume when pricing a financial instrument. Level 3 inputs are to be used only when Level 1 and Level 2 inputs are unavailable.

The methods and assumptions used to estimate the fair value of each class of financial instruments are as follows:

Cash and Cash Equivalents

The carrying value of cash and cash equivalents approximates fair value due to the relatively short-term nature of these instruments.

Investments and MBS

The fair value of investments and MBS has been valued using a matrix pricing technique based on quoted prices for similar instruments, which Sterling validates with non-binding broker quotes, in depth collateral analysis and cash flow stress testing.

 

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Loans Held for Sale

Sterling has elected to carry loans held for sale at fair value. The fair values are based on investor quotes in the secondary market based upon the fair value of options and commitments to sell or issue mortgage loans. The fair value election was made to match changes in the value of these loans with the value of their economic hedges. Loan origination fees, costs and servicing rights, which were previously deferred on these loans, are now recognized as part of the loan value at origination.

Loans Receivable

The fair value of performing loans is estimated by discounting the cash flows using interest rates that consider the current credit and interest rate risk inherent in the loans and current economic and lending conditions and does not incorporate the exit price concept of fair value. The fair value of nonperforming collateral dependent loans is estimated based upon the value of the underlying collateral. The fair value of other nonperforming loans is estimated by discounting management’s current estimate of future cash flows using a rate estimated to be commensurate with the risks involved. In addition, a liquidity discount has been applied against the entire portfolio to reflect the uncertainty surrounding the timing of when a sale may occur.

Mortgage Servicing Rights

The fair value of mortgage servicing rights is estimated using a discounted cash flow model to arrive at the present value of future expected earnings from the servicing of the loans. Model inputs include prepayment speeds, market interest rates, contractual interest rates on the loans being serviced, and the amount of other fee income generated over the servicing contract.

OREO

The fair value of OREO is estimated using third party appraisals, subject to updates to reflect comparable market transactions, with appraisals ordered for “as is” or “disposition” value.

Deposits

The fair values of deposits subject to immediate withdrawal such as interest and noninterest bearing checking, regular savings, and money market deposit accounts, are equal to the amounts payable on demand at the reporting date. Fair values for time deposits are estimated by discounting future cash flows using interest rates currently offered on time deposits with similar remaining maturities.

Borrowings

The carrying amounts of short-term borrowings under repurchase agreements, federal funds purchased, short-term FHLB advances and other short-term borrowings approximate their fair values due to the relatively short period of time between the origination of the instruments and the expected payment dates on the instruments. The fair value of advances under lines of credit approximates their carrying value because such advances bear variable rates of interest. The fair value of long-term FHLB advances and other long-term borrowings is estimated using discounted cash flow analyses based on Sterling’s current incremental borrowing rates for similar types of borrowing arrangements with similar remaining terms.

 

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Assets and Liabilities Measured at Fair Value on a Recurring Basis. The following table presents Sterling’s financial instruments that are measured at fair value on a recurring basis:

 

		Total				Level 1				Level 2				Level 3
		(in thousands)
Balance, September 30, 2011:
Investment securities available-for-sale:
MBS		$	2,221,948			$	0			$	2,221,948			$	0
Municipal bonds			205,005				0				205,005				0
Other			19,570				0				19,570				0
Total investment securities available-for-sale			2,446,523				0				2,446,523				0
Loans held for sale			241,039				0				241,039				0
Other assets - derivatives			12,205				0				12,205				0
Total assets		$	2,699,767			$	0			$	2,699,767			$	0
Other liabilities - derivatives		$	10,007			$	0			$	10,007			$	0
Balance, December 31, 2010:
Investment securities available-for-sale:
MBS		$	2,602,610			$	0			$	2,602,610			$	0
Municipal bonds			201,143				0				201,143				0
Other			21,257				0				21,257				0
Total investment securities available-for-sale			2,825,010				0				2,825,010				0
Loans held for sale			222,216				0				222,216				0
Other assets - derivatives			10,516				0				10,516				0
Total assets		$	3,057,742			$	0			$	3,057,742			$	0
Other liabilities - derivatives		$	6,176			$	0			$	6,176			$	0

Derivatives represent mortgage banking interest rate lock and loan delivery commitments, a common stock warrant carried as a derivative liability and interest rate swaps. Market values on the interest rate swaps equal the present value differential between the fixed interest rate payments, as established in the swap agreement, and the floating interest rate payments, as projected by the forward interest rate curve, over the term of the swap. See Note 9 for a further discussion of these derivatives. The difference between the aggregate fair value and the aggregate unpaid principal balance of loans held for sale that are carried at fair value were included in earnings as follows:

 

		Nine Months Ended September 30,
		2011				2010
		(in thousands)
Mortgage banking operations		$	8,542			$	8,778

 

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Assets and Liabilities Measured at Fair Value on a Non-recurring Basis. Sterling may be required, from time to time, to measure certain assets at fair value on a non-recurring basis from application of lower of cost or market (“LOCOM”) accounting or write-downs of individual assets. The following table presents the carrying value for these assets as of the dates indicated:

 

September 30, 2011

Total Carrying Value

Level 1

Level 2