UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549








FORM 10-Q





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


For the quarterly period ended March 31, 2011.




OR




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









Commission file number0-25286








CASCADE FINANCIAL CORPORATION


(Exact name of registrant as specified in its charter)





Washington

91-1661954(State or other jurisdiction of incorporation or organization)

(I.R.S. Employer Identification No.)2828 Colby AvenueEverett, Washington

98201(Address of principal executive offices)

(Zip Code)(425) 339-5500(Registrant's telephone number, including area code)





Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve 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 ninety days. Yes þ     No  ̈




Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding twelve months (or for such shorter period that the registrant was required to submit and post such files).  Yes þ    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  ̈   Smaller Reporting Company þ




Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).


Yes  ̈     No þ





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 May 12, 2011Common Stock ($.01 par value)
12,271,529


1


CASCADE FINANCIAL CORPORATION





FORM 10-Q


For the Quarter Ended March 31, 2011








INDEX





PAGEPART I — Financial Information:Item 1
— Financial Statements:— Condensed Consolidated Balance Sheets
3— Condensed Consolidated Statements of Operations
4— Condensed Consolidated Statements of Stockholders’ Equity
5— Condensed Consolidated Statements of Comprehensive Loss
5— Condensed Consolidated Statements of Cash Flows
6— Notes to Condensed Consolidated Financial Statements
8Item 2
— Management’s Discussion and Analysis of Financial Condition and Results of Operations
34Item 3
— Quantitative and Qualitative Disclosures about Market Risk
61Item 4
— Controls and Procedures
63PART II — Other Information:Item 1
— Legal Proceedings
64Item 1A
— Risk Factors
64Item 6
— Exhibits
65—Signatures
65







2





PART I –– FINANCIAL INFORMATION


Item 1 – Financial Statements





CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES


CONDENSED CONSOLIDATED BALANCE SHEETS


(Unaudited)





March 31,


December 31,(Dollars in thousands, except share and per share amounts)

2011


2010AssetsCash on hand and in banks

$
4,486


$
3,871Interest-earning deposits in other financial institutions


108,794



127,464Securities available-for-sale, fair value


232,277



234,606Securities held-to-maturity, amortized cost


52,419



53,912Federal Home Loan Bank (FHLB) stock


11,920



11,920Loans, net


950,483



967,661Real estate owned (REO)


32,311



34,412Premises and equipment, net


13,127



13,325Cash surrender value of bank owned life insurance (BOLI), net


25,736



25,489Prepaid FDIC insurance premiums


2,210



2,968Accrued interest receivable


5,865



4,884Other assets


17,577



17,822Total assets

$
1,457,205


$
1,498,334LiabilitiesDeposits

$
1,069,087


$
1,107,554FHLB advances


159,000



159,000Securities sold under agreements to repurchase


145,000



145,000Junior subordinated debentures


15,465



15,465Junior subordinated debentures, fair value


1,500



1,500Accrued interest payable, expenses, and other liabilities


12,508



11,363Total liabilities


1,402,560



1,439,882Commitments and contingencies (Note 9)Stockholders’ EquityPreferred stock, no par value. Authorized 38,970 shares;


37,607



37,488Series A (liquidation preference $1,000 per share); issued and outstanding 38,970 shares at March 31, 2011 and December 31, 2010Preferred stock, $.01 par value. Authorized 500,000 shares;no shares issued or outstanding


-



-Common stock, $.01 par value. Authorized 65,000,000 shares;issued and outstanding 12,271,529 shares at March 31, 2011 andDecember 31, 2010


123



123Additional paid-in capital


43,942



43,932Accumulated deficit


(21,253
)


(17,965
)Accumulated other comprehensive loss


(5,774
)


(5,126
)Total stockholders’ equity


54,645



58,452Total liabilities and stockholders’ equity

$
1,457,205


$
1,498,334(See Notes to Condensed Consolidated Financial Statements)





3


CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS




(Unaudited)





Three Months Ended

March 31,(Dollars in thousands, except share and per share amounts)

2011


2010Interest IncomeLoans, including fees

$
13,918


$
16,166Securities available-for-sale


1,210



2,472Securities held-to-maturity


419



417Interest-earning deposits


65



76Total interest income


15,612



19,131Interest ExpenseDeposits


2,851



4,251FHLB advances


1,273



2,565Securities sold under agreements to repurchase


2,127



2,131FRB TAF borrowing


-



2Junior subordinated debentures


537



495Total interest expense


6,788



9,444Net interest income


8,824



9,687Provision for loan losses


2,550



31,290Net interest income (loss) after provision for loan losses


6,274



(21,603
)Other IncomeChecking service fees


1,209



1,263Other service fees


252



233Increase in cash surrender value of BOLI, net


247



237Gain on sales of securities available-for-sale, net


-



25Gain on calls of securities held-to-maturity, net


-



3Gain on sale of loans


-



26Other


111



125Total other income


1,819



1,912Other ExpensesCompensation & employee benefits


3,411



3,680Occupancy & equipment


932



1,016FDIC insurance premiums


771



853Business insurance


341



376REO expenses, write-downs & losses on sales of REO


2,587



994Contract services


529



200Information services


411



392Legal


374



162B&O tax


248



263Other


1,136



1,301Total other expenses


10,740



9,237Loss before provision for income taxes


(2,647
)


(28,928
)Provision for income taxes


-



3,211Net loss


(2,647
)


(32,139
)Dividends on preferred stock


522



499Accretion of issuance discount on preferred stock


119



112Net loss attributable to common stockholders

$
(3,288
)

$
(32,750
)(See Notes to Condensed Consolidated Financial Statements)








4


CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES





CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Continued)


(Unaudited)





Three Months Ended

March 31,(Dollars in thousands, except share and per share amounts)

2011


2010Loss per common share, basic

$
(0.27
)

$
(2.69
)Weighted average number of common shares outstanding, basic


12,271,529



12,165,167Loss per common share, diluted

$
(0.27
)

$
(2.69
)Weighted average number of common shares outstanding, diluted


12,271,529



12,165,167










CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY


(Unaudited)


Common(Dollars in thousands, except share and per share amounts)

Preferred Stock


Shares


Amount


Additional

Paid-InCapital


Accumulated Deficit


Accumulated Other Comprehensive Loss


Total Stockholders’

EquityBalances at December 31, 2010

$
37,488



12,271,529


$
123


$
43,932


$
(17,965
)

$
(5,126
)

$
58,452Dividends declared - Preferred stock  ($13.39 per share)


-



-



-



-



-522



-



-522Stock compensation expense


-



-



-



10



-



-



10Net loss


-



-



-



-



-2,647



-



-2,647Accretion of discount on preferred  stock


119



-



-



-



-119



-



-Other comprehensive loss


-



-



-



-



-



-648



-648Balances at March 31, 2011

$
37,607



12,271,529


$
123


$
43,942


$
(21,253
)

$
(5,774
)

$
54,645








CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS


(Unaudited)





Three Months Ended

March 31,(Dollars in thousands)

2011


2010Net loss

$
(2,647
)

$
(32,139
)Unrealized gain on cash flow hedging instruments


310



-Unrealized holding (loss) gain on securities available-for-sale, net oftax provision of $0 and $1,287


(958
)


2,386Reclassification adjustment for gain on securities available-for-saleincluded in net loss, net of tax benefit of $0 and $9


-



(16
)Comprehensive loss

$
(3,295
)

$
(29,769
)





(See Notes to Condensed Consolidated Financial Statements)





5


CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(Unaudited)





Three Months Ended

March 31,(Dollars in thousands)

2011


2010Cash flows from operating activities:Net loss

$
(2,647
)

$
(32,139
)Adjustments to reconcile net loss to net cash provided by operatingactivities:Depreciation and amortization of premises and equipment


429



515Provision for losses on loans


2,550



31,290REO write-downs


1,990



706Increase in cash surrender value of BOLI


(247
)


(237
)Amortization of retained servicing rights


4



6Amortization of core deposit intangible


35



35Deferred federal income taxes


-



(9,861
)Deferred loan fees, net of amortization


(55
)


297Gain on sale of loans


-



(26
)Origination of loans held-for-sale


-



(1,159
)Proceeds from sales of loans held-for-sale


-



1,435Stock compensation expense


10



16Net gain on sales of securities available-for-sale


-



(25
)Net gain on calls of securities held-to-maturity


-



(3
)Net loss (gain) on sales of REO


282



(8
)Net change in accrued interest receivable and other assets


293



11,738Net change in accrued interest payable, expenses and other liabilities


323



1,887Net cash provided by operating activities


2,967



4,467Cash flows from investing activities:Loans originated, net of principal repayments


3,215



4,073Purchases of securities available-for-sale


-



(50,015
)Proceeds from sales of securities available-for-sale


-



28,203Principal repayments on securities available-for-sale


1,371



6,049Purchases of securities held-to-maturity


-



(7,663
)Proceeds from calls on securities held-to-maturity


-



10,000Principal repayments on securities held-to-maturity


1,493



887Net purchases of premises and equipment


(231
)


(257
)Proceeds from paydowns/sales of REO


11,784



2,920REO capitalized costs


(487
)


(970
)Net cash provided by (used) in investing activities

$
17,145


$
(6,773
)








(See Notes to Condensed Consolidated Financial Statements)





6





CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)


(Unaudited)





Three Months Ended

March 31,(Dollars in thousands)

2011


2010Cash flows from financing activities:Proceeds from issuance of common stock

$
-


$
55Net (decrease) increase in deposits


(38,467
)


32,484Net decrease in Federal Reserve TAF borrowing


-



(20,000
)Net increase in securities sold under agreements to repurchase


-



655Net increase in advance payments by borrowers for taxes and insurance


300



328Net cash (used in) provided by financing activities


(38,167
)


13,522Net (decrease) increase in cash and cash equivalents


(18,055
)


11,216Cash and cash equivalents at beginning of period


131,335



145,595Cash and cash equivalents at end of period

$
113,280


$
156,811Supplemental disclosures of cash flow information – cashpaid during the period for:Interest

$
6,366


$
9,087Supplemental schedule of non-cash investing activities:Change in unrealized (loss) gain on securities available-for-sale


(958
)


2,370Change in unrealized gain on interest rate caps


310



-Dividends accrued on preferred stock


522



499Transfers of loans to REO


11,468



11,200








(See Notes to Condensed Consolidated Financial Statements)





7





CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


March 31, 2011


(Unaudited)





Note 1 – Basis of Presentation of Financial Information


The accompanying financial information is unaudited and has been prepared from the consolidated financial statements of Cascade Financial Corporation (the Corporation) and its wholly-owned subsidiaries, Cascade Bank (Cascade or the Bank), including Colby R.E., LLC and 2011 Yale Avenue East, LLC, Cascade Capital Trusts I, II and III (the Trusts). This financial information conforms to accounting principles generally accepted in the United States of America (GAAP) and to general practices within the financial institutions industry, where applicable. All significant intercompany balances have been eliminated in the consolidation. In the opinion of management, the financial information reflects all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the financial condition, results of operations, and cash flows of the Corporation pursuant to the requirements of the Securities and Exchange Commission (SEC) for interim reporting. Operating results for the three months ended March 31, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.





Certain information and footnote disclosures included in the Corporation’s financial statements for the year ended December 31, 2010, have been condensed or omitted from this report. Accordingly, these statements should be read in conjunction with the financial statements and notes thereto included in the Corporation’s December 31, 2010 Annual Report on Form 10-K.




The Condensed Consolidated Financial Statements have been prepared in conformity with GAAP established by the Financial Accounting Standards Board (FASB).  References to GAAP issued by the FASB in these footnotes are to the FASBAccounting Standards CodificationTM , sometimes referred to as the Codification or ASC.  In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses for the reporting period.  Actual results could differ from those estimates.  Material estimates that are particularly susceptible to significant change in the near term are the fair value of financial instruments, evaluation of other-than-temporary impairment (OTTI), the valuation of real estate owned (REO), the allowance for loan losses, and deferred income taxes.





Recently Issued Accounting Standards





In April 2010, the FASB issued ASU 2010-18, Receivables (Topic 310) -Effect of a Loan Modification When the Loan Is Part of a Pool that is Accounted for as a Single Asset.  This ASU clarifies that modifications of loans that are accounted for within a pool under Topic 310-30 do not result in the removal of those loans from the pool even if the modification of those loans would otherwise be considered a troubled debt restructuring. An entity will continue to be required to consider whether the pool of assets in which the loan is included is impaired if expected cash flows for the pool change. No additional disclosures are required with this ASU. The amendments in this ASU are effective for modifications of loans accounted for within pools under Topic 310-30 occurring in the first interim or annual period ending on or after July 15, 2010. The amendments are to be applied prospectively and early application is permitted. Upon initial adoption of the guidance in this ASU, an entity may make a onetime election to terminate accounting for loans as a pool under Topic 310-30. This election may be applied on a pool-by-pool basis and does not preclude an entity from applying pool accounting to subsequent acquisitions of loans with credit deterioration. The adoption of this ASU did not have a material impact on the Corporation's Consolidated Financial Statements.





In July 2010, the FASB issued ASU 2010-20, Receivables (Topic 310) – Amendments to Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. The amendments require an entity to provide enhanced or additional disclosures that facilitate financial statement users’ evaluation of the nature of credit risk inherent in the entity’s portfolio of financing receivables, how that risk is analyzed and assessed in arriving at the allowance for credit losses, and the changes and reasons for those changes in the allowance for credit losses. This guidance requires that the enhanced and additional reporting disclosures must be disaggregated by portfolio segment. It is likely that this ASU will have the greatest effect on financial institutions.  This ASU is effective for interim and annual reporting periods ending on or after December 15, 2010. The adoption of this ASU requires significant additional disclosures in the Corporation’s financial statements.





8


In December 2010, the FASB issued ASU 2010-29, Business Combinations (Topic 805) -Disclosure of Supplementary Pro Forma Information for Business Combinations. This update clarifies that if comparative financial statements are presented in disclosure of supplementary pro forma information for a business combination, revenue and earnings of the combined entity should be disclosed as though the business combination occurred as of the beginning of the comparable prior annual reporting period only. Additionally, supplemental pro forma disclosures should include a description of the nature and amount of material, nonrecurring pro forma adjustments included in the reported pro forma revenue and earnings. This update is effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. The adoption of this ASU did not have a material impact on the Corporation’s Consolidated Financial Statements.





In December 2010, the FASB issued ASU 2010-28, Intangibles-Goodwill and Other (Topic 350) - When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts. The amendments in this update modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist. The qualitative factors are consistent with the existing guidance, which requires that goodwill of a reporting unit be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. For public entities, the amendments in this update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. The adoption of this ASU did not have a material impact on the Corporation’s Consolidated Financial Statements.





In January 2011, the FASB issued ASU 2011-01, Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20. This ASU temporarily delays the effective date of the disclosures about troubled debt restructurings in Update 2010-20 for public entities. The delay is intended to allow the Board time to complete its deliberations on what constitutes a troubled debt restructuring. The effective date of the new disclosures about troubled debt restructurings for public entities and the guidance for determining what constitutes a troubled debt restructuring will then be coordinated. Currently, that guidance is anticipated to be effective for interim and annual periods ending after June 15, 2011. However, the Corporation has included the disclosures required by this ASU.





In April, 2011, FASB issued ASU 2011-02, Receivables (Topic 310) - A Creditor's Determination of Whether a Restructuring Is a Troubled Debt Restructuring. This update to Topic 310 -Receivables, provides guidance for evaluating whether a restructuring constitutes a troubled debt restructuring. The ASU indicates that the creditor's evaluation must separately conclude that both the following exist: (a) the restructuring constitutes a concession; and (b) the debtor is experiencing financial difficulties. The amendments also further clarify the guidance on a creditor's evaluation of whether a concession has been granted and whether a debtor is experiencing financial difficulties. The amendments in this update are effective for the first interim or annual period beginning on or after June 15, 2011. Early adoption is permitted. This also requires that the disclosures deferred by ASU 2011-01 be reported for interim and annual periods beginning on or after June 15, 2011. The adoption of this ASU did not have a material impact on the Corporation's Consolidated Financial Statements.





In May 2011, the FASB issued ASU 2011-03, Transfers and Servicing (Topic 860)- Reconsideration of Effective Control for Repurchase Agreements. The ASU is intended to improve financial reporting of repurchase agreements (repos) and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before their maturity. In a typical repo transaction, an entity transfers financial assets to a counterparty in exchange for cash with an agreement for the counterparty to return the same or equivalent financial assets for a fixed price in the future. FASB Topic 860, Transfers and Servicing, prescribes when an entity may or may not recognize a sale upon the transfer of financial assets subject to repo agreements. That determination is based, in part, on whether the entity has maintained effective control over the transferred financial assets. The amendments to the Codification in this ASU are intended to improve the accounting for these transactions by removing from the assessment of effective control the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets. The guidance in this ASU is effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted.




9


Note 2 – Regulatory Actions, Recent Events and Going Concern Considerations





While we have begun to see initial signs of improvement in the overall economy, we continue to operate in a difficult environment and have been significantly impacted by the unprecedented credit and economic market turmoil, as well as the recessionary economy that began in the latter part of 2007.  Deterioration in real estate markets in our primary geographic market areas of Snohomish, King, Pierce and Skagit counties in western Washington and related declines in property values in those markets over the past three years has led to the recognition of significant credit costs, which has negatively impacted our operating results, capital position and overall financial condition.





Regulatory Actions





FDIC Consent Order.On July 20, 2010, the Board of Directors of the Bank stipulated to the entry of a Consent Order with the FDIC and the Washington State Department of Financial Institutions (DFI), effective July 21, 2010 (FDIC Order). Under the terms of the FDIC Order, the Bank cannot pay any cash dividends or make any payments to its stockholders without the prior written approval of the FDIC and the Washington State DFI. Other material provisions of the FDIC Order require the Bank to:





·
review the qualifications of the Bank’s management;


·
provide the FDIC with 30 days written notice prior to adding any individual to the Board of Directors of the Bank or employing any individual as a senior executive officer;


·
increase director participation and supervision of Bank affairs;


·
develop a capital plan and increase Tier 1 leverage capital to 10% of the Bank’s average total assets and increase total risk-based capital to 12% of the Bank’s risk-weighted assets by November 18, 2010, and maintain such capital levels, in addition to maintaining a fully funded allowance for loan losses satisfactory to the regulators;


·
eliminate from its books, by charge-off or collection, all loans classified as “loss” and all amounts in excess of the fair value of the underlying collateral for assets classified as “doubtful” in the Report of Visitation dated February 16, 2010 that have not been previously collected or charged-off, by July 30, 2010;


·
reduce the amount of loans classified “substandard” and “doubtful” in the Report of Visitation that have not previously been charged off to not more than 130% of the Bank’s Tier 1 capital and allowance for loan losses, within 180 days;


·
eventually reduce the total of all adversely classified loans by collection, charge-off or sufficiently improving the quality of adversely classified loans to warrant removing any adverse classification, as determined by the regulators;


·
formulate a written plan to reduce the Bank’s levels of nonperforming assets and/or assets listed for “special mention” by the Bank to an acceptable level and to reduce the Bank’s concentrations in commercial real estate and acquisition, development and construction loans;


·
develop a three-year strategic plan and budget with specific goals for total loans, total investment securities and total deposits, and improvements in profitability and net interest margin, and reduction of overhead expenses;


·
submit a written plan for eliminating the Bank’s reliance on brokered deposits, in compliance with FDIC’s rules;


·
eliminate and/or correct all violations of law set forth in the Report of Visitation and the Report of Examination dated May 18, 2009, and ensure future compliance with all applicable laws and regulations;


·
implement a comprehensive policy for determining the adequacy of the allowance for loan losses satisfactory to the regulators and remedy any deficiency in the allowance in the calendar quarter discovered by a charge to current operating earnings;


·
refrain from extending additional credit with respect to loans charged-off or classified as “loss” and uncollected;


·
refrain from extending additional credit with respect to other adversely classified loans, without the prior approval of a majority of the directors on the Bank Board or its loan committee, and without first collecting all past due interest;


·
implement a liquidity and funds management policy to reduce the Bank’s reliance on brokered deposits and other non-core funding sources; and


·
prepare and submit periodic progress reports to the FDIC and the Washington State DFI.





The FDIC Order will remain in effect until modified or terminated by the FDIC and the Washington State DFI. A complete copy of the FDIC Order was filed as Exhibit 10.1 to the Form 8-K filed by the Corporation with the SEC on July 21, 2010.





10


FRB Written Agreement.Additionally, based on an examination concluded on March 11, 2010, the Corporation entered into a Written Agreement (FRB Agreement) with the FRB of San Francisco on November 4, 2010. Under the FRB Agreement, the Corporation cannot do any of the following without prior written approval of the FRB:





·
declare or pay any dividends;


·
make any distributions of principal or interest on junior subordinated debentures or trust preferred securities;


·
incur, increase or guarantee any debt; or


·
redeem any outstanding stock.





The FRB Agreement also requires the Corporation to:





·
take steps to ensure that the Bank complies with the FDIC Order;


·
submit a written capital plan that provides for sufficient capitalization of both the Corporation and the Bank within 60 days, and notify the FRB no more than 45 days after the end of any quarter in which any of the Corporation’s capital ratios fall below the approved plan’s minimum ratios;


·
submit a written cash flow projection plan for 2011 within 60 days;


·
comply with FRB regulations governing affiliate transactions, as well as submit a written plan to reimburse the Bank for all payments made by the Bank in violation of sections 23A and 23B of the Federal Reserve Act or to collateralize the loan made by the Bank to the Corporation in accordance with the requirements of sections 23A and 23B of the Federal Reserve Act;


·
comply with notice and approval requirements of the Federal Deposit Insurance Act (FDI Act) related to the appointment of directors and senior executive officers or change in the responsibility of any current senior executive officer;


·
comply with restrictions on paying or agreeing to pay certain indemnification and severance payments without prior written approval; and


·
submit a quarterly process report to the FRB.





Based on our most recent examination, the FRB staff recently advised us that in its opinion, the Corporation has not complied with all of the requirements of the FRB Agreement. The FRB found that we were not in compliance with the requirement to serve as a source of strength for the Bank, as a result of our failure to raise additional capital to support the Bank’s higher risk profile as a result of the levels of non-performing loans and OREO, continuing losses and declining capital levels. The FRB also criticized the capital plan we submitted on January 4, 2011, which called for raising approximately $90.0 million in additional capital, for failing to address the adequacy of the Bank’s capital, taking into account the level of adversely classified loans, the results of loan portfolio stress tests, the Bank’s risk profile, the adequacy of the allowance for loan losses, current and projected asset growth, and projected earnings, as required in the FRB Agreement. Finally, the FRB staff cited the Corporation’s failure to correct an alleged violation of Regulation W of the Federal Reserve Board of Governors, under Sections 23A and 23B of the Federal Reserve Act, related to a $430,000 loan by the Bank to the Corporation. The FRB observed that the outstanding debt owed to the Bank remains unpaid and uncollateralized, and that the Corporation would be unable to correct the violation until additional capital is raised to reimburse the Bank.




The Board of Directors is committed to taking all actions necessary to meet each of the requirements of the FRB Agreement and the FDIC Order. The Board of Directors is working diligently to comply with the requirement to raise capital, and on March 4, 2011, the Corporation announced that the Corporation, the Bank and Opus Bank entered into a definitive agreement, providing for Opus Bank to acquire the Corporation and the Bank, and for the merger of the Bank into Opus Bank. See “Proposed Merger” below.




Proposed Merger





On March 4, 2011, the Corporation announced that the Corporation, the Bank and Opus Bank entered into a definitive agreement, providing for Opus Bank to acquire the Corporation and the Bank, and for the merger of the Bank into Opus Bank.  Opus Bank is a California-chartered bank with its executive offices located in Irvine, California.  According to the terms of the merger agreement, Opus Bank will pay approximately $16.25 million to retire the Corporation’s $39.0 million in preferred stock and the associated warrant issued to the United States Department of the Treasury (the Treasury) under the Treasury’s Capital Purchase Program, and $5.5 million in cash to the holders of the Corporation’s common stock.  The purchase price for the Corporation’s common stock represents approximately $0.45


11
 per share outstanding. In addition, Opus Bank will assume all of the Corporation’s obligations with respect to the trust preferred securities issued by the Corporation’s trust subsidiaries.  The proposed transaction is subject to the approval of the Corporation’s shareholders at a special meeting of shareholders to be held on May 31, 2011, the approval of federal and state regulatory authorities, and other customary conditions.  The parties expect to close the transaction in the latter part of the second quarter of 2011.  Notwithstanding this, there are no assurances that the Corporation, the Bank and Opus Bank will be able to successfully close the proposed merger.





Going Concern Considerations





The consolidated financial statements have been prepared assuming that the Corporation will continue as a going concern. The Corporation and the subsidiary Bank were considered “under-capitalized” as of March 31, 2011.  Due to market conditions discussed above and other factors, there is uncertainty about the Corporation’s ability to satisfy regulatory requirements, including restoration of the Bank to capital levels stipulated in the FDIC Order issued by the FDIC and Washington State DFI in July 2010. The FDIC Order required the Bank to develop a capital plan and increase Tier 1 leverage capital to 10% of the Bank’s average total assets and increase total risk-based capital to 12% of the Bank’s risk-weighted assets.  The additional capital required to satisfy the requirements of the FDIC Order as of March 31, 2011 was approximately $65.0 million.  In addition, the Corporation entered into a Written Agreement with the FRB of San Francisco on November 4, 2010 which required the Corporation to take steps to ensure that the Bank complies with the FDIC Order.




As a part of its most recent capital raising efforts launched late in 2009, the Corporation engaged a highly qualified investment banking firm with expertise in the financial services sector to assist with a review of all strategic opportunities available to the Corporation.  On March 4, 2011, the Corporation announced that it had entered into a definitive agreement, providing for Opus Bank to acquire the Corporation and the Bank, and for the merger of the Bank into Opus Bank.  See “Proposed Merger” above.





During the second quarter of 2009, the Corporation suspended payment of a quarterly cash dividend and, effective with the fourth quarter of 2009, dividend payments on trust preferred securities were deferred in accordance with provisions of the related indentures. Efforts to improve the Bank’s capital levels through improved internal equity generation were also initiated in conjunction with various cost cutting measures implemented by the bank but elevated loan charge-offs, REO write-downs, legal expenses, foreclosure expenses and FDIC insurance premiums have precluded the Corporation from improving capital levels to date.





During 2009 and 2010, as a result of declining real estate values, the Corporation took decisive actions to address the deterioration in the construction and land acquisition and development sectors of the loan portfolio resulting from a general and severe deterioration in residential real estate valuations and sales activity. Loan charge-offs of $56.3 million were recognized during 2010, of which over 78% were related to construction and land acquisition and development loans. Loan charge-offs of $34.7 million were recognized during 2009, of which over 87% were related to construction and land acquisition and development loans. Although additional loan loss provisions and charge-offs will likely be recognized during 2011, the Company does not expect the other segments of the portfolio will suffer from extreme losses and, accordingly, that the regulatory capital levels will not be impacted by the same magnitude in 2011 as they were in the previous two years. Loan charge-offs were $2.9 million for the first quarter of 2011.




Despite the restrictions on issuance and renewal of brokered certificates of deposit, which became effective in July 2010, the Bank maintained an adequate liquidity position as of March 31, 2011 through the strength of its core deposit base, issuance of promotional rate retail certificates of deposit and benefit of the recently increased FDIC deposit insurance limits. Additionally, the reduction in loans and the liquidity generated from the sale of foreclosed assets have contributed significantly to the Bank’s liquidity position.





As noted above, the Bank sustained significant credit losses in 2009 and 2010 as a result of the impact of the recession and the related deterioration in the real estate markets on its loan portfolios, more specifically the real estate construction portfolio.  While the Bank’s credit losses are not likely to continue at the same level as in 2010, the Bank’s nonperforming assets and related costs remain elevated and continuing losses remain a risk.  The losses sustained since 2009 have reduced the capital levels at the Corporation and the Bank significantly and resulted in an accumulated deficit of $21.3 million for the Corporation as of March 31, 2011.  Although the Corporation is working diligently to close the proposed merger transaction described above, there are no assurances that the transaction will be closed as anticipated.  If the Corporation is not able to close the proposed merger transaction, failure to meet the requirements under the FDIC Order or the FRB Agreement exposes the Corporation and


12
 the Bank to additional restrictions and regulatory actions.  Despite all of our efforts to restore the financial condition of the Corporation and the Bank, there remains uncertainty, which raises substantial doubt about the ability of the Corporation to continue as a going concern.  The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.





Note 3 - Investment Securities





The following table presents the amortized cost, unrealized gains, unrealized losses and fair value of available-for-sale and held-to-maturity securities at March 31, 2011 and December 31, 2010:







March 31, 2011(Dollars in thousands)

Amortized

Cost


Gross

Unrealized

Gains


Gross

Unrealized

Losses


Fair

ValueSecurities available-for-saleMortgage-backed securities

$
68,928


$
11


$
(3,247
)

$
65,692Agency notes & bonds


116,633



-



(6,282
)


110,351US treasury notes


56,316



43



(125
)


56,234Total

$
241,877


$
54


$
(9,654
)

$
232,277Securities held-to-maturityMortgage-backed securities

$
23,644


$
601


$
(440
)

$
23,805Agency notes & bonds


28,000



-



(1,522
)


26,478Other


775



-



-



775Total

$
52,419


$
601


$
(1,962
)

$
51,058





December 31, 2010(Dollars in thousands)

Amortized

Cost


Gross

Unrealized

Gains


Gross

Unrealized

Losses


Fair

ValueSecurities available-for-saleMortgage-backed securities

$
70,270


$
10


$
(3,077
)

$
67,203Agency notes & bonds


116,632



-



(5,513
)


111,119US treasury notes


56,346



-



(62
)


56,284Total

$
243,248


$
10


$
(8,652
)

$
234,606Securities held-to-maturityMortgage-backed securities

$
25,137


$
755


$
(383
)

$
25,509Agency notes & bonds


28,000



-



(1,216
)


26,784Other


775



-



-



775Total

$
53,912


$
755


$
(1,599
)

$
53,068





13


The amortized cost and estimated fair value of investment securities are shown in the following table by contractual or expected maturity at March 31, 2011. During certain interest rate environments, some of these securities may be called for redemption by their issuers prior to the scheduled maturities.





March 31, 2011(Dollars in thousands)

Amortized

Cost


Fair

Value


YieldSecurities available-for-sale (AFS)Agency and US Treasury:Due after one through five years

$
72,816


$
72,187



0.93
%Due after five through ten years


100,091



94,356



2.81Due after ten years


42



42



0.00Subtotal


172,949



166,585



2.00Mortgage-backed securities:Due less than one year


55



55



4.50Due after one through five years


385



396



4.86Due after five through ten years


68,488



65,241



3.07Subtotal


68,928



65,692



3.08Total securities AFS

$
241,877


$
232,277



2.30
%Securities held-to-maturity (HTM)Agency:Due less than one year

$
28,000


$
26,478



2.31
%Due after ten years


775



775



7.50Subtotal


28,775



27,253



2.45Mortgage-backed securities:Due less than one year


34



34



5.01Due after one through five years


10,331



10,876



4.59Due after five through ten years


13,279



12,895



4.14Subtotal


23,644



23,805



4.34Total securities HTM

$
52,419


$
51,058



3.33
%





No investment securities were pledged to the FHLB at March 31, 2011. The fair value of investment securities pledged to the FHLB at December 31, 2010, totaled $15.9 million. The fair value of investment securities pledged to fund repurchase agreements was $210.9 million at March 31, 2011 and $212.9 million at December 31, 2010.





The following table presents gross unrealized losses and the fair value of available-for-sale and held-to-maturity securities at March 31, 2011 and December 31, 2010:





March 31, 2011Fair

Value


Gross

Unrealized

Losses

Less Than

1 Year


Fair

Value


Gross

Unrealized

Losses

More Than

1 Year


Total(Dollars in thousands)

Fair

Value


Unrealized

LossesSecurities available-for-saleMortgage-backed securities

$
65,296


$
(3,247
)

$
-


$
-


$
65,296


$
(3,247
)Agency notes & bonds


110,218



(6,282
)


-



-



110,218



(6,282
)US Treasury notes


21,207



(125
)


-



-



21,207



(125
)Total

$
196,721


$
(9,654
)

$
-


$
-


$
196,721


$
(9,654
)Securities held-to-maturityMortgage-backed securities

$
5,990


$
(440
)

$
-


$
-


$
5,990


$
(440
)Agency notes & bonds


26,478



(1,522
)


-



-



26,478



(1,522
)Total

$
32,468


$
(1,962
)

$
-


$
-


$
32,468


$
(1,962
)




14





December 31, 2010Fair

Value


Gross

Unrealized

Losses

Less Than

1 Year


Fair

Value


Gross

Unrealized

Losses

More Than

1 Year


Total(Dollars in thousands)

Fair

Value


Unrealized

LossesSecurities available-for-saleMortgage-backed securities

$
66,668


$
(3,077
)

$
-


$
-


$
66,668


$
(3,077
)Agency notes & bonds


110,987



(5,513
)


-



-



110,987



(5,513
)US Treasury notes


56,284



(62
)


-



-



56,284



(62
)Total

$
233,939


$
(8,652
)

$
-


$
-


$
233,939


$
(8,652
)Securities held-to-maturityMortgage-backed securities

$
6,046


$
(383
)

$
-


$
-


$
6,046


$
(383
)Agency notes & bonds


26,784



(1,216
)


-



-



26,784



(1,216
)Total

$
32,830


$
(1,599
)

$
-


$
-


$
32,830


$
(1,599
)





The Corporation had no securities in its available-for-sale portfolio or held-to-maturity portfolio with unrealized losses greater than one year at March 31, 2011 or December 31, 2010. Available-for-sale securities had unrealized losses less than one year of $9.7 million and held-to-maturity securities had unrealized losses less than one year of $2.0 million Securities having fair values less than amortized cost and containing unrealized losses are evaluated periodically by the Corporation for other-than-temporary impairment. The Corporation does not intend to sell the securities nor does it anticipate being required to sell these securities. In the analysis for March 31, 2011, the Corporation determined that the decline in value was temporary and related to the change in market interest rates since purchase. All investment securities were rated AAA for credit quality by at least one major rating agency. The decline in value was not related to any company or industry specific event. The Corporation anticipates full recovery of par value with respect to these securities at maturity or sooner in the event of a more favorable market interest rate environment.





As of March 31, 2011 and December 31, 2010, the Corporation was required to maintain 71,550 shares, of $100 par value FHLB stock. As a member of the FHLB system, the Bank is required to maintain a minimum level of investment in FHLB stock based on specific percentages of its outstanding mortgages, total assets, or FHLB advances. The Bank’s minimum required investment in FHLB stock was $7.2 million at March 31, 2011 and December 31, 2010. The Bank may request redemption at par value of any stock in excess of the minimum required investment. Stock redemptions are at the discretion of the FHLB.




At March 31, 2011, the Bank held FHLB of Seattle stock with a par value of $11.9 million. The Corporation does not anticipate any impairment charges associated with these instruments. The FHLB stock does not have readily determinable fair value and the equity ownership rights are more limited than would be the case for a public company because of the Federal Housing Finance Agency’s (FHFA) oversight role in budgeting and approving dividends. FHLB stock is generally viewed as a long-term investment and as a restricted investment security, which is carried at cost. Thus, when evaluating FHLB stock for impairment, its value is determined based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value.





Under FHFA regulations, a Federal Home Loan Bank that fails to meet any regulatory capital requirement may not declare a dividend or redeem or repurchase capital stock in excess of what is required for members’ current loans.  Moody’s Investors Service’s (Moody’s) current assessment of the FHLB’s portfolios indicates that the true economic losses embedded in these securities are significantly less than the accounting impairments would suggest and are manageable given the FHLB’s capital levels.  According to Moody’s, the large difference between the expected economic losses and the mark-to-market impairment losses for accounting purposes is attributed to market illiquidity, de-leveraging and stress in the credit market in general. Furthermore, Moody’s believes that the FHLB has the ability to hold the securities until maturity.  The FHLB has access to the U.S. Government-Sponsored Enterprise Credit Facility, a secured lending facility that serves as a liquidity backstop, substantially


15
 reducing the likelihood that the FHLB would need to sell securities to raise liquidity and, thereby, cause the realization of large economic losses.  In addition, the Federal Reserve has begun to purchase direct debt obligations of Freddie Mac, Fannie Mae and the FHLB. Moody’s has stated that their AAA senior debt rating and Prime-1 short-term debt rating are likely to remain unchanged based on expectations that the FHLB has a very high degree of government support.  Based on the above, the Corporation has determined there is no impairment of the FHLB stock investment as of March 31, 2011.





Note 4 - Loans and Allowance for Loan Losses





A summary of loans at March 31, 2011 and December 31, 2010, follows:





(Dollars in thousands)

Loans

March 31,

2011


December 31,

2010Business

$
392,233


$
400,047R/E construction(1)Spec construction


23,033



25,303Land acquisition & development/land


57,235



54,142Commercial R/E construction


2,332



2,333Total R/E construction


82,600



81,778Commercial R/E


190,191



201,885Multifamily


89,461



89,350Home equity/consumer


29,270



29,964Residential


196,389



194,677Total loans

$
980,144


$
997,701Deferred loan fees


(3,879
)


(3,934
)Allowance for loan losses


(25,782
)


(26,106
)Loans, net

$
950,483


$
967,661





(1)        Real estate construction loans are net of loans in process.





The allowance for loan losses (ALLL) is an estimate of the total potential principal loss inherent in the loan portfolio as of the reporting date.  The ALLL is maintained based on a review of several factors.  These factors include delinquency trends, level and trend of adversely classified loans, historical loss experience, additional management judgment, peer group and industry review, impaired loan analyses and qualitative (Q) factors.  These Q factors include regional/local economic trends, health of the real estate market, loan and collateral concentrations, size of borrowing relationships, change in loan delinquencies and charge-offs and changes in classifications.





The allowance consists of general and specific components. To determine the general component of the allowance, for loans not identified as impaired, the loan portfolio is separated by loan type and then by risk rating.  The loan types are as follows: business and business real estate (combined below, but analyzed separately), real estate construction, commercial real estate, multifamily, home equity/consumer and residential. A loss factor based on a two-year historical loss average has been used.  However, for the first quarter of 2011, the one-year loss factor was used for the real estate construction loan category because management believes it is more representative of the current market environment for those loan types. Historical losses are then adjusted to incorporate Q factors as noted above. Specific Q factors are assigned to each loan type based on the risks identified in each segment of the loan portfolio. Management has also added an additional management judgment factor after thorough analysis of the historical trends and Q factors as well as the breakdown between special mention and pass loans.





For the specific portion of the reserve, loans identified as impaired are reviewed individually to determine if specific reserves are needed.  A few smaller dollar loans are grouped and reviewed in pools. Any portion of the ALLL that is not allocated to the general or specific components of the reserve is considered to be unallocated.




Loan risk ratings are a critical part of the ALLL process.  Credit administration management actively reviews loan risk ratings as part of their ongoing review of credits.  Classified Loan Status Reports are reviewed monthly by the Asset Review Committee.  At March 31, 2011, substantially all of the substandard loans were individually reviewed for impairment.




The total allowance reflects management’s estimate of loan losses inherent in the loan portfolio and management considers the allowance of $25.8 million adequate to cover loan losses at March 31, 2011.




16


The following table presents the changes in the allowance for loan losses by type:





(Dollars in thousands)

Three Months Ended March 31, 2011Allowance for Loan Losses

Business


R/E

Construction


Commercial

R/E


Multi-

family


Home

Equity/ Consumer


Residential


Unallocated


TotalBalance at beginning of period

$
9,437


$
10,591


$
2,745


$
1,410


$
642


$
1,281


$
-


$
26,106Net charge-offs


(1,103
)


(1,253
)


51



-



(266
)


(303
)


-



(2,874
)Provision for losses


874



1,604



(249
)


(224
)


308



157



80



2,550Ending balance

$
9,208


$
10,942


$
2,547


$
1,186


$
684


$
1,135


$
80


$
25,782Loans individually evaluated for impairment

$
33,034


$
28,772


$
45,547


$
11,138


$
400


$
4,057


$
-


$
122,948Loans evaluated in a group forimpairment *


-



-



-



-



655



345



-



1,000Total impaired


33,034



28,772



45,547



11,138



1,055



4,402



-



123,948Loans not impaired


359,199



53,828



144,644



78,323



28,215



191,987



-



856,196Total loans

$
392,233


$
82,600


$
190,191


$
89,461


$
29,270


$
196,389


$
-


$
980,144





* Small dollar, homogeneous loans





A loan is considered impaired when, based on current information and events, the Bank determines that it is probable it will not be able to collect all amounts due according to the loan contract, including scheduled interest payments. When the Bank identifies a loan as impaired, it measures the impairment using discounted cash flows, except when the sole remaining source of the repayment for the loan is the liquidation of the collateral. In these cases, the Bank uses the current fair value of the collateral, less selling costs, instead of discounted cash flows. If the Bank determines that the value of the impaired loan is less than the recorded investment in the loan, it either recognizes an impairment reserve as a specific component to be provided for in the allowance for loan losses or charges-off the impaired balance on collateral dependent loans if it is determined that such amount represents a confirmed loss. The combination of the general allowance calculation and the specific reserve on impaired loans resulted in the total allowance for loan losses.





At March 31, 2011, the recorded investment in loans classified as impaired totaled $123.9 million.  Included in this total are $33.9 million in impaired loans with a corresponding specific reserve (included in the allowance for loan losses) of $6.6 million. The remaining $90.0 million in impaired loans are considered collateral dependent and have been written-down to their estimated net realizable value. At December 31, 2010, the total recorded investment in impaired loans was $144.0 million, including $40.0 million that had a corresponding specific reserve of $5.8 million.





At March 31, 2011 and December 31, 2010, impaired loans of $69.0 million and $63.8 million, respectively, were classified as performing troubled debt restructured (TDR) loans. The restructurings were granted in response to borrower financial difficulty, and generally provide for a temporary modification of loan repayment terms. In order for a restructured loan to be considered performing and on accrual status, the loan’s collateral coverage generally will be greater than or equal to 100% of the loan balance (net of specific reserves as applicable), the loan is current on payments, and the borrower must either prefund an interest reserve or have demonstrated the ability to make payments from a verified source of cash flow.





17


The following table shows the recorded investment, unpaid principal balance and specific reserve for impaired loans:





March 31, 2011(Dollars in thousands)

Recorded

Investment

(Loan Balance

Less Charge-Off)


Unpaid

Principal

Balance (Gross

of Charge-off)


Specific

ReserveImpaired Loans With No Specific ReserveBusiness

$
24,288


$
25,066


$
-R/E constructionSpec construction


14,467



19,562



-Land acquisition & development/land


2,944



4,652



-Total R/E construction


17,411



24,214



-Commercial R/E


41,080



41,111



-Multifamily


2,967



2,967



-Home equity/consumer


325



401



-Residential


3,954



4,101



-Total


90,025



97,860



-Impaired Loans With Specific ReserveBusiness


8,746



8,777



1,486R/E constructionLand acquisition & development/land


11,361



11,361



3,225Total R/E construction


11,361



11,361



3,225Commercial R/E


4,467



4,467



1,154Multifamily


8,171



8,171



712Home equity/consumer


420



536



47Residential


758



759



12Total


33,923



34,071



6,636Total Impaired LoansBusiness


33,034



33,843



1,486R/E constructionSpec construction


14,467



19,562



-Land acquisition & development/land


14,305



16,013



3,225Total R/E construction


28,772



35,575



3,225Commercial R/E


45,547



45,578



1,154Multifamily


11,138



11,138



712Home equity/consumer


745



937



47Residential


4,712



4,860



12Total

$
123,948


$
131,931


$
6,636


18





December 31, 2010(Dollars in thousands)

Recorded

Investment

(Loan Balance

Less Charge-Off)


Unpaid

Principal

Balance (Gross

of Charge-off)


Specific

ReserveImpaired Loans With No Specific ReserveBusiness

$
27,435


$
28,315


$
-R/E constructionSpec construction


14,753



19,410



-Land acquisition & development/land


4,303



4,303



-Total R/E construction


19,056



23,713



-Commercial R/E


51,472



52,812



-Multifamily


2,976



2,976



-Home equity/consumer


244



244



-Residential


2,808



3,055



-Total


103,991



111,115



-Impaired Loans With Specific ReserveBusiness


12,184



12,218



1,215R/E constructionSpec construction


875



875



-Land acquisition & development/land


12,144



13,615



2,416Total R/E construction


13,019



14,490



2,416Commercial R/E


4,483



4,483



1,148Multifamily


8,186



8,186



886Home equity/consumer


804



817



17Residential


1,332



1,332



119Total


40,008



41,526



5,801Total Impaired LoansBusiness


39,619



40,533



1,215R/E constructionSpec construction


15,628



20,285



-Land acquisition & development/land


16,447



17,918



2,416Total R/E construction


32,075



38,203



2,416Commercial R/E


55,955



57,296



1,148Multifamily


11,162



11,162



886Home equity/consumer


1,048



1,060



17Residential


4,140



4,387



119Total

$
143,999


$
152,641


$
5,801





19


The following tables show summarized information on impaired loans:





(Dollars in thousands)

Impaired loans

March 31,

2011


December 31,

2010Impaired loans without a specific reserve

$
90,025


$
103,991Impaired loans with a specific reserve


33,923



40,008Total impaired loans

$
123,948


$
143,999Allowance for loan losses related to impaired loans

$
6,636


$
5,801Total nonperforming loans


35,191



48,098Total loans past-due ninety days or more and still accruing


145



-Performing TDR loans

$
69,006


$
63,773Nonperforming TDR loans


31,568



30,399Total TDR loans

$
100,574


$
94,172





Federal regulations provide for the classification of loans as substandard, doubtful and loss.  A substandard asset is inadequately protected by the current net worth and paying capacity of the debtor or the collateral pledged.  These assets have well defined weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loans classified doubtful have the same concerns as substandard but with additional likelihood that collection or liquidation in full, based on existing facts, conditions and values, is highly questionable and improbable. Loans designated loss should be fully charged-off since these loans are determined to be uncollectible and of such little value that their continuance as assets is not warranted.





The Bank uses an additional seven categories to describe loans that are not classified.  These categories include special mention and watch loans, which include borrowers with declining earnings, strained cash flow and downward trends requiring close management attention.  Loans considered pass include five separate categories of loans from substantially risk free to average risk.





The following table shows the loan portfolio by loan classification and type of loan:





March 31, 2011(Dollars in thousands)

Doubtful


Substandard


Special Mention/Watch


Pass


TotalBusiness

$
-


$
32,616


$
93,206


$
266,411


$
392,233R/E constructionSpec construction


-



14,467



7,401



1,165



23,033Land acquisition & development/land


-



11,454



27,123



18,658



57,235Commercial R/E construction


-



-



-



2,332



2,332Total R/E construction


-



25,921



34,524



22,155



82,600Commercial R/E


-



45,547



33,342



111,302



190,191Multifamily


-



11,138



21,760



56,563



89,461Home equity/consumer


-



946



124



28,200



29,270Residential


-



3,918



7,230



185,241



196,389Total

$
-


$
120,086


$
190,186


$
669,872


$
980,144





20





December 31, 2010(Dollars in thousands)

Doubtful


Substandard


Special Mention/Watch


Pass


TotalBusiness

$
337


$
39,321


$
67,905


$
292,484


$
400,047R/E constructionSpec construction


-



15,628



8,104



1,571



25,303Land acquisition & development/land


128



16,319



23,310



14,385



54,142Commercial R/E construction


-



-



-



2,333



2,333Total R/E construction


128



31,947



31,414



18,289



81,778Commercial R/E


-



55,955



30,665



115,265



201,885Multifamily


-



11,161



17,506



60,683



89,350Home equity/consumer


-



1,532



427



28,005



29,964Residential


-



3,684



7,934



183,059



194,677Total

$
465


$
143,600


$
155,851


$
697,785


$
997,701





The following table includes an aging analysis of the recorded investment of past-due loans by type as of March 31, 2011 and December 31, 2010, and shows the amount of loans that are current by type. The table excludes performing/nonperforming status and is calculated based on days delinquent. As of March 31, 2011, there were $8.8 million in nonperforming loans that were not past due.





(Dollars in thousands)

March 31, 2011Age Analysis of Past Due Loans

30-59 Days Past Due


60-89 Days Past Due


Greater Than 90 Days Past Due


Total

Past Due


Current


Total

LoansBusiness

$
7,609


$
14


$
2,451


$
10,074


$
382,159


$
392,233R/E construction


181



-



10,553



10,734



71,866



82,600Commercial R/E


11,458



-



-



11,458



178,733



190,191Multifamily


-



-



-



-



89,461



89,461Home equity/consumer


523



-



176



699



28,571



29,270Residential


4,345



-



315



4,660



191,729



196,389Total

$
24,116


$
14


$
13,495


$
37,625


$
942,519


$
980,144








(Dollars in thousands)

December 31, 2010Age Analysis of Past Due Loans

30-59 Days Past Due


60-89 Days Past Due


Greater Than 90 Days Past Due


Total

Past Due


Current


Total

LoansBusiness

$
1,949


$
160


$
2,474


$
4,583


$
395,464


$
400,047R/E construction


254



619



11,537



12,410



69,368



81,778Commercial R/E


-



-



10,962



10,962



190,923



201,885Multifamily


167



-



-



167



89,183



89,350Home equity/consumer


95



157



697



949



29,015



29,964Residential


1,087



744



796



2,627



192,050



194,677Total

$
3,552


$
1,680


$
26,466


$
31,698


$
966,003


$
997,701





21


The following table shows the loan portfolio by performing and nonperforming status by type of loan as of March 31, 2011 and December 31, 2010:





March 31, 2011(Dollars in thousands)

Performing


Nonperforming


TotalBusiness

$
389,415


$
2,818


$
392,233R/E constructionSpec construction


14,531



8,502



23,033Land acquisition & development/land


54,628



2,607



57,235Commercial R/E construction


2,332



-



2,332Total R/E construction


71,491



11,109



82,600Commercial R/E


172,233



17,958



190,191Multifamily


89,461



-



89,461Home equity/consumer


28,524



746



29,270Residential


193,829



2,560



196,389Total

$
944,953


$
35,191


$
980,144








December 31, 2010(Dollars in thousands)

Performing


Nonperforming


TotalBusiness

$
395,700


$
4,347


$
400,047R/E constructionSpec construction


15,598



9,705



25,303Land acquisition & development/land


51,294



2,848



54,142Commercial R/E construction


2,333



-



2,333Total R/E construction


69,225



12,553



81,778Commercial R/E


173,533



28,352



201,885Multifamily


89,350



-



89,350Home equity/consumer


28,916



1,048



29,964Residential


192,879



1,798



194,677Total

$
949,603


$
48,098


$
997,701





The following table includes the number of TDR loans and the recorded investment as of March 31, 2011 and December 31, 2010. The outstanding balances at March 31, 2011 are net of $5.0 million in charge-offs. The Bank is committed to fund the undisbursed balance on TDR loans, totaling $152,000 as of March 31, 2011.





(Dollars in thousands)

March 31, 2011


December 31, 2010TDR Loans

Number

of Loans


Outstanding

Balance


Number

of Loans


Outstanding

BalanceBusiness


24


$
22,493



25


$
19,614R/E construction


11



27,582



12



30,373Commercial R/E


7



37,484



4



32,238Multifamily


4



8,610



4



8,619Home equity/consumer


3



294



1



244Residential


8



4,111



5



3,084Total


57


$
100,574



51


$
94,172





22


Note 5 – Real Estate Owned (REO)





REO includes real estate acquired in settlement of loans. REO is recorded at the lower of carrying amount or fair value, based upon an appraisal, less estimated costs to sell. Developments and improvements related to the property are capitalized. Any losses recorded at the time a foreclosure occurs are classified as a charge-off against the allowance for loan losses. Losses that result from the ongoing periodic valuation of these properties, are charged to expense in the period identified. Revenue and expenses from operations and subsequent adjustments to the carrying amount of the property are included in noninterest expense in the statement of operations.





The following table presents real estate owned activity for the periods presented:





Three Months Ended

March 31,(Dollars in thousands)

2011


2010Beginning balance

$
34,412


$
18,842Transfers to REO


11,468



11,200Capitalized costs


487



970Paydowns/sales


(11,784
)


(2,920
)Write-downs/losses


(2,272
)


(698
)Ending balance

$
32,311


$
27,394








Note 6 - Junior Subordinated Debentures





On March 1, 2000, the Corporation issued $10.3 million of 11.0% junior subordinated debentures. In turn, Cascade Capital Trust I, a wholly owned business trust whose common equity is 100% owned by the Corporation, issued trust preferred securities underlying the debentures. The Trust exists for the exclusive purpose of issuing the trust preferred securities underlying the junior subordinated debentures issued by the Corporation, and engaging in only those other activities necessary, advisable or incidental to the above. The Corporation used the proceeds for general corporate purposes including stock repurchases and investment in the Bank. The junior subordinated debentures will mature on March 1, 2030, unless redeemed prior to such date if certain conditions are met.





On December 15, 2004, the Corporation issued $5.2 million in junior subordinated debentures.  In turn, Cascade Capital Trust II, a wholly owned business trust whose common equity is 100% owned by the Corporation, issued trust preferred securities underlying the debentures. The Trust exists for the exclusive purpose of issuing the trust preferred securities underlying the junior subordinated debentures issued by the Corporation, and engaging in only those other activities necessary, advisable or incidental to the above. These debentures had a fixed coupon of 5.82% for the first five years and as of January 7, 2010, float at the three-month LIBOR plus 1.90% for the remaining twenty-five years. The coupon rate on the debentures was 2.20% as of March 31, 2011. The debentures were callable at par after the first five years.





On March 30, 2006, the Corporation issued $10.3 million in junior subordinated debentures. In turn, Cascade Capital Trust III, a wholly owned business trust whose common equity is 100% owned by the Corporation, issued trust preferred securities underlying the debentures. The Trust exists for the exclusive purpose of issuing the trust preferred securities underlying the junior subordinated debentures issued by the Corporation, and engaging in only those other activities necessary, advisable or incidental to the above. These debentures have a fixed coupon of 6.65% for the first five years and as of June 15, 2011, float, if not called, at the three-month LIBOR plus 1.40% for the remaining twenty-five years.





The junior subordinated debentures issued by the Corporation incorporate the same structure and are considered Tier 1 capital for regulatory purposes, subject to FRB restrictions.





The Corporation applied fair value accounting to the junior subordinated debentures issued by Cascade Capital Trust I.  The change in fair market value of the junior subordinated debentures is recorded as a component of other income. The Corporation determines the fair value by using a discounted cash flow model.  The discount rate is determined using a risk free interest rate approximating the remaining maturity of the debentures combined with a credit and liquidity spread determined based upon quotes from brokers and from valuations by holders of Cascade Capital Trust I, which were obtained from public filings. The bonds are assumed to be outstanding until maturity.  For the quarter ended March 31, 2011, there was no change in the fair value of the junior subordinated debentures. The fair value was $1.5 million at March 31, 2011 and December 31, 2010. The fair value option was not selected for the junior subordinated debentures issued in connection with Cascade Capital Trust II and III, which are reported at the combined book value of $15.5 million.




During the fourth quarter of 2009, FDIC restrictions prohibited dividend payments from the Bank to the holding company, which in turn led the Corporation to defer the payment of interest on the Trust Preferred Securities. Under the terms of each instrument deferral of payments is permitted without triggering an event of default. Generally, during any deferral period, the Corporation is prohibited from





23
 paying any dividends or distributions on, or redeem, purchase or acquire, or make a liquidation payment with respect to the Corporation’s capital stock, or make any payment of principal or interest on, or repay, repurchase or redeem any debt securities of the Corporation that rank pari passu in all respects with, or junior to, the specific instrument. In addition, during any deferral period, interest on the trust preferred securities is compounded from the date such interest would have been payable.





Note 7 – Derivatives and Hedging





In the fourth quarter of 2010, the Bank entered into derivative contracts to add stability to net interest income and to manage its exposure to changes in interest rates. The Bank sought to minimize the volatility that changes in interest rates have on its variable-rate debt by entering into interest rate cap agreements.  The Bank purchased a series of interest rate caps from two different major financial institutions based on their credit rating and other factors. Both counterparties provide cash collateral to the Bank on the majority of the fair value of the cap to significantly mitigate credit risk of these transactions.  The Bank purchased interest rate caps designated as cash flow hedges to protect against movements in interest rates above the caps’ strike rate, which is tied to three month LIBOR.  The interest rate caps have an aggregate notional amount of $159.0 million, strike rates of 1.29% and a maturity date of October 20, 2015. The Bank formally documented the relationship between the hedging instruments and hedged items, as well as its risk management objective and strategy before initiating the hedge. The caps were used to hedge the variable cash flows associated with variable rate FHLB advances that reprice based upon three month LIBOR on the same day that the rate caps reprice. The fair value of the interest rate caps is based on derivative valuation models using market data inputs as of the valuation date that can generally be verified and do not typically involve significant management judgments. (Level 2 inputs). The valuation is performed on each reporting date to determine if the hedge was effective over the reporting period, using the hypothetical derivative method, by comparing the actual changes in the hedged item to a “perfectly effective” hypothetical interest rate cap.  If the ratio of the change in fair value of the actual cap to the change in fair value of the hypothetical cap falls between the effectiveness parameters the hedge will be considered to have been effective. The March 31, 2011 valuations showed the hedge to be “perfectly effective” and resulted in a mark-to-market gain on the interest rate caps totaling $3.8 million, which is included in accumulated other comprehensive loss. As of January 1, 2011, the Bank began amortizing the cost of the interest rate caps.  The expense is reclassified into earnings. As of March 31, 2011, approximately $1,000 had been expensed.





The following table presents the notional value, strike rate, and fair value and collateral held at March 31, 2011:





(Dollars in thousands)

Derivatives

March 31, 2011


December 31, 2010Notional Value

$
159,000


$
159,000Strike Rate


1.29
%


1.29
%Fair Value

$
9,042


$
8,732Cash Collateral


7,790



7,620








Note 8 - Income Taxes





At March 31, 2010, the Corporation assessed whether it was more likely than not that it would realize the benefits of its deferred tax asset. The Corporation determined that the negative evidence associated with a cumulative three-year loss, entering into an FDIC Order (see Note 2) with its regulators, and credit deterioration in its loan portfolio outweighed the positive evidence. Therefore, during the first quarter in 2010, the Corporation established a full valuation allowance against its deferred tax asset.  The valuation allowance totaled $26.7 million at March 31, 2011, with net operating loss carryforwards accounting for $17.9 million of deferred tax assets.




24


In the future, the Corporation’s effective tax rate could be adversely affected by several factors, many of which are outside of the Corporation’s control.  The effective tax rate is affected by the proportion of revenues and income before taxes in the various domestic jurisdictions in which the Corporation operates. Further, the Corporation is subject to changing tax laws, regulations and interpretations in multiple jurisdictions in which the Corporation operates, as well as the requirements, pronouncements and rulings of certain tax, regulatory and accounting organizations. The Corporation estimates its annual effective tax rate each quarter based on a combination of actual and forecasted results of subsequent quarters. Consequently, significant changes in its actual quarterly or forecasted results may impact the effective tax rate for the current or future periods. In addition, the Corporation will not receive a tax benefit for any future losses as long as it is required to maintain a valuation allowance on its deferred tax assets.  The Corporation will not be able to recognize the tax benefits on current and future losses until it can show that it is more likely than not that it will generate enough taxable income in future periods to realize the benefits of its deferred tax asset and loss carryforwards.





Note 9 – Commitments and Contingencies





Lease Commitments





The Bank leases space for various branches. These leases run for a period ranging from 2 to 10 years and allow for established rent increases each year. Generally, these leases require the Bank to pay all taxes, maintenance and utility costs, as well as maintain certain types of insurance.





Rental expenses charged to operations were approximately $229,000 and $230,000 for the three months ended March 31, 2011 and 2010, respectively.





Loan Commitments





Commitments to extend credit under lines of credit/loans in process are agreements to lend to a customer as long as there is no violation of any condition established in the loan documents. Unfunded commitments totaled $82.5 million at March 31, 2011, and $81.9 million at December 31, 2010.  Commitments generally have fixed maturity dates.  Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if it is deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the borrower. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, other real estate including residential, multifamily and land, and income-producing commercial properties.





Standby letters of credit and financial guarantees written are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. These guarantees are primarily issued to support public and private borrowing arrangements, bond financing, and similar transactions. The Bank underwrites its standby letters of credit using its policies and procedures applicable to loans in general. Standby letters of credit are made on both an unsecured and secured basis. The Bank has not been required to perform on any standby letters of credit or financial guarantees during the past two years.





The Bank did not incur any losses on its commitments for the three months ended March 31, 2011 and 2010.





At March 31, 2011 and December 31, 2010, the following financial instruments with off-balance sheet risk were outstanding:





(Dollars in thousands)

March 31, 2011


December 31, 2010Commitments to grant loans

$
2,015


$
2,100Unfunded commitments under lines of credit/loans in process


82,544



81,868Standby letters of credit and financial guarantees written


1,626



1,576Unused commitments on bankcards


13,500



13,472Total

$
99,685


$
99,016





25


Legal Contingencies





The Corporation is a defendant in various legal proceedings arising in connection with its business. It is the opinion of management that the financial position and the results of operations of the Corporation will not be materially adversely affected by the final outcome of these legal proceedings and will have no material effect on the Corporation’s Consolidated Financial Statements.





Loss Contingencies





The Bank has $50.0 million in repurchase agreements that have provisions allowing the agreements to be terminated by its counterparty. While the Bank has received no indication that the repurchase transactions will be terminated prior to maturity and the transactions are secured by securities pledged to the counterparty, management believes that the likelihood of termination of the agreements is reasonably possible. If these repurchase agreements had been terminated as of March 31, 2011, the termination fee would have been approximately $12.5 million. An additional $75.0 million in repurchase agreements have provisions allowing termination, but these agreements cannot be terminated prior to December 2012, provided the Bank offers the lender additional securities in November and December 2011. Repurchase agreements with this lender totaling $25.0 million and $50.0 million could be terminated in December 2012 and November 2013 respectively.  The termination fee related to these agreements cannot be estimated because the calculation of the estimate requires knowledge of interest rates at the future termination dates in 2012 and 2013.





Significant Concentrations of Credit Risk





Concentration of credit risk is the risk associated with a lack of diversification, such as having substantial loan concentrations in a specific type of loan within the Bank’s loan portfolio, thereby exposing the Bank to greater risks resulting from adverse economic, political, regulatory, geographic, industrial or credit developments. At March 31, 2011, the Bank’s most significant concentration of credit risk was in loans secured by real estate. These loans totaled approximately $847.5 million or 86.5% of the Bank’s total loan portfolio. Real estate construction, including land acquisition and development/land, commercial real estate, multifamily, home equity and residential loans are included in the total loans secured by real estate for purposes of this calculation.  There has been deterioration in the real estate market over the last three years, which has led to an increase in nonperforming loans and the allowance for loan losses.





At March 31, 2011, the Bank’s most significant concentration of credit risk within its investment portfolio was with the U.S. Government, its agencies and Government Sponsored Enterprises. The Bank’s exposure from this source of investment credit risk was $293.4 million or almost 100% of the Bank’s total investment portfolio (including FHLB stock).





Regulatory Examinations





At periodic intervals, the Washington State DFI, the FDIC, and the FRB routinely examine the Corporation’s financial statements as part of their legally prescribed oversight of the banking industry. Based on these examinations, the regulators can direct the Corporation’s financial statements be adjusted in accordance with their findings. As a result of the Bank’s FDIC Order, it is subject to more frequent examinations by regulators.





Note 10 - Stockholders’ Equity





U.S. Treasury Department’s Capital Purchase Program – TARP





On November 21, 2008, the Corporation completed its $39.0 million capital raise as a participant in the U.S. Treasury Department’s CPP. Under the terms of the transaction, the Corporation issued 38,970 shares of Series A Fixed-Rate Cumulative Perpetual Preferred Stock and a warrant to purchase 863,442 shares of the Corporation’s common stock at an exercise price of $6.77 per share.





In determining the value of the Series A Preferred Stock and the attendant warrant from the U.S. Treasury’s CPP, the Corporation apportioned the values using the relative fair value approach. The Corporation computed the present value of the preferred stock at $23.5 million assuming a ten-year life, 5% interest rate for the first five years and 9% for the second five years (the dividend that the Corporation will pay the Treasury). A discount rate of 14% was used as the approximate current cost of capital for the Corporation.





26


The Corporation computed a fair value of the warrants using the Black-Scholes option valuation model. The assumptions in deriving the value were a 34% volatility rate of the Corporation’s common stock, a 2.60% annual dividend rate on the Corporation’s common stock, a 2.75% risk free interest rate, which corresponded to the yield on the five year Treasury note at the time of the issuance, and an assumed life of ten years. The present value of the warrants was computed to be $1.6 million. The present value of the preferred stock represented 93.87% of the combined present value of $25.0 million of the components of the $39.0 million received or $36.6 million. The resulting value for the warrants was 6.13% of the proceeds or $2.4 million.





During the fourth quarter of 2009, FDIC restrictions prohibited dividend payments from the Bank to the holding company, which in turn led the Corporation to defer the dividend on the preferred stock. Under the terms of the preferred stock, deferral of payment is permitted without triggering an event of default. Generally, during any deferral period, the Corporation is prohibited from paying any dividends or distributions on, and may not redeem, purchase or acquire, or make a liquidation payment with respect to the Corporation’s capital stock, or make any payment of principal or interest on, or repay, repurchase or redeem any debt securities of the Corporation that rank pari passu in all respects with, or junior to, the specific instrument. In addition, during any deferral period, dividends on the preferred stock are compounded from the date such dividends would have been payable. As of March 31, 2011, the Corporation has deferred six consecutive dividend payments on the preferred stock.  Under the terms of the Capital Purchase Program, the Treasury can appoint two people of its choice to the board of directors of a corporation that misses six dividend payments.





Restrictions on Dividends





The principal source of the Corporation's revenue is dividends received from the Bank. The payment of dividends is subject to government regulation, in that regulatory authorities may prohibit banks and bank holding companies from paying dividends that would constitute an unsafe or unsound banking practice. In addition, a bank may not pay cash dividends if that payment could reduce the amount of its capital below that necessary to meet minimum applicable regulatory capital requirements. In November 2008, the Corporation issued preferred stock to the U.S. Treasury. As a provision of that issuance, the Corporation cannot increase its current cash dividend without prior approval of the U.S. Treasury for three years or until November 2011.  In June 2009, the Corporation announced that it would temporarily suspend its regular quarterly cash dividend on common stock to preserve capital.





The Bank was notified by the FDIC in late September 2009 that based on an off-site review of its financial information, the Bank, among other restrictions, could not pay a cash dividend to the Corporation unless it obtained a non-objection from the FDIC and the Washington State DFI. The Bank requested a non-objection and was informed orally that the request would be denied. Therefore, the Bank is unable to pay a cash dividend to the Corporation. Dividends from the Bank are the Corporation’s primary source of cash. In addition, the FDIC Order discussed in Note 2 prevents the Bank from paying any cash dividends to its stockholder without prior written approval from the regulators.





27


Regulatory Capital





Under a Consent Order with the FDIC and Washington State DFI, the Bank’s regulators directed the Bank to increase its overall capital levels and, in particular, required the Bank to increase its Tier 1 leverage capital to 10% of the Bank’s average total assets and total risk based capital to 12% of the Bank’s risk weighted assets by November 18, 2010. The Bank is considered “undercapitalized” under the regulatory framework for prompt corrective action and has not met the required capital ratios provided in its FDIC Order, but the Board of Directors is working diligently to comply with these requirements.





(Dollars in thousands)



Cascade Bank

Actual


Minimum

Requirements

For Capital

Adequacy


Well-Capitalized

RequirementsMarch 31, 2011:Total risk-based capital to risk-weighted assets

$
95,160



9.56
%

$
79,639



8.00
%

$
99,549



10.00
%Tier I (core) capital to risk-weighted assets


82,551



8.29



39,820



4.00



59,729



6.00Tier I (core) capital to average total assets


82,551



5.61



58,864



4.00



73,580



5.00December 31, 2010:Total risk-based capital to risk-weighted assets

$
97,456



9.60
%

$
81,213



8.00
%

$
101,516



10.00
%Tier I (core) capital to risk-weighted assets


84,600



8.33



40,606



4.00



60,910



6.00Tier I (core) capital to average total assets


84,600



5.56



60,902



4.00



76,128



5.00





The Corporation, as a bank holding company regulated by the FRB, is also subject to capital requirements that are similar to those for Cascade Bank.





(Dollars in thousands)



Cascade Financial Corporation

Actual


Minimum

Requirements

For Capital

Adequacy


Well-Capitalized

RequirementsMarch 31, 2011:Total risk-based capital to risk-weighted assets

$
97,841



9.83
%

$
79,592



8.00
%

$
99,490



10.00
%Tier I (core) capital to risk-weighted assets


80,379



8.08



39,796



4.00



59,694



6.00Tier I (core) capital to average total assets


80,379



5.46



58,893



4.00



73,617



5.00December 31, 2010:Total risk-based capital to risk-weighted assets

$
101,209



9.98
%

$
81,149



8.00
%

$
101,437



10.00
%Tier I (core) capital to risk-weighted assets


84,556



8.34



40,574



4.00



60,862



6.00Tier I (core) capital to average total assets


84,556



5.55



60,958



4.00



76,197



5.00





28


Note 11 - Stock-based Compensation





Compensation expense related to stock-based compensation was $10,000 and $16,000 for the three months ended March 31, 2011 and 2010, respectively. This expense is the result of the vesting of stock options previously granted but unexercised.  No stock options were granted in the three months ended March 31, 2011.





Changes in total options outstanding for the three months ended March 31, 2011, are as follows:





Options


Weighted-Average

Exercise

Price per Share


Weighted-Average

Remaining

Contractual

Term (in years)


Aggregate

Intrinsic ValueOutstanding on December 31, 2010


496,209


$
10.50



3.19


$
-Granted


-



-Exercised


-



-Forfeited/canceled


119,026



4.87Outstanding on March 31, 2011


377,183


$
12.28



3.86


$
-Exercisable on March 31, 2011


338,993


$
12.23



3.51


$
-





The unrecognized share-based compensation cost on unvested options at March 31, 2011 was $33,577, which will be recognized over the remaining average requisite service period of the options which is approximately two years.





Options were granted to certain employees and directors at prices equal to the market value of the stock at the close of trading on the dates the options were granted. The options granted have a term of ten years from the grant date. Incentive stock options granted to employees vest over a five-year period. Non-qualified options granted to directors vest over a four-year period. Compensation expense is recorded as if each vesting portion of the award is a separate award. The Bank has estimated the fair value of all stock option awards as of the date of the grant by applying a Black-Scholes option pricing valuation model. The application of this valuation model involves assumptions that are judgmental and sensitive in the determination of compensation expense. The total options authorized at March 31, 2011 were 919,912.





The Bank uses historical information for its key assumptions. Historical information is the primary basis for the selection of the expected volatility, projected dividend yield and expected lives of the options. The Bank has collected a long history of option activity and believes that this historical information presents the best basis for future projections related to expected term. The risk-free interest rate was selected based upon U.S. Treasury issues with a term equal to the expected life of the option being valued at the time of the grant.





The Bank is required to recognize stock-based compensation for the number of awards that are expected to vest. As a result, for most awards, recognized stock compensation expense was reduced by estimated forfeitures primarily based on historical forfeiture rates.





The Bank has maintained an Employee Stock Purchase Plan (ESPP) under the terms of which 213,212 shares of common stock were authorized for issuance. In July 2010, the final 54,309 shares were issued to employees participating in the ESPP.  The plan allowed employees of the Bank with three months of service the opportunity to purchase common stock through accumulated salary deductions during each offering period. On the first day of each six-month offering period (January 1 and July 1 of each year), eligible employees who elected to participate were granted options to purchase a limited number of shares and unless the participant withdrew from the plan, the option was effectively exercised on the last day of each offering period. The aggregate number of shares to be purchased in any given offering was determined by dividing the accumulated salary deduction for the period by the lower of 85% of the market price of a common share at the beginning or end of an offering period.  The ESPP permitted for shares to be purchased in the open market or new shares could be issued from the Bank’s authorized but unissued shares. All of the final 54,309 shares issued in July 2010 were purchased on the open market.





29


Note 12 – Loss per Common Share





The following table presents loss per common share information:





Three Months Ended March 31,(Dollars in thousands)

2011


2010Net loss

$
(2,647
)

$
(32,139
)Dividends on preferred stock


522



499Accretion of issuance discount on preferred stock


119



112Net loss attributable to common stockholders

$
(3,288
)

$
(32,750
)Weighted average number of common shares outstanding, basic


12,271,529



12,165,167Weighted average number of common shares outstanding, diluted


12,271,529



12,165,167Loss per common share, basic

$
(0.27
)

$
(2.69
)Loss per common share, diluted


(0.27
)


(2.69
)





For purposes of calculating basic and diluted loss per common share, the numerator of net loss attributable to common stockholders is the same. There were outstanding options to purchase 377,183 and 586,772 shares of common stock at March 31, 2011 and 2010, respectively, which are considered anti-dilutive and have been excluded from the above calculation. Anti-dilutive options have an exercise price that is greater than the current market price of the stock. Also, as of March 31, 2011 and 2010, the warrant issued to the U.S. Treasury to purchase up to 863,442 shares of common stock was not included in the computation of diluted loss per common share because the warrant’s exercise price was greater than the average market price of common shares.





Note 13 - Fair Value Measurements





Financial Instruments





The fair value estimates presented below are subjective in nature, involve uncertainties and matters of significant judgment and, therefore, are not necessarily indicative of the amounts the Corporation could realize in a current market exchange. The Corporation has not included certain material items in its disclosure, such as the value of the long-term relationships with the Corporation’s lending and deposit customers, since this is an intangible and not a financial instrument. Additionally, the estimates do not include any tax ramifications. There may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, that could materially affect the results. For all of these reasons, the aggregation of the fair value calculations presented herein do not represent, and should not be construed to represent, the underlying value of the Corporation.





30


The following table presents a summary of the fair value of the Corporation’s financial instruments:





March 31, 2011


December 31, 2010(Dollars in thousands)

Carrying Value


Estimated Fair Value


Carrying Value


Estimated Fair ValueFinancial assets:Cash and cashequivalents

$
113,280


$
113,280


$
131,335


$
131,335Securities available-for-sale


232,277



232,277



234,606



234,606Securities held-to-maturity


52,419



51,058



53,912



53,068FHLB stock


11,920



11,920



11,920



11,920Cash surrender value of BOLI, net


25,736



25,736



25,489



25,489Loans, net


950,483



910,107



967,661



932,932Interest rate caps


9,042



9,042



8,732



8,732Financial liabilities:Deposit accounts

$
1,069,087


$
1,051,512


$
1,107,554


$
1,095,089FHLB advances


159,000



187,744



159,000



187,087Securities sold under agreements to repurchase


145,000



176,227



145,000



179,450Junior subordinated debentures


15,465



2,715



15,465



2,715Junior subordinated debentures, fair value


1,500



1,500



1,500



1,500





Cash and Cash Equivalents.The carrying amount represents fair value.





Investment securities.Fair values are based on quoted market prices or dealer quotations when available or through the use of alternate approaches, such as matrix or model pricing, when market quotes are not readily available.





FHLB Stock.The Bank’s investment in FHLB stock is carried at par value ($100 per share), which approximates its fair value.





Cash Surrender Value of BOLI.The carrying amount of BOLI approximates its fair value, net of any surrender charges. Fair value of BOLI is estimated using the cash surrender value.





Loans.Fair values are estimated using current market interest rates to discount future cash flows for each of the different loan types. Interest rates used to discount the cash flows are based on published current market rates for similar products. Prepayment rates are based on expected future prepayment rates, or, where appropriate and available, market prepayment rates. Fair value for loans is reduced by the allowance for loan losses as a credit adjustment. The majority of impaired loans are individually analyzed each quarter for impairment and impairments are included with the credit adjustment factor. A liquidity and marketability adjustment is also used to adjust the fair value of loans.  This factor discounts loans based upon type of loan and current loan classifications.





Deposits.The fair value of deposits with no stated maturity, such as checking accounts, money market deposit accounts and savings accounts, equals the amount payable on demand plus a premium based on current interest rates. The fair value of certificates of deposits is calculated based on the discounted value of contractual cash flows. The discount rate is equal to the market rate currently offered on similar products.





FHLB advances and securities sold under agreements to repurchase.The fair value is calculated based on market price quotations and confirmed with the discounted cash flow method, adjusted for market interest rates and terms to maturity.





Junior Subordinated Debentures.The fair value is calculated based on the discounted cash flow method, adjusted for market interest rates, terms to maturity, credit and liquidity risk.





Junior Subordinated Debentures, at fair value.The Corporation determines the fair value by using a discounted cash flow model.  The discount rate is determined using a risk free interest rate approximating the remaining maturity of the debentures combined with a credit and liquidity spread determined based upon quotes from brokers and from valuations by holders of Cascade Capital Trust I, which were obtained from public filings. The bonds are assumed to be outstanding until maturity.





31


Off-balance-sheet financial instruments.Commitments to extend credit, standby letters of credit and financial guarantees represent the principal categories of off-balance instruments. The fair value of these commitments is not considered material because they are for a short period of time and subject to customary credit terms.





Financial Assets and Liabilities Carried at Fair Value on a Recurring and Non-recurring Basis





Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date. It also establishes a consistent framework for measuring fair value and expands disclosure requirements about fair value measurements. In determining fair value, the Bank maximizes the use of observable inputs and minimizes the use of unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Bank’s estimates for market assumptions.





Valuation inputs refer to the assumptions market participants would use in pricing a given asset or liability using one of the three valuation techniques. Inputs can be observable or unobservable. Observable inputs are those assumptions that market participants would use in pricing the particular asset or liability. These inputs are based on market data and are obtained from a source independent of the Bank. Unobservable inputs are assumptions based on the Bank’s own information or estimate of assumptions used by market participants in pricing the asset or liability. Unobservable inputs are based on the best and most current information available on the measurement date.




All inputs, whether observable or unobservable, are ranked in accordance with a prescribed fair value hierarchy that gives the highest ranking to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1) and the lowest ranking to unobservable inputs (Level 3). Fair values for assets or liabilities classified as Level 2 are based on one or a combination of the following factors: (i) quoted prices for similar assets; (ii) observable inputs for the asset or liability, such as interest rates or yield curves; or (iii) inputs derived principally from or corroborated by observable market data.





Available-for-sale securities are priced using matrix pricing based on the securities’ relationship to other benchmark quoted prices (Level 2). Inputs to the valuation methodology include quoted prices for similar assets in active markets that are observable for the asset.





The Corporation applied fair value accounting to the junior subordinated debentures issued by Cascade Capital Trust I.  The change in fair market value of the junior subordinated debentures is recorded as a component of other income. The Corporation determines the fair value by using a discounted cash flow model.  The discount rate is determined using a risk free interest rate approximating the remaining maturity of the debentures combined with a credit and liquidity spread determined based upon quotes from brokers and from valuations by holders of Cascade Capital Trust I, which were obtained from public filings. The bonds are assumed to be outstanding until maturity.  For the quarter ended March 31, 2011, there was no change in the fair value of the junior subordinated debentures. The fair value was $1.5 million at March 31, 2011 and December 31, 2010. The fair value option was not selected for the junior subordinated debentures issued in connection with Cascade Capital Trust II and III, which are reported at the combined book value of $15.5 million.





Fair values of impaired collateral dependent loans are sometimes recorded to reflect partial write-downs based on the current appraised value of the collateral or internally developed models, which contain management’s assumptions concerning the amount and timing of the cash flows associated with that loan.





Real estate owned and other repossessed assets are recorded at the lower of the carrying amount of the loan or fair value less selling costs at the time of acquisition. Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan losses. After foreclosure, management periodically performs valuations such that the real estate is carried at the lower of its new cost basis or fair value, net of estimated costs to sell.





32


There were no transfers between fair value categories during the three months ended March 31, 2011. The following table presents the balances of assets and liabilities measured at fair value on a recurring basis at March 31, 2011 and December 31, 2010:





Fair Value at March 31, 2011(Dollars in thousands)

Level 1


Level 2


Level 3


TotalAssetsMortgage-backed securities

$
-


$
65,692


$
-


$
65,692Agency notes & bonds


-



110,351



-



110,351U.S. Treasury notes


-



56,234



-



56,234Interest rate caps


-



9,042



-



9,042Total

$
-


$
241,319


$
-


$
241,319LiabilitiesJunior subordinated debentures

$
-


$
-


$
1,500


$
1,500Total

$
-


$
-


$
1,500


$
1,500





Fair Value at December 31, 2010(Dollars in thousands)

Level 1


Level 2


Level 3


TotalAssetsMortgage-backed securities

$
-


$
67,203


$
-


$
67,203Agency notes & bonds


-



111,119



-



111,119U.S. Treasury notes


-



56,284



-



56,284Interest rate caps


-



8,732



-



8,732Total

$
-


$
243,338


$
-


$
243,338LiabilitiesJunior subordinated debentures

$
-


$
-


$
1,500


$
1,500Total

$
-


$
-


$
1,500


$
1,500





The change in fair market value of the junior subordinated debentures is recorded as a component of non-operating income. The following table presents the fair value adjustments for the junior subordinated debentures, which use significant unobservable inputs (Level 3) for the periods presented:




Fair Value Measurements UsingSignificant Unobservable Inputs(Level 3)Three Months EndedMarch 31,(Dollars in thousands)

2011


2010Beginning balance

$
1,500


$
3,341Total gains recognized


-



-Ending balance

$
1,500


$
3,341


The following table presents the balance of assets measured at fair value on a nonrecurring basis at March 31, 2011 and December 31, 2010:





Fair Value at March 31, 2011(Dollars in thousands)

Level 1


Level 2


Level 3


Total (1)Impaired loans

$
-


$
-


$
117,312


$
117,312REO


-



-



32,311



32,311Total

$
-


$
-


$
149,623


$
149,623





33




Fair Value at December 31, 2010(Dollars in thousands)

Level 1


Level 2


Level 3


Total (1)Impaired loans

$
-


$
-


$
138,198


$
138,198REO


-



-



34,412



34,412Total

$
-


$
-


$
172,610


$
172,610





(1)
Impaired loans include loans on nonaccrual, classified doubtful and/or individually analyzed for impairment, adjusted by the impairment amount. REO is disclosed at the year-end book balance.





The following table presents the total losses resulting from nonrecurring fair value adjustments for the periods presented:





Three Months Ended

March 31,(Dollars in thousands)

2011


2010Impaired loans(1)

$
8,321


$
28,544REO(2)


2,272



698Total

$
10,593


$
29,242





(1)
Total losses for loans includes the actual impairment amount, plus the allowance for loan loss write downs during the period for those loans considered impaired at March 31, 2011 and 2010.


(2)
Losses for REO are the net losses recognized during the period.




Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations





The following discussion is intended to assist in understanding the financial condition and results of the Corporation’s operations. The information contained in this section should be read with the unaudited Condensed Consolidated Financial Statements and accompanying notes included in this Quarterly Report, and the December 31, 2010 audited Consolidated Financial Statements and accompanying notes included in our recent Annual Report on Form 10-K.





Forward Looking Statements





This report includes forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and subject to the safe harbor created by the Private Securities Litigation Reform Act of 1995, that are subject to risks and uncertainties that could cause actual results to differ materially from those projected.  These statements may be identified by the use of forward-looking terminology such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “potential,” “predict,” “should” or “will” or the negative thereof or other variations thereon or comparable terminology. We have based these forward-looking statements on our current expectations, assumptions, estimates and projections. While we believe these expectations, assumptions, estimates and projections are reasonable, such forward-looking statements are only predictions and involve known and unknown risks and uncertainties, many of which are beyond our control. These and other important factors, including those discussed below under the headings “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” may cause our actual results, performance or achievements to differ materially from any future results, performance or achievements expressed or implied by these forward-looking statements. Some of the key factors that could cause actual results to differ from our expectations are:





·
management’s ability to raise capital to meet regulatory requirements and fund future operations;


·
management’s ability to effectively execute its business plan and strategy;


·
the credit risks of lending activities, including changes in the level and trend of loan delinquencies, collections and write-offs and changes in our allowance for loan losses and provision for loan losses that may be impacted by deterioration in the housing and commercial real estate markets;


·
changes in general economic conditions, either nationally or in our market areas;


·
the availability of and costs associated with sources of liquidity;


·
inflation, interest rates, market and monetary fluctuations;


·
legislative or regulatory changes or changes in accounting principles, policies or guidelines;




34




·
the possibility that we will be unable to comply with certain conditions imposed upon us in regulatory actions, which could result in the imposition of further restrictions on our operations, penalties or other regulatory actions;


·
the costs and effects of legal and regulatory developments, including the resolution of legal proceedings or regulatory or other governmental inquiries and the results of regulatory examinations or reviews;


·
our ability to attract and retain deposits;


·
further increases in premiums for deposit insurance;


·
the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation;


·
our success at managing the risks involved in the foregoing; and


·
other risks which may be described in the Corporation’s future filings with the SEC under the Securities Exchange Act of 1934.





Given these risks and uncertainties, you are cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements included or incorporated by reference into this report are made only as of the date hereof. We do not undertake and specifically decline any obligation to update any such statements or to publicly announce the results of any revisions to any such statements to reflect future events or developments.  In addition, we may make certain statements in future Securities and Exchange Commission (SEC) filings, in press releases and in oral and written statements that are not statements of historical fact and may constitute forward-looking statements.





General





Cascade Financial Corporation (CFC or the Corporation) is a bank holding company incorporated in the state of Washington in 2003. At March 31, 2011, the Corporation’s wholly-owned subsidiaries were Cascade Bank (Cascade Bank or the Bank), and Cascade Capital Trusts I, II, and III, formed to hold trust preferred securities. Colby R.E., LLC, a subsidiary of the Bank, was incorporated in March 2009 and 2011 Yale Avenue East, LLC, a subsidiary of Colby R.E., LLC, was incorporated in May 2010.  Both were formed to acquire, manage and sell properties taken in foreclosure (REO properties). The executive offices of the Corporation are located at 2828 Colby Avenue, Everett, Washington, 98201. The telephone number is (425) 339-5500 and the website is www.cascadebank.com. Information on the website is not part of this report





The Bank has been serving the Puget Sound region since 1916 when it was organized as a mutual savings and loan association. On September 15, 1992, the Bank completed its conversion from a federal mutual to a federal stock savings bank. In July 2001, the Bank converted from a federal stock savings bank to a Washington state commercial bank.





The Corporation was organized on August 18, 1994, for the purpose of becoming the holding company for Cascade Bank. The reorganization was completed on November 30, 1994, on which date the Bank became the wholly-owned subsidiary of the Corporation, and the stockholders of the Bank became stockholders of the Corporation. Subsequent to this date, the primary activity of the Corporation has been holding the stock of the Bank. Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank.





The Corporation conducts its business from its main office in Everett, Washington, and 21 other full-service offices in the greater Puget Sound region. At March 31, 2011, the Corporation had total assets of $1.5 billion, total deposits of $1.1 billion and total equity of $54.6 million.





The Bank, a full-service commercial bank, offers a wide range of products and services. The deposits of the Bank are insured by the Federal Deposit Insurance Corporation (FDIC), up to the limits specified by law.





Recent Events





Regulatory Actions and Capital Raising Efforts





The Corporation and the Bank are subject to pending regulatory actions, including an FDIC Order and a FRB Agreement, restricting our businesses and operations, and requiring us to raise additional capital. See “Stockholders’ Equity and Regulatory Matters.”




35


As of March 31, 2011, Cascade Bank required approximately $65.0 million in new capital to meet the minimum Tier 1 leverage ratio requirement of 10% under the FDIC Order. Since late 2009, CFC’s Board of Directors and management team have been reviewing alternatives to improve the bank’s capital position with the assistance of its financial advisor, Sandler O’Neill + Partners LP, a nationally recognized investment banking firm and expert in the banking industry. As part of its review, the Board considered a range of alternatives including potential capital infusions from private investors and financial institutions, strategic combinations and private equity transactions, and actively solicited offers from potential investors and acquirers.





Proposed Merger





On March 4, 2011, the Corporation announced that it had entered into an agreement and plan of reorganization with Opus Bank, a California state-chartered bank.  The terms of this agreement provide for Opus Bank to acquire the Corporation and the Bank, and for the merger of the Bank into Opus Bank. The merger agreement with Opus Bank was unanimously approved by the Boards of Directors of the Corporation, the Bank and Opus Bank





Under the terms of the merger agreement, the Corporation’s common shareholders will receive an amount in cash of approximately $0.45 per share, which values the transaction at $5.5 million.  In addition, Opus Bank has offered to purchase the $39.0 million of the Corporation’s preferred stock and the associated warrant issued to the U.S. Department of the Treasury (the Treasury) under the Capital Purchase Program for $16.25 million in cash.  The Treasury has indicated its willingness to agree to sell the Corporation’s preferred stock and warrant for such cash consideration subject to the entry into definitive documentation acceptable to the Treasury in its sole discretion.  Opus also agreed to assume our $25.8 million of obligations with respect to the trust preferred securities issued by the Corporation’s trust subsidiaries.  Consummation of the merger is subject to approval by regulatory authorities, approval by the shareholders of the Corporation at a special meeting of shareholders to be held on May 31, 2011, and certain other conditions set forth in the merger agreement. The merger is expected to close in the latter part of the second quarter of 2011.  Notwithstanding this, there are no assurances that the Corporation, the Bank and Opus Bank will be able to successfully close the proposed merger.





Financial Overview





For the three months ended March 31, 2011, we had a net loss attributable to common stockholders of $3.3 million, or $0.27 per diluted common share, compared to $32.8 million, or $2.69 per diluted common share for the three months ended March 31, 2010.





Net interest income for the three months ended March 31, 2011 was $8.8 million, compared to $9.7 million for the three months ended March 31, 2010.  Other income was $1.8 million for the three months ended March 31, 2011, compared to $1.9 million for the three months ended March 31, 2010.  For the three months ended March 31, 2011, total other expenses increased to $10.7 million compared to $9.2 million for the three months ended March 31, 2010.  The increase was largely due to a $1.6 million increase in write-downs/losses on sales of REO.





Outlook for 2011





We face a variety of significant financial and operating challenges in 2011.  These include taking all necessary actions to comply with the regulatory orders we are operating under, specifically raising capital, improving credit quality, and returning to profitability. We continue to take an aggressive stance in addressing credit issues in our loan portfolio to minimize future risks. Since 2008 we have had a Special Assets team in place to focus on managing and reducing nonperforming loans and REO properties. While we have seen progress in reducing the level of nonperforming assets, credit quality will remain an issue as long as current economic trends, including high unemployment rates and depressed real estate prices, continue.




We expect our loan portfolio balance to level off during the remaining quarters of 2011. However, we must still face the challenges of the current economic environment and flat loan demand, which will make it difficult for us to maintain our current loan portfolio balance as our existing credits pay down. Currently, we expect that interest rates will remain flat for the remainder of 2011. We based our 2011 projections, budgets and goals on these expectations. If these trends move differently than expected in either direction or speed, they could have a material impact on our financial condition and results of operations. The areas of our operations most directly impacted would be the net interest margin, loan and deposit growth and the provision for loan losses.




36


We will also continue our efforts to control noninterest expenses by working to achieve maximum efficiencies within our franchise. However, our noninterest expenses for 2011 will continue to be negatively affected by costs associated with higher business insurance expense, REO expense associated with the management and disposition of real estate properties acquired through foreclosure and increased FDIC insurance premiums.




The information contained in this section should be read in conjunction with the Consolidated Financial Statements and accompanying Notes to the Condensed Consolidated Financial Statements of this report.





Critical Accounting Policies and Estimates





The Corporation’s significant accounting policies and estimates are essential to understanding Management's Discussion and Analysis of Financial Condition and Results of Operations. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions, which affect the reported amounts and disclosures. Changes in these estimates and assumptions are considered reasonably possible and may have a material impact on the consolidated financial statements and thus actual results could differ from the amounts reported and disclosed herein. The following policies involve a higher degree of judgment than do our other significant accounting policies detailed in Note 1 of the Notes to the Condensed Consolidated Financial Statements.




Material estimates particularly susceptible to significant change relate to the assessment of impaired assets, the determination of the allowance for loan losses, deferred income taxes, fair value measurements and valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowance for loan losses and the valuation of foreclosed assets held for sale, management obtains independent appraisals for significant properties.





Investment Securities





Debt and equity securities, including mortgage-backed securities (MBS), may be classified as available-for-sale or held-to-maturity. Securities available-for-sale are carried at fair value, with unrealized gains and losses reported as a component of other comprehensive (loss) income. Investment securities held-to-maturity are carried at amortized cost or principal balance, adjusted for amortization of premiums and accretion of discounts. Amortization of premiums and accretion of discounts are calculated using a method that approximates the level yield method. The Bank has the ability, and it is management’s positive intention, to hold held-to-maturity securities until maturity. Investments with fair values that are less than the amortized cost are considered impaired. Impairment may result from either a decline in the financial condition of the issuing entity or, in the case of fixed interest rate investments, from rising interest rates. Management reviews investment securities on an ongoing basis for the presence of other-than-temporary-impairment (OTTI) or permanent impairment, taking into consideration current market conditions; fair value in relationship to cost; extent and nature of the change in fair value; issuer rating changes and trends; whether management intends to sell a security or if it is likely that the Bank will be required to sell the security before recovery of the amortized cost basis of the investment, which may be upon maturity; and other factors. For debt securities, if management intends to sell the security or it is likely that the Bank will be required to sell the security before recovering its cost basis, the entire impairment loss would be recognized in earnings as an OTTI. If management does not intend to sell the security and it is not likely that the Bank will be required to sell the security, but management does not expect to recover the entire amortized cost basis of the security, only the portion of the impairment loss representing credit losses would be recognized in earnings. The credit loss on a security is measured as the difference between the amortized cost basis and the present value of the cash flows expected to be collected. Projected cash flows are discounted by the original or current effective interest rate depending on the nature of the security being measured for potential OTTI. The remaining impairment related to all other factors (i.e. the difference between the present value of the cash flows expected to be collected and fair value) is recognized as a charge to other comprehensive income. Impairment losses related to all other factors are presented as separate categories within other comprehensive income. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.





Allowance for Loan Losses





The allowance for loan losses is the amount which, in the opinion of management, is necessary to absorb future probable loan losses.  Management’s determination of the level of the provision for loan losses is based on various judgments and assumptions, including general economic conditions, loan portfolio composition, prior loan loss experience, the evaluation of credit risk related to specific credits and market segments and monitoring results from our ongoing internal credit review staff.  Subsequent recoveries, if any, are credited to the allowance.





37


Management and the Board review policies and procedures at least annually, and changes are made to reflect the current operating environment integrated with regulatory requirements.  Partly out of these policies has evolved an internal credit risk review process.  During this process, the quality grades of loans are reviewed and loans are assigned a dollar value of the loan loss reserve by degree of risk.  This analysis is performed quarterly and reviewed by senior management who makes the determination if the risk is reasonable and if the reserve is adequate.   This quarterly analysis is then reviewed by the Board of Directors.





Management determines the amount of the allowance for loan losses by utilizing a loan quality grading system to determine risk in the loan portfolio. The allowance consists of general and specific components.  When loans are originated, they are assigned a risk rating that is reassessed periodically during the term of the loan through the Bank’s credit review process. The Bank’s loan quality grading methodology assigns a loan quality grade from 1 to 10, where a higher numerical rating represents higher risk. These loan quality-rating categories are a primary factor in determining an appropriate amount for the allowance for loan losses. The loan portfolio is separated by loan type and then by risk rating. Loans not considered impaired are evaluated as a group, by loan type, with a loss rate based on average historical losses and adjusted for qualitative (Q) factors. The Q factors include regional/local economic trends, the health of the real estate market, loan and collateral concentrations, size of borrowing relationships, trends in loan delinquencies and charge-offs and changes in loan classifications and are included in the Bank’s analysis of the allowance for loan losses. Allocations for Q factors are based upon management’s review of each of the factors and are applied to all loans included in the general valuation component of the allowance. The Q factors augment the historical loss factors utilized in assessing the allowance to reflect the potential losses embedded in the loan portfolio as real estate property values have declined and sales have slowed. After reviewing all historical and qualitative factors by loan type, management may add a management judgment factor to certain loan types if there are additional concerns in these portfolios that were not identified by using historical or other qualitative factors. Management may also include a negative adjustment to the allowance factor for certain loan types if analysis shows that the historical allowance factor overstates the allocated reserve due to the financial strength of the borrowers/guarantors, the collateral position or other factors in the related portfolio.




Management believes that the allowance for loan losses was adequate as of March 31, 2011. There is, however, no assurance that future loan losses will not exceed the levels provided for in the allowance for loan losses and could possibly result in additional charges to the provision for loan losses.





Real Estate Owned (REO)





Real estate owned includes real estate acquired in settlement of loans. Real estate owned is recorded at the lower of carrying amount or fair value, based upon an appraisal, less estimated costs to sell. Developments and improvements related to the property are capitalized. Any losses recorded at the time a foreclosure occurs are classified as a charge-off against the allowance for loan losses. Losses that result from the ongoing periodic valuation of these properties, are charged to expense in the period identified. Revenue and expenses from operations and subsequent adjustments to the carrying amount of the property are included in noninterest expense in the statement of operations.





Income Taxes





The Corporation accounts for income taxes as required by FASB ASC Topic 740, Accounting for Income Taxes, under the liability method, which requires recognition of deferred tax assets and liabilities for the expected future income tax consequences of transactions that have been included in the Consolidated Financial Statements. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. A valuation allowance is required on deferred tax assets if it is “more likely than not” that the deferred tax asset will not be realized. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. These calculations are based on many complex factors including estimates of the timing of reversals of temporary differences, the interpretation of federal income tax laws, and a determination of the differences between the tax and the financial reporting basis of assets and liabilities. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax liabilities.





38


Fair Value Measurements





Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date. ASU 2010-06, Fair Value Measurements and Disclosures(Topic 820) – Improving Disclosures about Fair Value Measurements(ASU 10-06) establishes a consistent framework for measuring fair value and expands disclosure requirements about fair value measurements. In determining fair value, the Bank maximizes the use of observable inputs and minimizes the use of unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Bank’s estimates for market assumptions.





Valuation inputs refer to the assumptions market participants would use in pricing a given asset or liability using one of the three valuation techniques. Inputs can be observable or unobservable. Observable inputs are those assumptions that market participants would use in pricing the particular asset or liability. These inputs are based on market data and are obtained from a source independent of the Bank. Unobservable inputs are assumptions based on the Bank’s own information or estimate of assumptions used by market participants in pricing the asset or liability. Unobservable inputs are based on the best and most current information available on the measurement date.





All inputs, whether observable or unobservable, are ranked in accordance with a prescribed fair value hierarchy that gives the highest ranking to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1) and the lowest ranking to unobservable inputs (Level 3). Fair values for assets or liabilities classified as Level 2 are based on one or a combination of the following factors: (i) quoted prices for similar assets; (ii) observable inputs for the asset or liability, such as interest rates or yield curves; or (iii) inputs derived principally from, or corroborated by, observable market data.





Selected Financial Data





The following table sets forth certain selected financial data concerning the Corporation for the periods indicated:





At or For the

Three Months Ended

March 31,2011


2010Return on average assets (1)(2)


(0.91
)%


(7.74
)%Return on average stockholders’ common equity (1)(2)


(63.77
)


(137.53
)Average stockholders’ equity to average assets


3.97



7.79Other expenses to average assets (1)


2.96



2.18Efficiency ratio


100.91



79.64(1) Annualized

(2) Excludes preferred stock.





39


Financial Condition





Assets





The Corporation’s total assets at March 31, 2011, remained relatively unchanged at $­­­­1.5 billion compared to December 31, 2010.





Investment Securities





Total securities, including FHLB stock, decreased by $3.8 million to $296.6 million as of March 31, 2011, compared to December 31, 2010.  Securities designated as available-for-sale decreased to $232.3 million at March 31, 2011, versus $234.6 million at December 31, 2010. Securities designated as held-to-maturity decreased to $52.4 million at March  31, 2011, from $53.9 million at December 31, 2010. The securities in both portfolios consist of notes issued by Government Sponsored Enterprises (i.e. Federal Home Loan Bank (FHLB), Fannie Mae (FNMA), Freddie Mac (FHLMC) or mortgage-backed securities issued by FNMA, FHLMC, or Ginnie Mae). There were no investment securities that were backed by subprime loans and all investments received the highest credit rating from at least one of the major rating agencies.





The following table presents the amortized cost and fair value of available-for-sale and held-to-maturity securities at the dates indicated:





March 31, 2011(Dollars in thousands)

Amortized

Cost


Gross

Unrealized

Gains


Gross

Unrealized

Losses


Fair

ValueSecurities available-for-saleMortgage-backed securities

$
68,928


$
11


$
(3,247
)

$
65,692Agency notes & bonds


116,633



-



(6,282
)


110,351US treasury notes


56,316



43



(125
)


56,234Total

$
241,877


$
54


$
(9,654
)

$
232,277Securities held-to-maturityMortgage-backed securities

$
23,644


$
601


$
(440
)

$
23,805Agency notes & bonds


28,000



-



(1,522
)


26,478Other


775



-



-



775Total

$
52,419


$
601


$
(1,962
)

$
51,058





December 31, 2010(Dollars in thousands)

Amortized

Cost


Gross

Unrealized

Gains


Gross

Unrealized

Losses


Fair

ValueSecurities available-for-saleMortgage-backed securities

$
70,270


$
10


$
(3,077
)

$
67,203Agency notes & bonds


116,632



-



(5,513
)


111,119US treasury notes


56,346



-



(62
)


56,284Total

$
243,248


$
10


$
(8,652
)

$
234,606Securities held-to-maturityMortgage-backed securities

$
25,137


$
755


$
(383
)

$
25,509Agency notes & bonds


28,000



-



(1,216
)


26,784Other


775



-



-



775Total

$
53,912


$
755


$
(1,599
)

$
53,068








40





Certain securities at March 31, 2011 shown above currently have fair values less than amortized cost, and therefore, contain unrealized losses. Available-for-sale securities had unrealized losses of $9.7 million and held-to-maturity securities had unrealized losses of $2.0 million. In the opinion of management, these securities are considered only temporarily impaired due to changes in market interest rates and/or the widening of market spreads subsequent to the initial purchase of the securities or to disruptions to credit markets. Since all these securities are rated AAA, this temporary impairment is not due to concerns regarding the underlying credit of the issuers or the underlying collateral.  The Corporation does not intend to sell the securities nor does it anticipate being required to sell these securities.





Federal Home Loan Bank Stock.The Bank’s investment in Federal Home Loan Bank (FHLB) of Seattle stock is carried at par value ($100 per share) and does not have a readily determinable fair value. Ownership of FHLB stock is restricted to FHLB member institutions and can only be purchased and redeemed at par. As a member of the FHLB system, the Bank is required to maintain a minimum level of investment in FHLB stock, based on specified percentages of its outstanding FHLB advances. The Bank may request redemption at par value of any stock in excess of the amount the Bank is required to hold. Stock redemptions are at the discretion of the FHLB. At March 31, 2011, the Bank had 119,203 shares of FHLB stock.





The Bank evaluates FHLB stock for impairment. The determination of whether FHLB stock is impaired is based on an assessment of the ultimate recoverability of cost rather than declines in the book value of the shares. The determination of whether a decline affects the ultimate recoverability of cost is influenced by criteria such as: (1) the significance of any decline in net assets of the FHLB as compared to the capital stock amount for the FHLB and the length of time this situation has persisted, (2) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB, (3) the impact of legislative and regulatory changes on institutions and, accordingly, the customer base of the FHLB and (4) the liquidity position of the FHLB.





Based upon an analysis by Standard and Poors regarding the Federal Home Loan Banks, they stated that the FHLB System has a special public status (organized under the Federal Home Loan Bank Act of 1932) and because of the extraordinary support offered to it by the U.S. Treasury in a crisis, (though not used), the FHLB System can be considered an extension of the government. The U.S. government would almost certainly support the credit obligations of the FHLB System. The Bank has determined there is no impairment of the FHLB stock investment as of March 31, 2011.




In October 2010, the FHLB of Seattle entered into a Stipulation and Consent to the Issuance of a Consent Order with the Federal Housing Finance Agency (FHFA). The Stipulation and Consent provides that the FHLB agrees to a Consent Order issued by the FHFA, which requires the FHLB to take certain specified actions related to its business and operations (the Stipulation and Consent and the Consent Order are collectively referred to as the Consents). The Consents and related understandings with the FHFA constitute the FHLB's capital restoration plan and fulfill the FHFA's April 19, 2010, request of the FHLB for a business plan.





The Consents provide that, following a stabilization period (from the date of the Consent Order through the filing of the FHLB's second quarter 2011 quarterly report on Form 10-Q with the Securities and Exchange Commission) and once the FHLB reaches and maintains certain thresholds, it may begin repurchasing member capital stock at par.





41


Loans





The following summary reflects the Bank’s loan portfolio as of the dates indicated:





(Dollars in thousands)

Loans

March 31,

2011


% of

Portfolio


December 31,

2010


% of

PortfolioBusiness

$
392,233



40.0
%

$
400,047



40.1
%R/E construction(1)Spec construction


23,033



2.4



25,303



2.5Land acquisition & development/land


57,235



5.8



54,142



5.4Commercial R/E construction


2,332



0.3



2,333



0.3Total R/E construction


82,600



8.5



81,778



8.2Commercial R/E


190,191



19.4



201,885



20.2Multifamily


89,461



9.1



89,350



9.0Home equity/consumer


29,270



3.0



29,964



3.0Residential


196,389



20.0



194,677



19.5Total loans

$
980,144



100.0
%

$
997,701



100.0
%Deferred loan fees


(3,879
)






(3,934
)Allowance for loan losses


(25,782
)






(26,106
)Loans, net

$
950,483






$
967,661





(1)
Real estate construction loans are net of loans in process.





Virtually all of the Bank’s loans are to businesses or individuals in the Puget Sound area. Business loans are made to small and medium-sized businesses within this area for a wide array of purposes. Included in the business loan total are loans secured by real estate, the majority of which the borrower is the primary tenant of the property. Real estate construction loans are extended to builders and developers of residential and commercial real estate. Commercial real estate loans fund non-owner occupied buildings.





Residential loans held in the Bank’s portfolio are secured by single family residences. The Bank also originates longer term fixed rate residential loans, and sells many of those loans into the secondary market on a best efforts, servicing released basis. Beginning in 2009, the Bank has originated and holds loans generated under its Builder Sales Program, which offers attractive terms to qualified buyers of houses from builders financed by the Bank. As of March 31, 2011, the Bank held $86.3 million of these loans. Home equity loans are primarily second mortgages on the borrower’s primary residence. Consumer loans are non-residential (i.e. automobiles, credit cards or boats).





Total loans decreased by $17.6 million to $980.1 million from December 31, 2010 to March 31, 2011. Payments and payoffs totaled $65.0 million for the three months ended March 31, 2011 and offset $59.4 million in additional loan growth, most of which was due to advances/paydowns on existing business loans/lines as well as an increase in residential loans due to our Builder Sales program.  Total loans were further reduced by charge-offs of $3.0 million and $11.5 million in transfers to real estate owned (REO) for the three months ended March 31, 2011.





42


The following table presents the change in the Bank’s loan portfolio from December 31, 2010 to March 31, 2011:





(Dollars in thousands)



Loans

Balance at

March 31,

2011


Net

(Paydowns)

Additions


Reclassifi-

cations


Charge-

Offs(1)


Transfers

To REO


Balance at

December 31,

2010Business

$
392,233


$
(5,975
)

$
(641
)

$
(1,169
)

$
(29
)

$
400,047R/E constructionSpec construction


23,033



(1,254
)


(402
)


(614
)


-



25,303Land acquisition & development/land


57,235



3,816



22



(745
)


-



54,142Commercial R/E construction


2,332



(1
)


-



-



-



2,333Total R/E Construction


82,600



2,561



(380
)


(1,359
)


-



81,778Commercial R/E


190,191



(783
)


-



51



(10,962
)


201,885Multifamily


89,461



(298
)


409



-



-



89,350Home equity/consumer


29,270



50



(22
)


(245
)


(477
)


29,964Residential


196,389



1,382



634



(304
)


-



194,677Total loans


980,144



(3,063
)


-



(3,026
)


(11,468
)


997,701Deferred loan fees


(3,879
)


55



-



-



-



(3,934
)Allowance for loan losses


(25,782
)


(2,550
)


-



2,874



-



(26,106
)Loans, net

$
950,483


$
(5,558
)

$
-


$
(152
)

$
(11,468
)

$
967,661





(1)
Excludes $52 related to overdrawn checking accounts and recoveries of $204.





Allowance for Loan Losses





Management provides for potential future loan losses by maintaining an allowance for loan losses. The allowance for loan losses reflects management’s best estimate of probable losses as of a particular balance sheet date. The allowance for loan losses is maintained at levels based on management’s assessment of various factors affecting the loan portfolio, including analysis of adversely classified loans, delinquencies, trends in credit quality, local economic conditions, growth of the loan portfolio, past loss experience, and the portfolio’s composition. Increases in the allowance for loan losses made through provisions primarily reflect loan loss risks inherent in lending and the impact of the economic climate on the loan portfolio.





At March 31, 2011, the allowance for loan losses was $25.8 million (2.63% of total loans) compared to $26.1 million (2.62% of total loans) at December 31, 2010. The valuation reserve for off-balance sheet commitments was $50,000 at March 31, 2011 and December 31, 2010. The total allowance for loan losses, which includes the allowance for off-balance sheet commitments, was $25.8 million (2.64% of total loans) as of March 31, 2011, compared to $26.2 million (2.62% of total loans) as of December 31, 2010.





Activity in the allowance for loan losses during the year ended March 31, 2011, included a provision expense of $2.6 million and net charge-offs of $2.9 million. Charge-offs were primarily related to business and real estate construction, including land acquisition and development/land loans, which accounted for $2.5 million in charge-offs.





43


The following table sets forth information regarding changes in the Bank’s allowance for loan losses for the periods presented:





(Dollars in thousands)

Three Months Ended

March 31,Allowance for Loan Losses

2011


2010Balance at beginning of period

$
26,106


$
25,900Charge-OffsBusiness


(1,169
)


(710
)R/E construction


(1,359
)


(30,198
)Commercial R/E


51



-Home equity/consumer


(298
)


(118
)Residential


(303
)


(243
)Recoveries


204



82Net charge-offs


(2,874
)


(31,187
)Provision for loan losses


2,550



31,290Balance at end of period

$
25,782


$
26,003Average total loans

$
986,119


$
1,196,091Nonperforming (nonaccruing) loans


35,191



96,719Ratio of net charge-offs during the period to average total loans


0.29
%


2.61
%Ratio of allowance for loan losses to average total loans


2.61



2.17Ratio of allowance for loan losses to total loans


2.63



2.25Coverage ratio


73.26



26.89





Historical net charge-offs are not necessarily accurate indicators of future losses since net charge-offs vary from period to period due to economic conditions and other factors that cannot be accurately predicted. Thus, an evaluation based on historical loss experience within individual loan categories is only one of many factors considered by management in evaluating the adequacy of the overall allowance.





Management believes that the allowance for losses on loans is adequate to provide for losses that may be incurred on loans; however, there is no guarantee that management’s estimate will be sufficient to cover actual loan losses.





At March 31, 2011, the allowance for loan losses was 73.26% of total nonperforming loans (coverage ratio) compared to 26.89% at March 31, 2010. The increase in the coverage ratio for the current period was due to the decrease in nonperforming loans. Nonperforming loans decreased 63.6% from $96.7 million at March 31, 2010 to $35.2 million at March 31, 2011.  During the same period the allowance for loan losses decreased 0.8% from $26.1 million to $25.8 million.





Asset Quality





Banking regulations require that each insured institution review and classify its assets regularly. In addition, bank examiners have the authority to identify problem assets and, if appropriate, require them to be adversely classified. There are three classifications for problem assets: substandard, doubtful and loss. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have sufficient weaknesses that make collection or payment in full, based on currently existing facts, conditions and values, questionable. An asset classified as loss is considered uncollectible and of such little value that its continuance as an asset of the institution is not warranted. If an asset, or portion thereof, is classified as loss, the insured institution must either establish specific allowances for loan losses in the amount of 100% of the portion of the asset classified as loss or charge-off such amounts. The Bank uses two other asset classification categories for potential problem loans. They are watch and special mention. Borrowers with declining earnings, strained cash flow, increasing leverage and/or weakening market fundamentals that indicate above average risk are classified as watch. Loans identified as special mention represent borrowers who exhibit potential credit weaknesses or trends deserving Bank management’s close attention.





44


In order to proactively address credit quality issues within its loan portfolios, Cascade Bank maintains fully staffed Credit Administration and Special Assets departments to address the increased volume of classified assets. Generally, when a loan becomes classified, the relationship is transferred to the Special Assets department. Cascade Bank actively engages the borrower and guarantor to determine a course of action. Current financial information is requested from the borrower(s) and guarantor(s) and updated collateral values are requested. If the loan is secured by real estate, updated title information is obtained to determine the status of encumbrances on the collateral. When possible, Cascade Bank requires the borrower to provide additional collateral or capital. In conjunction with the receipt of additional collateral, Cascade Bank will sometimes modify the terms of the loan. Often the new modified terms of the loan are consistent with terms that Cascade Bank would offer a new borrower. If the modification of terms is considered concessionary and the borrower is having financial difficulty for economic or legal reasons, the loan is classified as a troubled debt restructuring (TDR). All TDR loans are considered impaired and are reviewed for impairment using fair market methodology or discounted cash flow techniques.





Cascade Bank also may consider allowing a borrower to sell the underlying collateral for less than the outstanding balance on the loan if the current collateral evaluation supports the offer price. In such situations, Cascade Bank often requires the borrower to sign a new note for the resulting deficiency or to bring cash to closing. In some situations, Cascade Bank releases the collateral only in a sale transaction, preserving its right to seek monetary judgments against the borrowers and guarantors.




A report containing delinquencies of all loans is reviewed frequently by management and the Board of Directors. Actions on delinquent loans are taken based upon the particular circumstance of each loan. The Bank’s general procedures provide that when a loan becomes delinquent, the borrower is contacted, usually by phone, within 30 days. When the loan is over 30 days delinquent, the borrower is typically contacted in writing. Generally, the Bank will initiate foreclosure or other corrective action against the borrower when principal and interest become 90 days or more delinquent. In most cases, interest income is reduced by the full amount of accrued and uncollected interest on loans once they become 90 days delinquent, go into foreclosure or are otherwise determined to be uncollectible. Once interest has been paid to date, the borrower establishes six months of timely repayment performance, and management considers the loan fully collectible, it is returned to accrual status.





Nonperforming (Nonaccrual) Loans





It is the Bank's practice to discontinue accruing interest on virtually all loans that are delinquent in excess of 90 days regardless of risk of loss, collateral, etc. Some problem loans, which are less than 90 days delinquent, are also placed into nonaccrual status if the success of collecting full principal and interest in a timely manner is in doubt.  Some loans will remain in nonaccrual status even after improved performance until a consistent timely repayment pattern is exhibited and/or timely performance is considered reliable.





At March 31, 2011, nonperforming loans totaled $35.2 million, compared to $48.1 million at December 31, 2010.  The level of nonperforming loans is primarily attributable to the slow down in the housing market and general economy, which significantly impacted our real estate construction portfolio and, to a lessor extent, our commercial real estate portfolio.  Of the total nonperforming loans at March 31, 2011, 31.6% relate to our real estate construction, land development and completed lot portfolios and 51.0% is related to our commercial real estate portfolio.





Loans are generally placed on nonaccrual status when they become past due over 90 days or when the collection of interest or principal is considered unlikely. Loans past due over 90 days that are not on nonaccrual status must be well secured by tangible collateral and in the process of collection. The Bank had two loans totaling $145,000 that were 90 days or more past due and still accruing interest at March 31, 2011.





45


The following table shows nonperforming loans versus total loans in each loan category:





(Dollars in thousands)

Balance at

March 31, 2011


Nonperforming Loans (NPL)


NPL as a % of Loan CategoryBusiness

$
392,233


$
2,818



0.7
%R/E ConstructionSpec construction


23,033



8,502



36.9Land acquisition & development/land


57,235



2,607



4.6Commercial R/E construction


2,332



-



0.0Total R/E construction


82,600



11,109



13.4Commercial R/E


190,191



17,958



9.4Multifamily


89,461



-



0.0Home equity/consumer


29,270



746



2.5Residential


196,389



2,560



1.3Total

$
980,144


$
35,191



3.6
%





Nonperforming loans decreased to $35.2 million at March 31, 2011, compared to $48.1 million at December 31, 2010. The decline is largely related to one nonperforming commercial real estate loan, totaling $11.0 million that transferred to REO during the quarter.




As of March 31, 2011, 13.4% of total real estate construction loans and 9.4% of commercial real estate loans were nonperforming. The other designated loan categories had no significant amounts of nonperforming loans compared to total loans outstanding in the respective categories.





Additions to nonperforming loans were $3.7 million for the quarter ended March 31, 2011, of which the largest loan categories included six business loans totaling $543,000, four land acquisition & development/land loans totaling $991,000, one commercial real estate loan totaling $600,000, and four residential loans totaling $1.1 million. Additions to nonperforming loans during the period were offset by $2.1 million in paydowns, $3.0 million in charge-offs, and $11.5 million in transfers to REO. Charge-offs were largely for real estate construction loans, which accounted for $1.4 million and business loans, which accounted for $1.2 million of the total charge-offs.





The following table shows the migration of nonperforming loans (NPLs) through the portfolio in each category as of March 31, 2011, compared to December 31, 2010:





(Dollars in thousands)

Nonperforming Loans

Balance at

March 31,

2011


Additions


Paydowns


Charge-

Offs(1)


Transfers

to REO


Balance at

December 31,

2010Business

$
2,818


$
543


$
(874
)

$
(1,169
)

$
(29
)

$
4,347R/E constructionSpec construction


8,502



70



(659
)


(614
)


-



9,705Land acquisition & development/land


2,607



991



(487
)


(745
)


-



2,848Total R/E construction


11,109



1,061



(1,146
)


(1,359
)


-



12,553Commercial R/E


17,958



600



(83
)


51



(10,962
)


28,352Home equity/consumer


746



429



(9
)


(245
)


(477
)


1,048Residential


2,560



1,089



(23
)


(304
)


-



1,798Total nonperforming loans

$
35,191


$
3,722


$
(2,135
)

$
(3,026
)

$
(11,468
)

$
48,098





(1)
Excludes $52 related to overdrawn checking accounts and recoveries of $204.





46


Impaired Loans





A loan is considered impaired when, based on current information and events, the Bank determines that it is probable it will not be able to collect all amounts due according to the loan contract, including scheduled interest payments. When the Bank identifies a loan as impaired, it measures the impairment using discounted cash flows, except when the sole remaining source of the repayment for the loan is the liquidation of the collateral. In these cases, the Bank uses the current fair value of the collateral, less selling costs, instead of discounted cash flows. If the Bank determines that the value of the impaired loan is less than the recorded investment in the loan, it either recognizes an impairment reserve as a specific component to be provided for in the allowance for loan losses or charges-off the impaired balance on collateral dependent loans if it is determined that such amount represents a confirmed loss. The combination of the general allowance calculation and the specific reserve on impaired loans result in the total allowance for loan losses.




When loans are identified as impaired they are typically transferred to the Bank’s Special Assets department. When the Bank identifies a loan as impaired, it measures the loan for potential impairment using discounted cash flows, except when the loan is collateral dependent. In these cases, the Bank uses the current fair value of collateral, less selling costs. The current fair value of collateral is generally determined through obtaining external appraisals. External appraisals are updated on a periodic basis as determined by the Chief Credit Officer. The Bank obtains appraisals from a pre-approved list of independent, third party, local appraisal firms. Larger appraisals are reviewed by the Bank’s Chief Appraiser, or a qualified third party reviewer to ensure the quality of the appraisal and the expertise and independence of the appraiser.  Appraisals on lower valued properties are reviewed by a Bank underwriter. Although an external appraisal is the primary source used to value collateral dependent loans, the Bank may also utilize values obtained through executed purchase and sale agreements, negotiated short sales, broker price opinions, historical sales activity, or internal evaluations. These alternative sources of value are used for interim periods between appraisals and only if deemed to be more representative of current value. Impairment analyses are updated, reviewed and approved on a quarterly basis at or near the end of each reporting period. Based on these processes, the Bank does not believe there are significant time lapses for the recognition of additional loan loss provisions or charge-offs from the date they become known.





At March 31, 2011, the recorded investment in loans classified as impaired totaled $123.9 million. Included in this total are $33.9 million in impaired loans with a corresponding specific reserve (included in the allowance for loan losses) of $6.6 million. The remaining $90.0 million in impaired loans are considered collateral dependent and have been written-down to their estimated net realizable value. At December 31, 2010, the total recorded investment in impaired loans was $144.0 million, including $40.0 million with a corresponding specific reserve of $5.8 million.





Impaired loans include $100.6 million and $94.2 million in loans that have been designated as troubled debt restructured (TDR) loans at March 31, 2011 and December 31, 2010, respectively. Of the total TDR loans, $69.0 million and $63.8 million are performing as agreed under the restructured notes at March 31, 2011 and December 31, 2010, respectively.





Troubled Debt Restructured (TDR) Loans





Loans are classified as TDR when a modification of terms is processed by the Bank, for economic or legal reasons related to the debtor’s financial difficulty, at terms and conditions that the Bank would not otherwise consider. In some cases, the Bank has extended the interest-only period of a loan or allowed a borrower to make interest-only payments to assist the borrower while trying to sell the collateral securing the loan.





47


The following table shows TDR loans outstanding as of the date indicated:





(Dollars in thousands)

March 31,


December 31,Troubled Debt Restructured Loans

2011


2010Business

$
22,493


$
19,614R/E constructionSpec construction


13,573



14,329Land acquisition and development/land


14,009



16,044Total R/E construction


27,582



30,373Commercial R/E


37,484



32,238Multifamily


8,610



8,619Home equity/consumer


294



244Residential


4,111



3,084Total

$
100,574


$
94,172





Real Estate Owned (REO)





REO consists of property acquired by the Bank through foreclosure and is carried at the lower of the estimated fair value less expected selling costs, or the principal balance of the foreclosed loans.  The costs related to repair or refurbish the property for sale are generally capitalized while routine maintenance and other costs are generally expensed. Any gains or shortfalls from the sale of REO are included in other income or other expense.  REO totaled $32.3 million at March 31, 2011, compared to $34.4 million at December 31, 2010. REO, as of March 31, 2011, consisted of $363,000 in residential construction, $13.3 million in land acquisition and development/land, $15.5 million in commercial real estate, $1.4 million in multifamily, and $1.7 million in completed single-family residences.




Transfers to REO were $11.5 million for the quarter ended March 31, 2011, including one commercial real estate loan totaling $11.0 million. This loan accounted for approximately 95.6% of the additions that occurred during the period.  Capitalized costs for the quarter ended March 31, 2011 were $487,000. Additions and capitalized costs for REO during the period were more than offset by $11.8 million in paydowns/sales and $2.3 million in write-downs/losses.





The following table presents the activity related to REO for the three months ended March 31, 2011:





(Dollars in thousands)



REO

Balance at

March 31,

2011


Transfers to REO


Capitalized

Costs


Paydowns/

Sales


Write-

downs/

Losses


Balance at

December 31,

2010R/E constructionResidential construction

$
363


$
-


$
124


$
-


$
-


$
239Land acquisition & development/land


13,262



29



144



(9,401
)


(1,216
)


23,706Total R/E construction


13,625



29



268



(9,401
)


(1,216
)


23,945Commercial R/E


15,521



10,962



165



(55
)


(525
)


4,974Multifamily


1,438



-



18



(182
)


(116
)


1,718Residential


1,727



477



36



(2,146
)


(415
)


3,775Total

$
32,311


$
11,468


$
487


$
(11,784
)

$
(2,272
)

$
34,412





48


Nonperforming Assets





The following table presents information with respect to the Bank’s nonperforming assets at the dates indicated:





(Dollars in thousands)

Nonperforming assets

March 31, 2011


December 31, 2010Business

$
2,818


$
4,347R/E constructionSpec construction


8,502



9,705Land acquisition & development/land


2,607



2,848Total R/E construction


11,109



12,553Commercial R/E


17,958



28,352Home equity/consumer


746



1,048Residential


2,560



1,798Total nonperforming loans


35,191



48,098REO


32,311



34,412Total nonperforming assets

$
67,502


$
82,510Total nonperforming loans to total loans


3.59
%


4.82
%Total nonperforming loans to total assets


2.41



3.21Total nonperforming assets to total assets


4.63



5.51





At March 31, 2011, nonperforming assets consisting of nonperforming (nonaccruing) loans and REO, totaled $67.5 million or 4.63% of total assets. Nonperforming assets totaled $82.5 million or 5.51% of total assets at December 31, 2010.





Certain other loans, currently in nonaccrual, are in the process of foreclosure and potentially could become REO.  Efforts, however, are constantly underway to reduce and minimize such nonperforming assets.  During 2008 and 2009, we expanded our special assets group to focus on reducing nonperforming assets.





The decision to begin a foreclosure action generally occurs after all other reasonable collection efforts have been found ineffective.  We comply with all applicable state statues regarding foreclosure proceedings.  Loans in foreclosure are always categorized as nonperforming assets, and as such, have been assigned a specific loan loss reserve based on the most current property valuations available, discounted to reflect foreclosure expense, holding time and sales costs.  Assuming no other legal actions, the statutory processing period for a so-called nonjudicial foreclosure in the state of Washington is a minimum of 120 days or 190 days after the date of default.  The first step is a notice of default that is mailed to the borrower and posted at the property or the notice is delivered to the borrower in person.  The borrower is given 30 days to respond to the notice of default.  If the borrower does not stop the foreclosure within 30 days after receiving the notice of default, we record a notice of sale with the appropriate county recorder.  The notice of sale is recorded at least 90 days before the sale date and is mailed to the borrower and any other lien holders.  The notice of sale is also published twice in a local newspaper.  A notice of foreclosure is also required to be sent to the borrower and/or guarantors if we want to retain the right to a deficiency.  We are required to publish the notice of sale once between the 32nd and 28th days prior to the sale, and once between the 11th and 7th days before the sale.  Foreclosure sales are by public auction with the property going to the highest bidder.





We will bid up to the amount of our loan balance.  If we do not have a buyer for the collateral by the sale date, and there is no other or higher bidder, then we acquire ownership of the property for the amount of our credit bid, and the property becomes an REO property of the Bank.  The obligations of the guarantors (but not the borrower) of a commercial loan for any deficiency (the amount by which the loan balance exceeds the foreclosure sale price), generally survives the sale and we may bring a lawsuit against the guarantors to collect the deficiency if we determine a judgment against the guarantors may be collectible and cost-effective.





A judicial foreclosure action may also be brought to collect a real estate loan in the state of Washington, and is used by Cascade Bank in certain cases; however, nonjudicial foreclosure is usually the preferred remedy because it is normally faster and less expensive than litigation, which can take from 6 months for summary judgment, to 2 years for trial.





49


In addition, where appropriate, instead of foreclosure, we may negotiate a settlement agreement with the borrower, with a deed in lieu of foreclosure conveying the property to the Bank, to enable the Bank to acquire possession of the property faster than pursuing the normal foreclosure process.





The transition of loans from performing to nonperforming status may result in the assignment of a specific reserve or charge-off, if the loan is collateral dependent, that adjusts the net book value of the loan’s principal balance to reflect the estimated fair value of supporting collateral or result in no assignment of a specific reserve or charge-off if the loan’s collateral value is in excess of its book value.  Subsequent write-downs, requiring additional loan loss provisioning, could occur as a loan moves through the foreclosure process into REO based on recurring impairment analysis up to and until a property becomes an REO.





Deposits





Total deposits decreased by $38.5 million to $1.07 billion at March 31, 2011, compared to December 31, 2010. Included in total deposits at March 31, 2011, were $910.0 million in retail deposits, $33.2 million in public deposits, $66.9 million in brokered deposits and $59.0 million in internet-based deposits.





Total demand deposit account balances decreased $381,000 to $337.2 million at March 31, 2011, compared to $337.6 million at December 31, 2010. Savings and MMDA increased $5.1 million to $182.0 million at March 31, 2011, compared to $176.9 million at December 31, 2010. CDs decreased $43.1 million to $549.9 million at March 31, 2011, compared to $593.0 million at December 31, 2010, mostly due to planned runoff of brokered CDs. The market for deposits has remained very competitive. It remains a key objective of the Bank to increase its demand deposit account balances and other low rate accounts.




The following table sets forth the balances for each major category of deposits at March 31, 2011 and December 31, 2010:





(Dollars in thousands)

Deposits by Type

March 31,

2011


December 31, 2010Noninterest-bearing demand deposits

$
112,352


$
110,042Interest-bearing demand deposits


224,833



227,524Money market deposits


169,763



164,944Savings deposits


12,217



12,001Certificates of deposit


549,922



593,043Total

$
1,069,087


$
1,107,554





FHLB Advances





The Bank uses FHLB advances to provide intermediate and longer term funding. The Bank had $159.0 million in FHLB advances totaling $159.0 million at March 31, 2011 and December 31, 2010.  During 2010, the Bank transitioned from a blanket pledge collateral agreement with the FHLB of Seattle to a custodial agreement.  Under the terms of this agreement, the Bank's future borrowings from the FHLB of Seattle currently are limited to overnight cash management advances (CMA), or short term advances with maturities of 90 days or less.





Securities Sold Under Agreements to Repurchase





The Bank also uses repurchase agreements for funding needs. The Bank had repurchase agreements outstanding totaling $145.0 million at March 31, 2011 and December 31, 2010. Interest rates paid on the repurchase agreements ranged from 4.6% to 7.0 % at March 31, 2011. The repurchase agreements consist of a series of transactions with maturity dates ranging from 2017 to 2022. The agreements have provisions that allow the lenders to periodically terminate the agreements. Termination dates typically occur once each quarter; however, a portion of the agreements may not be terminated prior to December 2012, provided the Bank offers the lender additional securities in November and December 2011. Repurchase agreements with this lender totaling $25.0 million and $50.0 million could be


50
 terminated in December 2012 and November 2013, respectively.  The termination fee related to these agreements cannot be estimated. Other repurchase agreements totaling $50.0 million have provisions allowing the repurchase agreements to be terminated quarterly (in January, April, July and October) upon providing 2 days notice. While the Bank has received no indication that these repurchase agreements will be terminated prior to maturity, and the transactions are well secured by securities pledged to the counterparty, management believes that the likelihood of termination of the agreements is reasonably possible. If these repurchase agreements had been terminated as of March 31, 2011, the termination fee would have been approximately $12.5 million.





Junior Subordinated Debentures





In March 2000, the Corporation issued $10.3 million of 11.0% junior subordinated debentures. In turn, Cascade Capital Trust I, a wholly owned business trust whose common equity is 100% owned by the Corporation, issued trust preferred securities underlying the debentures. These junior subordinated debentures have a fixed rate of 11.0% and mature on March 1, 2030, but were callable at a premium beginning on March 1, 2010. At March 31, 2011, the premium was 4.95%. The Corporation applies fair value accounting to the junior subordinated debentures issued by Cascade Capital Trust I.  The change in fair market value of the junior subordinated debentures is recorded as a component of other income. The fair value remained unchanged at $1.5 million at March 31, 2011, compared to December 31, 2010.  In December 2004, the Corporation issued an additional $5.2 million in junior subordinated debentures. In turn, Cascade Capital Trust II, a wholly owned business trust whose common equity is 100% owned by the Corporation, issued trust preferred securities underlying the debentures. These debentures had a fixed rate of 5.82% for the first five years and as of January 7, 2010, float at the three-month LIBOR plus 1.90% for the remaining twenty-five years. The rate payable on these debentures as of March 31, 2011 was 2.20%. The debentures are callable by the Corporation at par after the first five years. On March 30, 2006, the Corporation issued an additional $10.3 million in junior subordinated debentures. In turn, Cascade Capital Trust III, a wholly owned business trust whose common equity is 100% owned by the Corporation, issued trust preferred securities underlying the debentures. These debentures have an initial rate of 6.65% set for five years and convert to the three-month LIBOR plus 1.40%, as of June 15, 2011, for the remaining twenty-five years. The debentures are callable at par after the first five years. Subject to certain restrictions, the Corporation’s junior subordinated debentures are considered Tier 1 capital by financial institution regulators. All three trusts exist for the exclusive purpose of issuing the trust preferred securities underlying the junior subordinated debentures issued by the Corporation, and engaging in only those other activities necessary, advisable or incidental to the above.





During the fourth quarter of 2009, FDIC restrictions prohibited dividend payments from the Bank to the holding company, which in turn led the Corporation to defer the payment of interest on the trust preferred securities. Under the terms of each instrument, deferral of payments is permitted without triggering an event of default. Generally, during any deferral period, the Corporation is prohibited from paying any dividends or distributions on, or redeem, purchase or acquire, or make a liquidation payment with respect to the Corporation’s capital stock, or make any payment of principal or interest on, or repay, repurchase or redeem any debt securities of the Corporation that rank pari passu in all respects with, or junior to, the specific instrument. In addition, during any deferral period, interest on the trust preferred securities is compounded from the date such interest would have been payable. The balance of deferred interest was $3.1 million as of March 31, 2011.





Derivatives and Hedging





In the fourth quarter of 2010, the Bank entered into derivative contracts to add stability to interest income and to manage its exposure to changes in interest rates. The Bank sought to minimize the volatility that changes in interest rates have on its variable-rate debt by entering into interest rate cap agreements.  The Bank purchased a series of interest rate caps from two different major financial institutions based on their credit rating and other factors. Both counterparties provide cash collateral to the Bank on the majority of the fair value of the cap to significantly mitigate credit risk of these transactions.  The Bank purchased interest rate caps designated as cash flow hedges to protect against movements in interest rates above the caps’ strike rate, which is tied to three month LIBOR.  The interest rate caps have an aggregate notional amount of $159.0 million, strike rates of 1.29% and a maturity date of October 20, 2015. The Bank formally documented the relationship between the hedging instruments and hedged items, as well as its risk management objective and strategy before initiating the hedge. The caps were used to hedge the variable cash flows associated with variable rate FHLB advances that reprice based upon three month LIBOR on the same day that the rate caps reprice. The fair value of our interest rate caps, is based on derivative valuation models using market data inputs as of the valuation date that can generally be verified and do not typically involve significant management judgments. (Level 2 inputs). The valuation is performed on each reporting date to determine if the hedge was effective over the reporting period, using the hypothetical derivative method, by comparing the actual changes in the hedged item to a “perfectly effective” hypothetical interest rate cap.


51
 If the ratio of the change in fair value of the actual cap to the change in fair value of the hypothetical cap falls between the effectiveness parameters the hedge will be considered to have been effective. The March 31, 2011 valuations showed the hedge to be “perfectly effective” and resulted in a mark-to-market gain on the interest rate caps totaling $3.8 million, which is included in accumulated other comprehensive loss.  As of January 1, 2011, the Bank began amortizing the cost of the interest rate caps.  The expense is reclassified into earnings. As of March 31, 2011, approximately $1,000 had been expensed.





The following table presents the notional value, strike rate, fair value and collateral held for derivative instruments accounted for as a cash flow hedge at March 31, 2011:





(Dollars in thousands)

Derivatives

March 31, 2011


December 31, 2010Notional Value

$
159,000


$
159,000Strike Rate


1.29
%


1.29
%Fair Value

$
9,042


$
8,732Cash Collateral


7,790



7,620





Income Taxes





At March 31, 2010, the Corporation assessed whether it was more likely than not that it would realize the benefits of its deferred tax asset. The Corporation determined that the negative evidence associated with cumulative losses, the expectation of entering into a FDIC Order with its regulators, and credit deterioration in its loan portfolio outweighed the positive evidence. Therefore, during the first quarter of 2010, the Corporation established a full valuation allowance on its deferred tax asset. The Corporation will not be able to recognize the tax benefits on current and future losses until it can show that it is more likely than not that it will generate enough taxable income in future periods to realize the benefits of its deferred tax asset and loss carryforwards.





Stockholders’ Equity and Regulatory Matters





Total stockholders’ equity decreased $3.8 million from $58.5 million at December 31, 2010, to $54.6 million at March 31, 2011. The decrease in equity was largely due to the net loss for the period. The loss was primarily due to the $2.3 million in REO write-downs/losses for the three months ended March 31, 2011.





In 2008, the Board of Directors of Cascade Financial Corporation chose to participate in the U.S. Treasury's voluntary Capital Purchase Program.  On November 21, 2008, the Corporation completed its $39.0 million capital raise as a participant in the U.S. Treasury Department’s Capital Purchase Program. Under the terms of the transaction, the Corporation issued 38,970 shares of Series A Fixed-Rate Cumulative Perpetual Preferred Stock, and a warrant to purchase 863,442 shares of the Corporation’s common stock at an exercise price of $6.77 per share. During the fourth quarter of 2009, FDIC restrictions prohibited dividend payments from the Bank to the holding company, which in turn led the Corporation to defer the payment of dividends on the preferred stock. Under the terms of the preferred stock, deferral of payment is permitted without triggering an event of default. Generally, during any deferral period, the Corporation is prohibited from paying any dividends or distributions on, and may not redeem, purchase or acquire, or make a liquidation payment with respect to the Corporation’s capital stock, or make any payment of principal or interest on, or repay, repurchase or redeem any debt securities of the Corporation that rank pari passu in all respects with, or junior to, the specific instrument. In addition, during any deferral period, dividends on the preferred stock are compounded from the date such dividends would have been payable. The balance of deferred dividends was $3.3 million as of March 31, 2011.





The primary reason for the Corporation’s participation was the addition of cost-effective capital, which served to expand our ability to provide increased credit to businesses and consumers in our market area and added flexibility in considering strategic opportunities for growth.  The Corporation monitors its activities to determine how its participation in the program has assisted the Bank in supporting prudent lending and/or supporting efforts to work with existing borrowers to avoid unnecessary foreclosures.





As a condition for participating in the Capital Purchase Program, the Corporation accepted limitations on executive compensation and benefits. These limitations include restrictions on bonuses and incentive compensation to senior executive officers, a prohibition on making golden parachute payments to senior executive officers, and requiring clawback of any bonus or incentive compensation paid to a senior executive officer or one of the next twenty most highly compensated employees based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate.




52


The Corporation is committed to managing capital for maximum stockholder benefit and maintaining protection for depositors and creditors. The Corporation manages various capital levels at both the holding company and subsidiary bank level to attempt to maintain adequate capital ratios and levels in accordance with external regulations and capital guidelines established by the Board of Directors. The Corporation had a risk-based capital ratio of 9.83% and a Tier 1 capital ratio of 5.46% at March 31, 2011. The Bank had a risk-based capital ratio of 9.56% and a Tier 1 capital ratio of 5.61% at March 31, 2011.





The Corporation had paid its stockholders a cash dividend on a quarterly basis since 2002. In June 2009, the Corporation suspended its regular quarterly cash dividend on common stock to preserve capital.





Accumulated other comprehensive loss increased to $5.8 million at March 31, 2011, compared to a $5.1 million deficit at December 31, 2010.





On July 20, 2010, the Board of Directors of the Bank stipulated to the entry of a Consent Order with the Federal Deposit Insurance Corporation (FDIC) and the Washington State Department of Financial Institutions (DFI), effective July 21, 2010 (FDIC Order). The FDIC identified deficiencies in the management and supervision of Cascade Bank that primarily relate to loan underwriting, procedures and monitoring, excessive concentrations in construction and land development loans, and related concerns about Cascade Bank’s capital and liquidity.





Under the terms of the FDIC Order, the Bank cannot pay any cash dividends or make any payments to the Corporation without the prior written approval of the FDIC and the Washington State DFI. Other material provisions of the FDIC Order require the Bank to:





·
review the qualifications of the Bank’s management;


·
provide the FDIC with 30 days written notice prior to adding any individual to the Board of Directors of the Bank or employing any individual as a senior executive officer;


·
increase director participation and supervision of Bank affairs;


·
develop a capital plan and increase Tier 1 leverage capital to 10% of the Bank’s average total assets and increase total risk-based capital to 12% of the Bank’s risk-weighted assets by November 18, 2010, and maintain such capital levels, in addition to maintaining a fully funded allowance for loan losses satisfactory to the regulators;


·
eliminate from its books, by charge-off or collection, all loans classified as “loss” and all amounts in excess of the fair value of the underlying collateral for assets classified as “doubtful” in the Report of Visitation dated February 16, 2010 that have not been previously collected or charged-off, by July 30, 2010;


·
reduce the amount of loans classified “substandard” and “doubtful” in the Report of Visitation that have not previously been charged off to not more than 130% of the Bank’s Tier 1 capital and allowance for loan losses, within 180 days;


·
eventually reduce the total of all adversely classified loans by collection, charge-off or sufficiently improving the quality of adversely classified loans to warrant removing any adverse classification, as determined by the regulators;


·
formulate a written plan to reduce the Bank’s levels of nonperforming assets and/or assets listed for “special mention” by the Bank to an acceptable level and to reduce the Bank’s concentrations in commercial real estate and acquisition, development and construction loans;


·
develop a three-year strategic plan and budget with specific goals for total loans, total investment securities and total deposits, and improvements in profitability and net interest margin, and reduction of overhead expenses;


·
submit a written plan for eliminating the Bank’s reliance on brokered deposits, in compliance with FDIC’s rules;


·
eliminate and/or correct all violations of law set forth in the Report of Visitation and the Report of Examination dated May 18, 2009, and ensure future compliance with all applicable laws and regulations;


·
implement a comprehensive policy for determining the adequacy of the allowance for loan losses satisfactory to the regulators and remedy any deficiency in the allowance in the calendar quarter discovered by a charge to current operating earnings;


·
refrain from extending additional credit with respect to loans charged-off or classified as “loss” and uncollected;


·
refrain from extending additional credit with respect to other adversely classified loans, without the prior approval of a majority of the directors on the Bank Board or its loan committee, and without first collecting all past due interest;


·
implement a liquidity and funds management policy to reduce the Bank’s reliance on brokered deposits and other non-core funding sources; and




53




·
prepare and submit periodic progress reports to the FDIC and the Washington State DFI.





The FDIC Order will remain in effect until modified or terminated by the FDIC and the Washington State DFI. A complete copy of the FDIC Order was filed as Exhibit 10.1 to the Form 8-K filed by the Corporation with the SEC on July 21, 2010.





Additionally, based on an examination concluded on March 11, 2010, the Corporation entered into a Written Agreement (FRB Agreement) with the Federal Reserve Bank (FRB) of San Francisco on November 4, 2010. Under the FRB Agreement, the Corporation cannot do any of the following without prior written approval of the FRB:





·
declare or pay any dividends;


·
make any distributions of principal or interest on junior subordinated debentures or trust preferred securities;


·
incur, increase or guarantee any debt; or


·
redeem any outstanding stock.





The FRB Agreement also requires the Corporation to:





·
take steps to ensure that the Bank complies with the FDIC Order;


·
submit a written capital plan that provides for sufficient capitalization of both the Corporation and the Bank within 60 days, and notify the FRB no more than 45 days after the end of any quarter in which any of the Corporation’s capital ratios fall below the approved plan’s minimum ratios;


·
submit a written cash flow projection plan for 2011 within 60 days;


·
comply with FRB regulations governing affiliate transactions, as well as submit a written plan to reimburse the Bank for all payments made by the Bank in violation of sections 23A and 23B of the Federal Reserve Act or to collateralize the loan made by the Bank to the Corporation in accordance with the requirements of sections 23A and 23B of the Federal Reserve Act;


·
comply with notice and approval requirements of the Federal Deposit Insurance Act (FDI Act) related to the appointment of directors and senior executive officers or change in the responsibility of any current senior executive officer;


·
comply with restrictions on paying or agreeing to pay certain indemnification and severance payments without prior written approval; and


·
submit a quarterly process report to the FRB.





Based on our most recent examination, the FRB staff recently advised us that in its opinion, the Corporation has not complied with all of the requirements of the FRB Agreement. The FRB found that we were not in compliance with the requirement to serve as a source of strength for the Bank, as a result of our failure to raise additional capital to support the Bank’s higher risk profile as a result of the levels of non-performing loans and OREO, continuing losses and declining capital levels. The FRB also criticized the capital plan we submitted on January 4, 2011, which called for raising approximately $90.0 million in additional capital, for failing to address the adequacy of the Bank’s capital, taking into account the level of adversely classified loans, the results of loan portfolio stress tests, the Bank’s risk profile, the adequacy of the allowance for loan losses, current and projected asset growth, and projected earnings, as required in the FRB Agreement. Finally, the FRB staff cited the Corporation’s failure to correct an alleged violation of Regulation W of the Federal Reserve Board of Governors, under Sections 23A and 23B of the Federal Reserve Act, related to a $430,000 loan by the Bank to the Corporation. The FRB observed that the outstanding debt owed to the Bank remains unpaid and uncollateralized, and that the Corporation would be unable to correct the violation until additional capital is raised to reimburse the Bank.




The Board of Directors is committed to taking all actions necessary to meet each of the requirements of the FRB Agreement and the FDIC Order. The Board of Directors is working diligently to comply with the requirement to raise capital, and on March 4, 2011, the Corporation announced that the Corporation, the Bank and Opus Bank entered into a definitive agreement, providing for Opus Bank to acquire the Corporation and the Bank, and for the merger of the Bank into Opus Bank. See “Proposed Merger” below.




Proposed Merger





On March 4, 2011, the Corporation announced that the Corporation, the Bank and Opus Bank entered into a definitive agreement, providing for Opus Bank to acquire the Corporation and the Bank, and for the merger of the Bank into Opus Bank.  See “Recent Events – Proposed Merger”. The parties expect to close the transaction in the latter part of the second quarter of 2011.  Notwithstanding this, there are no assurances that the Corporation and the Bank will be able to successfully close the proposed merger.





54


Off-Balance Sheet Arrangements: Credit Commitments





Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.





The Bank underwrites standby letters of credit using its policies and procedures applicable to loans in general. Standby letters of credit are made on an unsecured and secured basis.





The Bank has not incurred any losses on its commitments for the three months ended March 31, 2011 or 2010.





At March 31, 2011 and December 31, 2010, the following financial instruments with off-balance sheet risk were outstanding:





(Dollars in thousands)

March 31, 2011


December 31, 2010Commitments to grant loans

$
2,015


$
2,100Unfunded commitments under lines of credit/loans in process


82,544



81,868Standby letters of credit and financial guarantees written


1,626



1,576Unused commitments on bankcards


13,500



13,472Total

$
99,685


$
99,016





Contractual Obligations and Commitments





The following table sets forth the Corporation’s long-term contractual obligations as of March 31, 2011:





Payments Due Per Period(Dollars in thousands)

<1 Year


1-3 Years


4-5 Years


>5 years


TotalCertificates of deposit

$
464,312


$
64,817


$
20,793


$
-


$
549,922FHLB advances


-



-



10,000



149,000



159,000Securities sold under agreements to repurchase


-



-



-



145,000



145,000Operating leases


918



1,853



1,479



7,470



11,720Junior subordinated debentures


-



-



-



25,000



25,000Total

$
465,230


$
66,670


$
32,272


$
326,470


$
890,642





Significant Concentrations of Credit Risk





Concentration of credit risk is the risk associated with a lack of diversification, such as having substantial loan concentrations in a specific type of loan within the Bank’s loan portfolio, thereby exposing the Bank to greater risks resulting from adverse economic, political, regulatory, geographic, industrial or credit developments. At March 31, 2011, the Bank’s most significant concentration of credit risk was in loans secured by real estate. These loans totaled approximately $847.5 million or 86.5% of the Bank’s total loan portfolio. Real estate construction, including land acquisition and development/land, commercial real estate, multifamily, home equity and residential loans are included in the total loans secured by real estate for purposes of this calculation.  There has been deterioration in the real estate market over the last three years, which has led to a significant increase in nonperforming loans and the allowance for loan losses.





At March 31, 2011, the Bank’s most significant investment concentration of credit risk was with the U.S. Government, its agencies and Government Sponsored Enterprises. The Bank’s exposure, which results from positions in securities issued by the U.S. Government, and its agencies, and securities guaranteed by Government Sponsored Enterprises, was $293.4 million, or almost 100% of the Bank’s total investment portfolio (including FHLB stock) at March 31, 2011.





55


Regulatory Capital





Cascade Bank is subject to the capital adequacy requirements of the FDIC. The Corporation, as a bank holding company, is subject to the capital adequacy requirements of the FRB. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Corporation’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgment by regulators about components, risk weightings, and other related factors.




The risk-based capital requirements of the FRB and the FDIC define capital and establish minimum capital requirements in relation to assets and off-balance sheet exposure, adjusted for credit risk. The risk-based capital standards currently in effect are designed to make regulatory capital requirements more sensitive to differences in risk profiles among bank holding companies and banks, to account for off-balance sheet exposure and to minimize disincentives for holding liquid assets. Assets and off-balance sheet items are assigned to broad risk categories, each with appropriate relative risk weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items.




The risk-based capital standards issued by the FRB require all bank holding companies to have a Tier 1 leverage ratio of at least 4.0% to be “adequately capitalized” and at least 5.0% to be “well-capitalized” and a total risk-based capital ratio (Tier 1 and Tier 2) of at least 8.0% of total risk-adjusted assets to be “adequately capitalized” and at least 10.0% to be “well-capitalized.” Tier 1 capital generally includes common shareholders’ equity and qualifying perpetual preferred stock together with related surpluses and retained earnings, less deductions for goodwill and various other intangibles. Tier 2 capital may consist of a limited amount of intermediate-term preferred stock, a limited amount of term subordinated debt, certain hybrid capital instruments and other debt securities, perpetual preferred stock not qualifying as Tier 1 capital, and a limited amount of the allowance for loan losses.




The FRB has also adopted guidelines which supplement the risk-based capital guidelines with a minimum ratio of Tier 1 capital to average total consolidated assets (leverage ratio) of 3.0% for institutions with well diversified risk, including no undue interest rate exposure; excellent asset quality; high liquidity; good earnings; and that are generally considered to be strong banking organizations, rated composite 1 under applicable federal guidelines, and that are not experiencing or anticipating significant growth. Other banking organizations are required to maintain a leverage ratio of at least 4.0% in order to be categorized as “adequately capitalized” and at least 5.0% to be categorized as “well-capitalized.” These rules further provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain capital positions substantially above the minimum supervisory levels and comparable to peer group averages, without significant reliance on intangible assets.





Our actual capital amounts and ratios are presented in the following table. No amount was deducted from capital for interest-rate risk exposure.





(Dollars in thousands)

Cascade Financial Corporation (Consolidated)


Cascade BankAmount


Ratio


Amount


RatioAs of March 31, 2011Total risk-based

$
97,841



9.83
%

$
95,160



9.56
%Tier 1 risk-based


80,379



8.08



82,551



8.29Tier 1 leverage


80,379



5.46



82,551



5.61As of December 31, 2010Total risk-based

$
101,209



9.98
%

$
97,456



9.60
%Tier 1 risk-based


84,556



8.34



84,600



8.33Tier 1 leverage


84,556



5.55



84,600



5.56





56


The minimum amounts of capital and ratios as established by banking regulators are as follows:




(Dollars in thousands)

Cascade Financial Corporation (Consolidated)


Cascade BankAmount


Ratio


Amount


RatioAs of March 31, 2011Total risk-based

$
79,592



8.00
%

$
79,639



8.00
%Tier 1 risk-based


39,796



4.00



39,820



4.00Tier 1 leverage


58,893



4.00



58,864



4.00As of December 31,  2010Total risk-based

$
81,149



8.00
%

$
81,213



8.00
%Tier 1 risk-based


40,574



4.00



40,606



4.00Tier 1 leverage


60,958



4.00



60,902



4.00





We are subject to capital adequacy guidelines of the FDIC at the bank level that are substantially similar to the FRB guidelines. Although current regulatory guidelines state that a financial institution must have a total risk-based capital ratio of 10.0%, a Tier 1 risk-based capital ratio of 6.0%, and a Tier 1 leverage ratio of 5.0% to be considered “well-capitalized” in accordance with the regulations, the primary regulator has the ability to impose higher ratios on financial institutions. These higher standards are imposed if the regulator believes that the risk profile of the institution is higher than they consider appropriate. Under the FDIC Order imposed on the Bank by the FDIC on July 21, 2010, Cascade Bank was required to achieve by November 18, 2010, and maintain on an ongoing basis, a Tier 1 leverage ratio of 10% and a total risk-based capital ratio of 12%. As of March 31, 2011, the Bank did not satisfy this regulatory requirement, as it had a Tier 1 leverage ratio of 5.61% and a total risk-based capital ratio of 9.56%.  The Bank needed $64.6 million of additional capital to meet this requirement.





Because of recent losses experienced by the Corporation and the Bank’s requirement for additional capital to meet these higher ratios, there is a need for the Corporation to raise additional capital. Since hiring a highly qualified investment firm in December of 2009, the Board and management have investigated various alternatives to raise capital. As a result of those efforts, on March 4, 2011, the Corporation announced that it has agreed to be acquired by Opus Bank. Opus Bank is a California-chartered bank with its executive offices located in Irvine, California. The terms of the merger agreement provide for Opus Bank to acquire the Corporation and the Bank, and for the merger of the Bank into Opus Bank. Under the terms of the merger agreement, our common shareholders will receive $5.5 million cash, or approximately $0.45 per share. In addition, Opus Bank has offered to purchase $39.0 million of the Corporation’s preferred stock and the associated warrant issued to the Treasury under the Capital Purchase Program for $16.25 million in cash. Consummation of the merger is subject to approval by regulatory authorities, approval by our shareholders at a special shareholders meeting to be held on May 31, 2011, and certain other conditions set forth in the agreement. The merger is expected to close in the latter part of the second quarter of 2011. Notwithstanding this, there are no assurances that the Corporation, the Bank and Opus Bank will be able to successfully close the proposed merger.





Results of Operations





Net Loss





Cascade Financial Corporation had a net loss of $2.6 million for the three months ended March 31, 2011, compared to $32.1 million for the three months ended March 31, 2010. After adjustments for preferred stock dividends and accretion of the issuance discount on preferred stock issued to the U.S. Treasury, net loss attributable to common stockholders for the three months ended March 31, 2011, was $3.3 million as compared to $32.8 million for the three months ended March 31, 2010. Net interest income decreased $863,000 million to $8.8 million during the three months ended March 31, 2011, primarily due to a decline in the loan portfolio. Other income decreased $93,000 to $1.8 million compared to $1.9 million for the three months ended March 31, 2010.





Return on Average Common Stockholders’ Equity





Return on average common stockholders’ equity (average stockholders’ equity excluding preferred stock) was (63.77)% for the three months ended March 31, 2011, compared to (137.53)% for the three months ended March 31, 2010.





57


Net Interest Income





The largest component of the Corporation’s earnings is net interest income. Net interest income is the difference between interest income earned on interest-earning assets (primarily loans, interest-earning deposits with banks, and investment securities) and the interest expense associated with interest-bearing liabilities (deposits and borrowings). Interest earned and interest paid is affected by general economic conditions, including the demand for loans, cost of deposits, market rates of interest and government policies. The Corporation’s operations may be sensitive to changes in interest rates and the resulting impact on net interest income.





Net interest income for the three months ended March 31, 2011, decreased by 8.9%, or $863,000, to $8.8 million from $9.7 million for the three months ended March 31, 2010. The decrease was primarily due to a decline in the loan portfolio.




Average earning assets were $1.3 billion and $1.5 billion for the three months ended March 31, 2011, and March 31, 2010, respectively.




Net interest margin is net interest income expressed as a percent of average earning assets. The net interest margin for the three months ended March 31, 2011, was 2.66%, compared to 2.60% for the three months ended March 31, 2010. For the quarter ended March 31, 2011 compared to the quarter ended March 31, 2010, the yield on earning assets decreased 43 basis points to 4.70% and the cost of interest-bearing liabilities decreased 46 basis points to 2.14%.





58


Average Balances and an Analysis of Average Rates Earned and Paid





The following table shows average balances and interest income or interest expense, with the resulting average yield or cost by category:




Three Months Ended March 31,2011


2010(Dollars in thousands)

Average

Balance


Interest

and

Dividend


Yield/

Cost


Average

Balance


Interest

and

Dividend


Yield/

CostAssetsInterest-earning assetsResidential loans

$
192,942


$
2,300



4.84
%

$
182,554


$
2,208



4.91
%Multifamily loans


89,243



1,292



5.87



85,580



1,373



6.51Commercial R/E loans


174,056



2,597



6.05



170,759



2,653



6.30R/E construction loans


69,678



964



5.61



166,108



2,020



4.93Home equity/consumer loans


28,793



454



6.40



31,197



523



6.79Business loans


394,855



6,311



6.48



452,668



7,389



6.62Total loans (1)


949,567



13,918



5.94



1,088,866



16,166



6.02Securities available-for-sale


233,513



1,210



2.10



243,443



2,472



4.12Securities held-to-maturity


53,188



419



3.20



39,256



417



4.31Interest-earning deposits in other institutions


109,616



65



0.24



140,481



76



0.22Total securities and interest-earningdeposits


396,317



1,694



1.73



423,180



2,965



2.84Total interest-earning assets


1,345,884



15,612



4.70



1,512,046



19,131



5.13Noninterest-earning assetsPremises and equipment, net


13,205











14,341REO


40,848











18,468Nonperforming loans


36,551











107,225Other noninterest-earning assets


36,026











63,444Total assets

$
1,472,514










$
1,715,524Liabilities and Stockholders’ EquityInterest-bearing liabilitiesSavings accounts

$
12,203


$
7



0.25
%

$
9,722


$
6



0.25
%Checking accounts


224,569



360



0.65



368,858



1,246



1.37Money market accounts


167,024



313



0.76



121,818



269



0.90Certificates of deposit


564,082



2,171



1.56



566,374



2,730



1.95Total interest-bearing deposits


967,878



2,851



1.19



1,066,772



4,251



1.57Other interest-bearing liabilitiesFHLB advances


159,000



1,273



3.25



239,000



2,565



4.35Securities sold under agreements to repurchase


145,000



2,127



5.95



145,603



2,131



5.94Junior subordinated debentures


16,965



537



12.85



18,806



495



10.68Other borrowings


-



-



-



2,888



2



0.25Total interest-bearing liabilities


1,288,843



6,788



2.14



1,473,069



9,444



2.60Other liabilities


125,232











108,803Total liabilities


1,414,075











1,581,872Stockholders’ equity


58,439











133,652Total liabilities and stockholders’ equity

$
1,472,514










$
1,715,524Net interest income (2)





$
8,824










$
9,687Interest rate spread (3)










2.56
%










2.53
%Net interest margin (4)






2.66
%










2.60
%Average interest-earning assets to averageinterest-bearing liabilities


104.43
%










102.65
%




(1)  Does not include interest or balances on loans 90 days or more past due that are classified as nonperforming.


(2)  Interest and dividends on total interest-earning assets less interest on total interest-bearing liabilities.


(3)  Total interest-earning assets yield less total interest-bearing liabilities cost.


(4)  Net interest income as a percentage of total interest-earning assets.





59


Rate/Volume Analysis





The following table sets forth the effects of changing rates and volumes on net interest income of the Corporation. Information is provided with respect to (i) effects on net interest income attributable to changes in volume (changes in volume multiplied by prior rate); (ii) effects on net interest income attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) changes in rate/volume mix (change in rate multiplied by change in volume).





(Dollars in thousands)

Three Months Ended

March 31, 2011

Compared to

March 31, 2010

Increase (Decrease) Due toInterest-earning assets

Rate


Volume


Mix


NetResidential loans

$
(32
)

$
127


$
(3
)

$
92Multifamily loans


(137
)


60



(5
)


(82
)Commercial R/E loans


(106
)


52



(1
)


(55
)R/E construction loans


281



(1,190
)


(148
)


(1,057
)Home equity/consumer loans


(31
)


(41
)


4



(68
)Business loans


(156
)


(957
)


35



(1,078
)Total loans


(181
)


(1,949
)


(118
)


(2,248
)Securities available-for-sale


(1,228
)


(102
)


68



(1,262
)Securities held-to-maturity


(109
)


150



(39
)


2Interest-earning deposits in other institutions


7



(17
)


(1
)


(11
)Total securities and interest-earning deposits


(1,330
)


31



28



(1,271
)Total net change in income on interest-earning assets

$
(1,511
)

$
(1,918
)

$
(90
)

$
(3,519
)Interest-bearing liabilitiesSavings accounts

$
-


$
(2
)

$
-


$
(2
)Checking accounts


664



495



(272
)


887Money market accounts


41



(101
)


16



(44
)Certificates of deposit


558



11



(10
)


559Total deposits


1,263



403



(266
)


1,400FHLB advances


660



871



(239
)


1,292Securities sold under agreements to repurchase


(4
)


8



-



4Junior subordinated debentures


(102
)


49



11



(42
)Other borrowings


-



2



-



2Total net change in expenses on interest-bearing liabilities


1,817



1,333



(494
)


2,656Net change in net interest income

$
306


$
(585
)

$
(584
)

$
(863
)





Provision for Loan Losses





The provision for loan losses totaled $2.6 million for the three months ended March 31, 2011, compared to $31.3 million for the three months ended March 31, 2010.





The provision for loan losses is based on management’s evaluation of inherent risks in the loan portfolio and a corresponding analysis of the allowance for loan losses.  Additional discussion on the allowance for loan losses is provided under the heading “Allowance for Loan Losses”.





Other Income





Other income is derived from sources other than interest and fees on earning assets. The Corporation’s primary sources of other income are service charge fees on deposit accounts, other service fees, accretion of cash surrender value of bank owned life insurance (BOLI) and rental income. Other income for the three months ended March 31, 2011, was $1.8 million, compared to $1.9 million for the three months ended March 31, 2010.





60


Other Expenses





Other expense includes expenses associated with compensation and employee benefits, occupancy and equipment, FDIC insurance premiums, REO (including write-downs and losses), FHLB prepayment penalties and other operations.




Other expenses increased by $1.5 million to $10.7 million for the three months ended March 31, 2011, from $9.2 million for the three months ended March 31, 2010.




Compensation and employee benefits decreased $269,000 to $3.4 million for the quarter ended March 31, 2011, compared to $3.7 million for the quarter ended March 31, 2010. Within this category, employee salary expense was down $203,000, or 6.6%, and director’s compensation expense was down $15,000, or 11.4%.  The reduction in employee salary expense was related to an 8.0% reduction in the number of total employees during the past 12 months.




REO expenses, write-downs and losses on sales of REO increased $1.6 million to $2.6 million for the quarter ended March 31, 2011, compared to $994,000 for the same quarter in 2010.  Contract services increased $329,000 to $529,000 for the quarter ended March 31, 2011, compared to $200,000 for the quarter ended March 31, 2010.  This category included costs related directly to capital raising activities, which totaled $325,000 for the quarter ended March 31, 2011, compared to $75,000 for the same quarter in 2010.  All other expenses increased $150,000 to $4.2 million for the quarter ended March 31, 2011, compared to $4.4 million for the quarter ended March 31, 2010.





Efficiency Ratio





A standard measurement used to calculate the overhead costs of financial institutions is the efficiency ratio. The efficiency ratio is calculated by dividing other expense by total revenue, which generally indicates how much an institution spends to generate a dollar of revenue. The lower the efficiency ratio, the more efficient the institution. Management continues to look for ways to improve the efficiency ratio by increasing net interest income and other income while diligently controlling costs and maintaining high standards of service. For the three months ended March 31, 2011 and 2010, the Corporation’s efficiency ratio was 100.91% and 79.64%, respectively. Increased expenses for write-downs/losses on sales of REO added to the increased ratio for the three months ended March 31, 2011.





Operating Segments





The Corporation and the Bank are managed as a legal entity and not by operating segments. The Bank’s operations include commercial banking services, such as lending activities, business services, deposit products and other services. The performance of the Bank as a whole is reviewed by the Board of Directors and Management Committee.





The Management Committee, which is the senior decision making group of the Bank, is comprised of six members including the President/CEO. Segment information is not necessary to be presented in the notes to the Consolidated Financial Statements because operating decisions are made based on the performance of the Corporation as a whole.





Item 3 – Quantitative and Qualitative Disclosures about Market Risk





Asset and Liability Management Activities





The Bank’s Asset/Liability Management Committee (ALCO) has the responsibility to measure and monitor interest rate risk, the liquidity position, and capital adequacy. The Bank uses a variety of tools to measure, monitor, and manage interest rate risk. The Finance Committee of the Board of Directors reviews the interest rate risk management activities of the Bank on a regular basis and has established policies and guidelines on the amount of risk deemed acceptable. The impact on the Bank’s net interest income and the fair value of its capital are modeled under different interest rate scenarios. The Board, through the Asset/Liability Management Policy, has established guidelines for the maximum negative impact that changes in interest rates have on the Bank’s net interest income and the fair value of equity under certain interest rate shock scenarios. Cascade Bank uses a simulation model to measure rate risk, the impact on net interest income and the fair value of equity. In general, the Bank seeks to manage its rate risk through its balance sheet. The Bank focuses on originating more interest rate sensitive assets, such as variable-rate loans, while reducing its long-term, fixed-rate assets through the sale of long-term residential mortgages in the secondary market. The vast majority of the loans that the Bank keeps in its portfolio have rate repricing periods of five years or less, except for those loans generated under the Bank’s Builder Sales program during the last two years.





61


Interest Rate Risk Management





The Bank, like other financial institutions, is subject to interest rate risk because its interest-bearing liabilities reprice on different terms than its interest-earning assets. Management actively monitors the inherent interest rate risk for the potential impact of changes in rates on the Bank.





The Bank uses a simulation model as its primary tool to measure its interest rate risk. A major focus of the Bank’s asset/liability management process is to preserve and enhance net interest income in likely interest rate scenarios. Further, Cascade Bank’s Board of Directors has enacted policies that establish targets for the maximum negative impact that changes in interest rates may have on the Bank’s net interest income and the fair value of equity under certain interest rate shock scenarios. Key assumptions are made to evaluate the change to Cascade Bank’s income and capital to changes in interest rates. These assumptions, while deemed reasonable by management, are inherently uncertain. As a result, the estimated effects of changes in interest rates from the simulation model will likely be different than actual experience.





At March 31, 2011, the Bank’s balance sheet was in a “liability-sensitive” position in the less than one-year period, as the repricing characteristics were such that an increase in market rates would have a negative effect on net interest income and fair value of equity.





To limit its interest rate risk, the Bank has sought to emphasize its loan mix towards short-term adjustable loans with rate floors. In addition, the Bank sells many of its 15 and 30 year fixed rate residential loans, except those loans generated under its Builder Sales program. The table below summarizes the Bank’s loan portfolio by rate type at March 31, 2011.





Type

% of PortfolioVariable


12
%Adjustable


47
%Fixed


41
%100
%





The Bank extends the maturity of its liabilities by offering long-term deposit products to customers and by obtaining longer-term other wholesale borrowings.  As of March 31, 2011, the FHLB advances portfolio of $159.0 million in long-term advances had original maturities greater than one year. This portfolio consists entirely of adjustable rate advances based on the 3-month LIBOR, which reprice quarterly. The Bank has purchased a series of interest rate caps totaling $159.0 million in notional amount to manage interest rate risk on these FHLB advances. The caps are designed to protect net interest margin and stockholders’ equity from potential future rising interest rates.





Liquidity and Sources of Funds





Liquidity Resources.Liquidity refers to the ability to generate sufficient cash to meet the funding needs of current loan demand, deposit withdrawals, principal and interest payments with respect to outstanding borrowings and payment of operating expenses.  The need for liquidity is affected by loan demand, net changes in deposit levels and the scheduled maturities of borrowings.  We monitor the sources and uses of funds on a daily basis to maintain an acceptable liquidity position.  Liquidity is derived from assets by receipt of interest and principal payments and prepayments, by the ability to sell assets at market prices, earnings and by utilizing unpledged assets as collateral for borrowings.





We continue to closely monitor and manage our liquidity position, understanding that this is of critical importance in the current economic environment.  At March 31, 2011, cash, interest-earning deposits and unpledged securities, as a percentage of total assets, totaled 12.7%.





In an effort to increase on-balance sheet liquidity, we have been focused on restructuring our balance sheet, and in particular, reducing the loan portfolio and increasing retail deposits.  As a result, we have maintained a high level of extremely liquid interest-earning balances totaling $108.8 million at March 31, 2011. Year-over-year, total loans decreased $175.8 million, or 15.2%. Retail deposits increased $51.9 million or 6.1% year-over-year.





As shown in the Condensed Consolidated Statements of Cash Flows, net cash provided by operating activities was $3.0 million for the quarter ended March 31, 2011.  The primary sources of cash provided by operating activities were the provision for loan losses of $2.6 million and REO write-downs of $2.0 million.  Net cash of $17.1 million provided by investing activities consisted primarily of $3.2 million from the net reduction of loans and $11.8 million from proceeds on the sale of other real estate owned.  The $38.2 million of cash used in financing activities primarily consisted of the $38.5 million decrease in deposits.





62


The primary objective of the Bank’s liquidity management program is to ensure that it will have adequate funds readily available at a reasonable cost to meet the financial obligations of the Bank. Potential uses of funds include new loan originations or advances against existing loan commitments, deposit withdrawals, and repayment of borrowings and other liabilities. Potential sources of funds include existing liquid assets; cash flow from operations; deposit growth; FHLB advances; repayment of existing loans; the sale of loans; and borrowings from the FRB.





To meet the Bank’s immediate liquidity needs, it maintains readily available funds in deposit accounts at the FHLB and the FRB. In addition, the Bank invests excess funds in short-term, highly liquid securities that can later be used as collateral for borrowing or sold as needed. At March 31, 2011, the Bank’s combined deposit balances at FHLB and FRB were $108.8 million, compared with $127.5 million at December 31, 2010. Unpledged investments totaled $71.6 million at March 31, 2011, compared with $57.9 million at December 31, 2010.





In addition to meeting the Bank’s funding needs using liquid assets, it has borrowed from the FHLB, the FRB, and through the use of wholesale repurchase agreements. At March 31, 2011, the Bank had $159.0 million in FHLB borrowings, plus a $40.0 million Letter of Credit that is being used to secure public funds. Based upon collateral pledged, at March 31, 2011, the Bank had adequate collateral at the FHLB. The Bank has also used reverse repurchase agreements (securities sold under agreements to repurchase) as a source of funding. These agreements require the market value of investments sold under agreements to repurchase to exceed the Corporation’s repurchase obligations. At March 31, 2011, the Bank had $145.0 million in reverse repurchase agreements outstanding. The agreements have provisions that allow the lenders to periodically terminate the agreements. Termination dates typically occur once each quarter, however, a portion of the agreements may not be terminated prior to December 2012, provided the Bank offers the lender additional securities in November and December 2011. The Bank has pledged $210.9 million in securities to secure the repurchase agreements. Termination of the repurchase agreements would have little or no effect on the Bank’s liquidity because the termination would free up the $210.9 million collateral that the Bank has pledged against these borrowings.




The Corporation’s ability to service its debts and pay its obligations is generally dependent upon the availability of dividends from the Bank.  The payment of dividends by the Bank is subject to limitations imposed by law and governmental regulations.  The Bank is currently prohibited by regulatory order from paying any dividends to the Corporation without prior regulatory approval.  As a result, the Corporation began deferring the payment of interest on the trust preferred securities and dividends on the preferred stock. The balance of deferred interest on the trust preferred securities was $3.1 million and the balance of deferred dividends on the preferred stock was $3.3 million as of March 31, 2011.





As a result of capital deficiencies, the Corporation and Bank have entered into the FDIC Order and FRB Agreement whereby the Bank must increase its capital ratios.  See the section entitled “Stockholders’ Equity and Regulatory Matters” for additional details.





Item 4 - Controls and Procedures





Evaluation of Disclosure Controls and Procedures





An evaluation of the Registrant's disclosure controls and procedures (as defined in section 13(a) - 14(c) of the Securities Exchange Act of 1934 (the "Act")) was carried out under the supervision and with the participation of the Registrant's Chief Executive Officer, Chief Financial Officer, and several other members of the Registrant's senior management as of March 31, 2011. The Registrant's Chief Executive Officer and Chief Financial Officer concluded that the Registrant's disclosure controls and procedures as then in effect were effective in ensuring that the information required to be disclosed by the Registrant in the reports it files or submits under the Act is (i) accumulated and communicated to the Registrant's management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms.





63


Changes in Internal Controls





In the quarter ended March 31, 2011, the Registrant did not make any significant changes in, nor take any corrective actions regarding its internal controls, or other factors that have materially affected or are reasonably likely to materially affect these controls.





PART II –– OTHER INFORMATION





Item 1: Legal Proceedings




We are periodically a party to or otherwise involved in legal proceedings arising in the normal and ordinary course of business, such as claims to enforce liens, foreclose on loan defaults, and other issues incident to its business. As of March 31, 2011, Cascade Bank had commenced collection proceedings on approximately 8 real estate loans, and there may be additional lawsuits or claims arising out of or related to the impaired loans.




We are unable to predict the outcome of these matters. Our cash expenditures, including legal fees, associated with the pending litigation described above, and the regulatory proceedings described in Item 2 of this report under the caption “Stockholders’ Equity and Regulatory Matters,” cannot be reasonably predicted at this time. Litigation and any potential regulatory actions or proceedings can be time-consuming and expensive and could divert management time and attention from our business, which could have a material adverse affect on our business, results of operations and financial condition.




Other than the proceedings described or referenced above and the anticipated institution of additional lawsuits or claims arising out of or related to the impaired loans, including lender liability claims and counterclaims, management does not believe that there are any proceedings threatened or pending against us which, if determined adversely, would have a material effect on our business, results of operations, cash flows or financial position.




Item 1A: Risk Factors




We are updating the following risk factors in our Annual Report on Form 10-K for the year ended December 31, 2010, which could materially affect our business, financial condition or future results. Any of the following risk factors as well as those described in the Form 10-K could materially and adversely affect our business, financial condition and results of operations after December 31, 2010, and these are not the only risks that we may face. Many of these factors are beyond our control, and in addition to the following risk factors you should read carefully the factors described in “Risk Factors” in the Corporation’s Form 10-K filed with the Securities and Exchange Commission for a description of some, but not all, risks, uncertainties and contingencies. Additional risks and uncertainties not currently known to us may also materially and adversely affect our business, financial condition or results of operations.




Restrictions imposed by regulatory actions could have an adverse effect on us and failure to comply with any of its provisions could result in further regulatory action or restrictions.




The businesses and operations of the Corporation and our subsidiary, Cascade Bank, are currently subject to regulatory actions, including the FDIC Order and the FRB Agreement, which, for example, generally prohibit us from paying dividends, repurchasing stock, retaining new directors or senior managers or changing the duties of senior management, paying management or consulting fees or other funds to the Corporation, and extending additional credit with respect to nonperforming and adversely classified loans. The FDIC Order also requires Cascade Bank to raise its Tier 1 leverage capital ratio to a higher than normal level of 10.0% of its assets and to maintain that capital level, in addition to maintaining a fully funded allowance for loan losses satisfactory to the FDIC and the Washington DFI. We are not in compliance with the requirement to raise additional capital and the FRB recently advised us, based on its latest examination, that we are not in compliance with certain other requirements of the FRB Agreement. These and other regulatory actions are described in more detail in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Stockholders’ Equity and Regulatory Matters.” These regulatory actions and any future actions could continue to adversely affect our earnings, business and operations. In addition, failure to comply with these regulatory actions or any future actions could result in further regulatory actions or restrictions, including monetary penalties and the potential closure of Cascade Bank.




See also the discussion of our risk factors on Form 10-K for the fiscal year ended December 31, 2010, as filed with the SEC on March 25, 2011.




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Item 6.  Exhibits





(a)  Exhibits





31.1
Certifications of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act31.2
Certifications of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act32
Certification pursuant to Section 906 of the Sarbanes-Oxley Act





(b)
Reports on Form 8-K




On April 26, 2011, the Corporation filed a Form 8-K reporting an attached press release announcing earnings for the quarter ended March 31, 2011, under Items 2.02 and 9.01 of Form 8-K.














SIGNATURES







Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.








CASCADE FINANCIAL CORPORATIONMay 12, 2011
/s/ Carol K. NelsonBy:     Carol K. Nelson,

President and Chief Executive Officer

(Principal Executive Officer)May 12, 2011
/s/ Debra L. JohnsonBy:     Debra L. Johnson,

Executive Vice President and Chief Financial Officer

(Principal Financial and Accounting Officer)


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