| HORIZON FINANCIAL CORP Item 1A Risk Factors |
| 27 Item 1A Risk Factors |
| - ----------------------- An investment in our common stock is subject to risks inherent to our business |
| Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report |
| The risks and uncertainties described below are not the only ones that affect us |
| Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair our business operations |
| This report is qualified in its entirety by these risk factors |
| If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected |
| If this were to happen, the value of our common stock could decline significantly, and you could lose all or part of your investment |
| Our financial condition and operations are influenced significantly by general economic conditions, including the absolute level of interest rates as well as changes in interest rates and the slope of the yield curve |
| Our profitability is dependent to a large extent on our net interest income, which is the difference between the interest received from our interest-earning assets and the interest expense incurred on our interest-bearing liabilities |
| Our activities, like all financial institutions, inherently involve the assumption of interest rate risk |
| Interest rate risk is the risk that changes in market interest rates will have an adverse impact on our earnings and underlying economic value |
| Interest rate risk is determined by the maturity and repricing characteristics of our assets, liabilities and off- balance-sheet contracts |
| Interest rate risk is measured by the variability of financial performance and economic value resulting from changes in interest rates |
| Interest rate risk is the primary market risk affecting the Corporationapstas financial performance |
| The greatest source of interest rate risk to us results from the mismatch of maturities or repricing intervals for rate sensitive assets, liabilities and off-balance-sheet contracts |
| Additional interest rate risk results from mismatched repricing indices and formulae (basis risk and yield curve risk), and product caps and floors and early repayment or withdrawal provisions (option risk), which may be contractual or market driven, that are generally more favorable to customers than to us |
| 27 Our primary monitoring tool for assessing interest rate risk is asset/liability simulation modeling, which is designed to capture the dynamics of balance sheet, interest rate and spread movements and to quantify variations in net interest income resulting from those movements under different rate environments |
| The sensitivity of net interest income to changes in the modeled interest rate environments provides a measurement of interest rate risk |
| We also utilize market value analysis, which addresses changes in estimated net market value of equity arising from changes in the level of interest rates |
| The net market value of equity is estimated by separately valuing our assets and liabilities under varying interest rate environments |
| The extent to which assets gain or lose value in relation to the gains or losses of liability values under the various interest rate assumptions determines the sensitivity of net equity value to changes in interest rates and provides an additional measure of interest rate risk |
| The interest rate sensitivity analysis we perform incorporates beginning-of-the-period rate, balance and maturity data, using various levels of aggregation of that data, as well as certain assumptions concerning the maturity, repricing, amortization and prepayment characteristics of loans and other interest-earning assets and the repricing and withdrawal of deposits and other interest-bearing liabilities into an asset/liability computer simulation model |
| We update and prepare simulation modeling at least quarterly for review by senior management and the directors |
| We believe the data and assumptions are realistic representations of our portfolio and possible outcomes under the various interest rate scenarios |
| Nonetheless, the interest rate sensitivity of our net interest income and net market value of equity could vary substantially if different assumptions were used or if actual experience differs from the assumptions used |
| Our Loan Portfolio Includes Loans with a Higher Risk of Loss |
| We originate commercial and multi-family real estate loans, construction and land development loans, commercial loans, consumer loans and residential mortgage loans primarily within our market areas |
| Generally, types of loans other than the residential mortgage loans have a higher risk of loss than residential mortgage loans |
| We have had a significant increase in our commercial real estate and construction and land development lending since March 31, 2003 |
| Commercial and multi-family real estate, construction and land development, commercial, and consumer loans may expose a lender to greater credit risk than loans secured by residential real estate because the collateral securing these loans may not be sold as easily as residential real estate |
| These loans also have greater credit risk than residential real estate for the following reasons and the reasons discussed under "e Item 1 |
| Business-Lending Activities "e |
| * Commercial and Multi-family Mortgage Loans |
| These loans typically involve higher principal amounts than other types of loans, and repayment is dependent upon income being generated from the property securing the loan in amounts sufficient to cover operating expenses\ and debt service |
| * Construction and Land Development Loans |
| This type of lending contains the inherent difficulty in estimating both a propertyapstas value at completion of the project and the estimated cost (including interest) of the project |
| If the estimate of construction cost proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to permit completion of the project |
| If the estimate of value upon completion proves to be inaccurate, we may be confronted at, or prior to, the maturity of the loan with a project the value of which is insufficient to assure full repayment |
| In addition, speculative construction loans to a builder are often associated with homes that are not pre-sold, and thus pose a greater potential risk to us than construction loans to individuals on their personal residences |
| Construction loans on land under development or held for future construction also poses additional risk because of the lack of income being produced by the property and the potential illiquid nature of the security |
| * Commercial Loans |
| Repayment is dependent upon the successful operation of the borrowerapstas business |
| * Consumer Loans |
| Consumer loans (such as personal lines of credit) are collateralized, if at all, with assets that may not provide an adequate source of payment of the loan due to depreciation, damage, or loss |
| As indicated in the Real Estate Development Subsidiary section of Part 1, Item 1 of this Form 10-K, the Bankapstas wholly owned subsidiary (Westward) is a land development company which periodically enters into joint ventures to develop residential real estate |
| While Westward has successfully partnered in various real estate developments since the 1970s, there can be no guarantee that success in this area will necessarily continue into the future |
| This activity may present additional risk to us, as we are exposed as an equity investor in the land being developed |
| Adverse movements in the value of the raw land or the values of the fully developed lots would negatively affect our financial performance |
| Adverse changes in real estate development regulations (ie environmental regulations, project density requirements, and other related development regulatory matters) may also negatively impact our success in this regard |
| In addition, this development activity exposes us to potential reputation risk, as some members of our communities might not necessarily approve of our involvement as a real estate development partner |
| In addition, certain projects may be perceived negatively by residents of the area where the properties are being developed, instead of favoring to leave the land in an undeveloped state |
| For these and potentially other reasons related to real estate development, our joint ventures in real estate development may expose us to additional risk, and no assurances can be provided regarding continued success in this area |
| Our Profitability Depends Significantly on Economic Conditions in Our Primary Market Area |
| Our success depends primarily on the general economic conditions of the State of Washington and the specific local markets in which we operate |
| Unlike larger national or other regional banks that are more geographically diversified, we provide banking and financial services to customers located primarily in Whatcom, Skagit, Snohmish and Pierce Counties of Washington |
| The local economic conditions in our market areas have a significant impact on the demand for our products and services as well as the ability of our customers to repay loans, the value of the collateral securing loans and the stability of our deposit funding sources |
| A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities markets or other factors could impact these local economic conditions and, in turn, have a material adverse effect on our financial condition and results of operations |
| We make various assumptions and judgments about the collectibility of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans |
| In determining the amount of the allowance for loan losses, we review our loans and the loss and delinquency experience, and evaluate economic conditions |
| If our assumptions are incorrect, the allowance for loan losses may not be sufficient to cover losses inherent in our loan portfolio, resulting in the need for additions to our allowance |
| Material additions to the allowance could materially decrease our net income |
| Our allowance for loan losses was 1dtta52prca of total loans at March 31, 2006 |
| In addition, bank regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs |
| Any increase in our allowance for loan losses or loan charge-offs as required by these regulatory authorities may have a material adverse effect on our financial condition and results of operations |
| If External Funds Were Not Available, this Could Adversely Impact Our Growth and Prospects |
| We rely on deposits and advances from the FHLB-Seattle and other borrowings to fund our operations |
| Although we have historically been able to replace maturing deposits and advances if desired, no assurance can be given that we would be able to replace such funds in the future if our financial condition or the financial condition of the FHLB or market conditions were to change |
| Although we consider such sources of funds adequate for our liquidity needs, we may seek additional debt in the future to achieve our long-term business objectives |
| There can be no assurance additional borrowings, if sought, 29 would be available to us or, if available, would be on favorable terms |
| If additional financing sources are unavailable or are not available on reasonable terms, our growth and future prospects could be adversely affected |
| Strong Competition Within Our Market Area May Limit Our Growth and Profitability |
| Competition in the banking and financial services industry is intense |
| We compete in our market areas with commercial banks, savings institutions, mortgage brokerage firms, credit unions, finance companies, mutual funds, insurance companies, and brokerage and investment banking firms operating locally and elsewhere |
| Some of these competitors have substantially greater resources and lending limits than we do, have greater name recognition and market presence that benefit them in attracting business, and offer certain services that we do not or cannot provide |
| In addition, larger competitors may be able to price loans and deposits more aggressively than we do |
| Our profitability depends upon our continued ability to successfully compete in our market areas |
| The greater resources and deposit and loan products offered by some of our competitors may limit our ability to increase our interest-earning assets |
| For additional information see Item 1, "e Business Competition "e |
| We believe that our success depends largely on the efforts and abilities of our senior management |
| Their experience and industry contacts significantly benefit us |
| The competition for qualified personnel in the financial services industry is intense, and the loss of any of our key personnel or an inability to continue to attract, retain and motivate key personnel could adversely affect our business |
| If Our Common Stock Was No Longer Included in the Russell 2000 or Russell 3000 Indices There Could be a reduction in Liquidity and Prices for Our Stock |
| Our common stock is included in the Russell 2000 and Russell 3000 indices |
| Inclusion in these indices may have positively impacted the price, trading volume and liquidity of our common stock, in part, because index funds or other institutional investors often purchase securities that are in these indices |
| Conversely if our market capitalization falls below the minimum necessary to be included in either or both of these indices at any annual reconstitution date, the opposite could occur |
| We are subject to extensive federal and state regulation and supervision primarily through the Bank and certain non-bank subsidiaries |
| Banking regulations are primarily intended to protect depositors &apos funds, federal deposit insurance funds and the banking system as a whole, not shareholders |
| These regulations affect our lending practices, capital structure, investment practices, dividend policy and growth, among other things |
| Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes |
| Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect us in substantial and unpredictable ways |
| Such changes could subject us to additional costs, limit the types of financial services and products we may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things |
| Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on our business, financial condition and results of operations |
| While we have policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur |
| See Item 1, "e Business -- Regulation and Supervision "e |
| We rely heavily on communications and information systems to conduct our business |
| Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems |
| While we have policies and procedures designed to limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, 30 interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed |
| The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations |
| Horizon Financial is a separate and distinct legal entity from its subsidiaries |
| We receive substantially all of our revenue from dividends from our subsidiaries |
| These dividends are the principal source of funds to pay dividends on our common stock and interest and principal on our debt |
| Various federal and/or state laws and regulations limit the amount of dividends that Horizon Bank and certain non-bank subsidiaries may pay to Horizon Financial |
| Also, our right to participate in a distribution of assets upon a subsidiaryapstas liquidation or reorganization is subject to the prior claims of the subsidiaryapstas creditors |
| In the event Horizon Bank is unable to pay dividends to Horizon Financial, Horizon Financial may not be able to service debt, pay obligations or pay dividends on Horizon Financialapstas common stock |
| The inability to receive dividends from Horizon Bank could have a material adverse effect on our business, financial condition and results of operations |
| If We Fail to Maintain an Effective System of Internal Control over Financial Reporting, We May Not Be Able to Accurately Report Our Financial Results or Prevent Fraud, and, as a Result, Investors and Depositors Could Lose Confidence in Our Financial Reporting, Which Could Adversely Affect Our Business, the Trading Price of Our Stock and Our Ability to Attract Additional Deposits |
| In connection with the enactment of the Sarbanes-Oxley Act of 2002 ( "e Act "e ) and the implementation of the rules and regulations promulgated by the SEC, we document and evaluate our internal control over financial reporting in order to satisfy the requirements of Section 404 of the Act |
| This requires us to prepare an annual management report on our internal control over financial reporting, including among other matters, managementapstas assessment of the effectiveness of internal control over financial reporting and an attestation report by our independent auditors addressing these assessments |
| If we fail to identify and correct any significant deficiencies in the design or operating effectiveness of our internal control over financial reporting or fail to prevent fraud, current and potential shareholders and depositors could lose confidence in our Companyapstas internal controls and financial reporting, which could adversely affect our business, financial condition and results of operations, the trading price of our stock and our ability to attract additional deposits |