UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006

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

FOR THE TRANSITION PERIOD FROM                      TO                     .

STERLING FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

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

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

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ       Accelerated Filer o       Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o 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 November 1, 2006
Common Stock ($1.00 par value)		37,086,449

 

 

STERLING FINANCIAL CORPORATION

FORM 10-Q
For the Quarter Ended September 30, 2006

TABLE OF CONTENTS

		Page
PART I — Financial Information			1
Item 1 Financial Statements (Unaudited)			1
Consolidated Balance Sheets			1
Consolidated Statements of Income			2
Consolidated Statements of Cash Flows			3
Consolidated Statements of Comprehensive Income			5
Notes to Consolidated Financial Statements			6
Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations			16
Item 3 Quantitative and Qualitative Disclosures About Market Risk			35
Item 4 Controls and Procedures			35
PART II — Other Information			36
Item 1 Legal Proceedings			36
Item 1a Risk Factors			36
Item 2 Unregistered Sales of Equity Securities and Use of Proceeds			36
Item 3 Defaults Upon Senior Securities			36
Item 4 Submission of Matters to a Vote of Security Holders			36
Item 5 Other Information			36
Item 6 Exhibits			36
Signatures			37
EXHIBIT 10.1
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PART I — Financial Information

		September 30,				December 31,
		2006				2005
		(Dollars in thousands)
ASSETS:
Cash and cash equivalents:
Interest bearing		$	8,779			$	9,400
Non-interest bearing and vault			134,833				121,907
Restricted cash			1,363				862
Investment securities and mortgage-backed securities (“MBS”):
Available for sale			1,864,923				2,076,615
Held to maturity			83,681				51,924
Loans receivable, net			6,240,512				4,885,916
Loans held for sale			119,406				7,894
Accrued interest receivable			47,843				35,805
Real estate owned and other collateralized assets, net			4,369				779
Office properties and equipment, net			79,150				82,432
Bank-owned life insurance (“BOLI”)			112,383				107,649
Goodwill			144,861				112,707
Other intangible assets			16,634				17,625
Mortgage servicing rights, net			6,813				5,430
Prepaid expenses and other assets, net			47,167				41,983
Total assets		$	8,912,717			$	7,558,928
LIABILITIES:
Deposits		$	5,953,767			$	4,806,301
Advances from Federal Home Loan Bank Seattle (“FHLB Seattle”)			1,373,513				1,443,462
Securities sold subject to repurchase agreements and funds purchased			623,612				611,676
Other borrowings			237,222				110,688
Cashiers checks issued and payable			7,336				5,483
Borrowers’ reserves for taxes and insurance			3,571				1,527
Accrued interest payable			35,116				18,169
Accrued expenses and other liabilities			69,859				54,937
Total liabilities			8,303,996				7,052,243
Commitments and Contingencies
SHAREHOLDERS’ EQUITY:
Preferred stock, $1 par value; 10,000,000 shares authorized; no shares issued and outstanding			0				0
Common stock, $1 par value; 60,000,000 shares authorized; 37,024,265 and 34,855,549 shares issued and outstanding			37,024				34,856
Additional paid-in capital			441,547				385,353
Accumulated other comprehensive loss:
Unrealized losses on investment securities and MBS available-for-sale, net of deferred income taxes of $20,641 and $20,021			(35,249	)			(34,219	)
Retained earnings			165,399				120,695
Total shareholders’ equity			608,721				506,685
Total liabilities and shareholders’ equity		$	8,912,717			$	7,558,928

The accompanying notes are an integral part of the consolidated financial statements.

STERLING FINANCIAL CORPORATION

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
						(Dollars in thousands, except per share data)
Interest income:
Loans		$	125,554			$	73,375			$	321,021			$	214,037
MBS			21,626				20,757				67,444				65,697
Investments and cash equivalents			1,028				642				2,642				2,162
Total interest income			148,208				94,774				391,107				281,896
Interest expense:
Deposits			51,653				23,827				127,372				63,255
Short-term borrowings			10,055				10,491				25,301				26,856
Long-term borrowings			16,467				7,368				48,396				32,065
Total interest expense			78,175				41,686				201,069				122,176
Net interest income			70,033				53,088				190,038				159,720
Provision for losses on loans			(4,698	)			(3,400	)			(13,998	)			(10,550	)
Net interest income after provision for losses on loans			65,335				49,688				176,040				149,170
Non-interest income:
Fees and service charges			11,526				9,260				31,220				24,868
Mortgage banking operations			5,572				2,969				10,568				14,447
Loan servicing fees			473				90				1,224				330
Real estate owned and other collateralized assets operations			(138	)			(23	)			247				188
BOLI			1,225				1,164				3,611				3,331
Other non-interest expense			(207	)			(154	)			(372	)			186
Total non-interest income			18,451				13,306				46,498				43,350
Non-interest expenses			55,302				42,599				146,531				123,848
Income before income taxes			28,484				20,395				76,007				68,672
Income tax provision			(9,145	)			(6,505	)			(24,321	)			(22,883	)
Net income		$	19,339			$	13,890			$	51,686			$	45,789
Earnings per share — basic		$	0.52			$	0.40			$	1.45			$	1.32
Earnings per share — diluted		$	0.52			$	0.40			$	1.44			$	1.31
Weighted average shares outstanding — basic			36,891,986				34,660,107				35,645,887				34,581,606
Weighted average shares outstanding — diluted			37,273,560				35,097,474				35,992,764				35,033,011

The accompanying notes are an integral part of the consolidated financial statements.

STERLING FINANCIAL CORPORATION

		Nine Months Ended
		September 30,
		2006				2005
		(Dollars in thousands)
Cash flows from operating activities:
Net income		$	51,686			$	45,789
Adjustments to reconcile net income to net cash provided by operating activities:
Provisions for losses on loans and real estate owned			14,168				10,550
Stock dividends on FHLB Seattle stock			0				(303	)
Accretion of deferred gain on sale of branches			(151	)			0
Net gain on sales of loans, investment securities and MBS			(4,832	)			(9,280	)
Stock based compensation			182				0
Excess tax benefit from stock based compensation			(1,638	)			0
Stock issuances relating to 401(k) match			1,203				0
Other gains and losses			888				(16,818	)
Change in cash surrender value of BOLI			(3,611	)			(3,332	)
Depreciation and amortization			14,084				14,805
Change in:
Accrued interest receivable			(8,770	)			(2,446	)
Prepaid expenses and other assets			1,217				13,071
Cashiers checks issued and payable			721				602
Accrued interest payable			16,307				1,117
Accrued expenses and other liabilities			(2,910	)			(263	)
Proceeds from sales of loans originated for sale			304,302				129,711
Loans originated for sale			(299,639	)			(126,830	)
Net cash provided by operating activities			83,207				56,373
Cash flows from investing activities:
Change in restricted cash			(501	)			(5,705	)
Loans funded and purchased			(3,169,552	)			(2,418,560	)
Loan principal received			2,120,741				1,889,705
Proceeds from sales of other loans			51,144				472,682
Purchase of investment securities			(44,416	)			(13,645	)
Proceeds from maturities of investment securities			11,400				1,405
Proceeds from sales of investment securities			0				14,844
Purchase of BOLI			0				(10,000	)
Purchase of mortgage-backed securities			0				(203,276	)
Principal payments on mortgage-backed securities			208,160				292,211
Proceeds from sales of mortgage-backed securities			0				115,837
Purchase of office properties and equipment			(11,742	)			(9,066	)
Sales of office properties and equipment			18,882				249
Improvements and other changes to real estate owned			(248	)			(273	)
Proceeds from sales and liquidation of real estate owned			1,353				2,158
Cash and cash equivalents issued as part of mergers			(5,983	)			0
Net cash provided by (used in) investing activities			(820,762	)			128,566

The accompanying notes are an integral part of the consolidated financial statements.

STERLING FINANCIAL CORPORATION
Consolidated Statements of Cash Flows
(Unaudited)

		Nine Months Ended
		September 30,
		2006				2005
		(Dollars in thousands)
Cash flows from financing activities:
Net change in checking, regular savings and money market deposits		$	224,549			$	246,858
Proceeds from issuance of time deposits			2,803,087				1,674,652
Payments for maturing time deposits			(2,437,358	)			(1,453,474	)
Interest credited to deposits			110,760				59,425
Advances from FHLB Seattle			1,985,866				530,229
Repayment of advances from FHLB Seattle			(2,055,766	)			(881,710	)
Net change in securities sold subject to repurchase agreements and funds purchased			11,936				(318,418	)
Proceeds from other borrowings			130,000				0
Repayment of other borrowings			(25,000	)			(19,000	)
Payments for fractional shares and certain merger costs			0				(14	)
Proceeds from stock issuance and exercise of stock options, net of repurchases			4,774				2,781
Excess tax benefit from stock based compensation			1,638				0
Deferred financing costs			0				(75	)
Cash dividend paid to shareholders			(6,670	)			0
Other			2,044				446
Net cash provided by (used in) financing activities			749,860				(158,300	)
Net change in cash and cash equivalents			12,305				26,639
Cash and cash equivalents, beginning of period			131,307				93,187
Cash and cash equivalents, end of period		$	143,612			$	119,826
Supplemental disclosures:
Cash paid during the period for:
Interest		$	184,122			$	121,059
Income taxes			28,732				9,560
Noncash financing and investing activities:
Loans converted into real estate owned and other collateralized assets			4,406				2,266
Common stock cash dividends accrued			2,594				1,738
Deferred gain on sale of branches			9,029				0
Common stock issued upon business combination			50,565				0

The accompanying notes are an integral part of the consolidated financial statements.

STERLING FINANCIAL CORPORATION

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
						(Dollars in thousands)
Net income		$	19,339			$	13,890			$	51,686			$	45,789
Other comprehensive income:
Change in unrealized gains (losses) on investment securities and MBS available-for-sale			39,170				(25,624	)			(1,650	)			(27,260	)
Less deferred income taxes			(14,490	)			9,483				620				10,095
Net other comprehensive income (loss)			24,680				(16,141	)			(1,030	)			(17,165	)
Comprehensive income (loss)		$	44,019			$	(2,251	)		$	50,656			$	28,624

The accompanying notes are an integral part of the consolidated financial statements.

STERLING FINANCIAL CORPORATION

1. Basis of Presentation:

The foregoing unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X as promulgated by the Securities and Exchange Commission. Accordingly, these financial statements do not include all of the disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2005. In the opinion of management, the unaudited interim consolidated financial statements furnished herein include all adjustments, all of which are of a normal recurring nature, necessary for a fair statement of the results for the interim periods presented.

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

2. Other Borrowings:

The components of other borrowings are as follows (in thousands):

		September 30,				December 31,
		2006				2005
Trust Preferred Securities		$	236,768			$	108,707
Other			454				1,981
Total		$	237,222			$	110,688

Sterling raises capital from time to time through the formation of trusts (“Capital Trusts”), which issue capital securities (“Trust Preferred Securities”) to investors. Sterling has also acquired Capital Trusts in connection with business acquisitions. These Capital Trusts are business trusts in which Sterling owns all of the common equity. The proceeds from the sale of the Trust Preferred Securities are used to purchase junior subordinated deferrable interest debentures (“Junior Subordinated Debentures”) issued by Sterling. Sterling’s obligations under the Junior Subordinated Debentures and related documents, taken together, constitute a full and unconditional guarantee by Sterling of the Capital Trusts’ obligations under the Trust Preferred Securities. The Trust Preferred Securities are treated as debt of Sterling. The Junior Subordinated Debentures and related Trust Preferred Securities generally mature 30 years after issuance and are redeemable at the option of Sterling under certain conditions, including, with respect to certain of the Trust Preferred Securities, payment of call premiums. Interest is paid quarterly or semi-annually. Details of the Trust Preferred Securities are as follows:

2. Other Borrowings, continued:

Rate at

Carrying

Maturity

Initial

September 30,

Value (in

Subsidiary Issuer

Issue Date

Date

Call Date

Rate Index

2006

thousands)

Sterling Capital

Sept 2006

Sept 2036

Sept 2011

3 month LIBOR

7.02

%

$

51,547

Trust VIII

plus 1.63%

Sterling Capital

June 2006

June 2036

June 2011

3 month LIBOR

6.92

56,702

Trust VII

plus 1.53%

Lynnwood Financial

June 2005

June 2033

June 2008

3 month LIBOR

7.19

10,310

Statutory Trust II

plus 1.80%

Sterling Capital

June 2003

Sept 2033

Sept 2008

3 month LIBOR

8.59

10,310

Trust VI

plus 3.20%

Sterling Capital

May 2003

May 2033

June 2008

3 month LIBOR

8.62

20,619

Statutory Trust V

plus 3.25%

Sterling Capital

May 2003

May 2033

May 2008

3 month LIBOR

8.56

10,310

Trust IV

plus 3.15%

Sterling Capital

April 2003

April 2033

April 2008

3 month LIBOR

8.74

14,433

Trust III

plus 3.25%

Lynnwood Financial

Mar 2003

Mar 2033

Mar 2007

3 month LIBOR

8.52

9,486

Statutory Trust I

plus 3.15%

Klamath First Capital

April 2002

April 2032

April 2007

6 month LIBOR

8.99

13,151

Trust II

plus 3.70%

Klamath First Capital

July 2001

July 2031

June 2006

6 month LIBOR

9.30

15,157

Trust I

plus 3.75%

Sterling Capital

July 2001

July 2031

June 2006

Fixed

10.25

24,743

8.04

%*

$

236,768

During 2002, Sterling financed the sale of certain loans to an unrelated party. Since the underlying loans served as collateral on the loan to the purchaser, this sale was accounted for as a financing, and is included in other borrowings under the caption “Other.”

On August 21, 2006, Sterling entered into a $30 million one-year variable-rate revolving credit agreement (the “Credit Facility”) with Wells Fargo Bank, National Association, replacing a $40 million credit facility Sterling previously had with Bank of Scotland. As of September 30, 2006, no amount was drawn on the credit facility. Amounts loaned pursuant to the Credit Facility will bear interest, at Sterling’s election, at either two percent below prime, or at LIBOR plus 90 basis points. The Credit Facility contains representations and warranties, and negative and affirmative covenants by Sterling, including financial covenants and restrictions on certain actions by Sterling, such as Sterling’s ability to incur debt, make investments and merge into or consolidate with other entities. The Credit Facility may be terminated and loans under the Credit Facility may be accelerated if an event of default

occurs, as defined in the Credit Facility. Sterling is obligated to repay the principal balance of any advances issued pursuant to the Credit Facility on August 3, 2007.

3. Earnings Per Share:

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

		Three Months Ended September 30,
		2006												2005
		Net				Weighted				Per Share				Net				Weighted				Per Share
		Income				Avg. Shares				Amount				Income				Avg. Shares				Amount
		(Dollars in thousands, except per share amounts)
Basic computations		$	19,339				36,891,986			$	0.52			$	13,890				34,660,107			$	0.40
Effect of dilutive securities:
Common stock options			0				369,570				0.00				0				401,355				0.00
Contingently issuable shares			0				12,004				0.00				0				36,012				0.00
Diluted computations		$	19,339				37,273,560			$	0.52			$	13,890				35,097,474			$	0.40
Antidilutive options not included in diluted earnings per share							0												456,000

		Nine Months Ended September 30,
		2006												2005
		Net				Weighted				Per Share				Net				Weighted				Per Share
		Income				Avg. Shares				Amount				Income				Avg. Shares				Amount
		(Dollars in thousands, except per share amounts)
Basic computations		$	51,686				35,645,887			$	1.45			$	45,789				34,581,606			$	1.32
Effect of dilutive securities:
Common stock options			0				334,873				(0.01	)			0				415,393				(0.01	)
Contingently issuable shares			0				12,004				0.00				0				36,012				0.00
Diluted computations		$	51,686				35,992,764			$	1.44			$	45,789				35,033,011			$	1.31
Antidilutive options not included in diluted earnings per share							0												456,000

4. Non-Interest Expenses:

The following table details the components of Sterling’s total non-interest expenses:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
		(Dollars in thousands)								(Dollars in thousands)
Employee compensation and benefits		$	31,479			$	23,274			$	82,278			$	67,625
Occupancy and equipment			8,755				6,578				23,046				19,241
Depreciation			2,662				2,227				7,377				6,348
Amortization of core deposit intangibles			586				556				1,697				1,667
Advertising			2,900				2,251				7,155				6,668
Data processing			3,746				3,179				10,601				9,391
Insurance			364				304				963				934
Legal and accounting			622				486				1,861				2,274
Travel and entertainment			1,454				1,081				4,040				3,263
Goodwill litigation costs			25				0				245				189
Merger and acquisition costs			191				0				191				0
Other			2,518				2,663				7,077				6,248
Total		$	55,302			$	42,599			$	146,531			$	123,848

5. Segment Information:

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

•

The Community Banking segment consists of the operations conducted by Sterling’s subsidiaries, Sterling Savings Bank and Golf Savings Bank.

•

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

•

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

•

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

•

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

5. Segment Information, continued:

The following table presents certain financial information regarding Sterling’s segments and provides a reconciliation to Sterling’s consolidated totals for the periods presented:

		As of and for the Three Months Ended September 30, 2006
						Residential				Commercial
		Community				Mortgage				Mortgage				Retail				Other and
		Banking				Banking				Banking				Brokerage				Eliminations				Total
		(Dollars in thousands)
Interest income		$	142,654			$	4,832			$	2,407			$	0			$	(1,685	)		$	148,208
Interest expense			(76,132	)			0				0				0				(2,043	)			(78,175	)
Net interest income (expense)			66,522				4,832				2,407				0				(3,728	)			70,033
Provision for loan losses			(4,698	)			0				0				0				0				(4,698	)
Noninterest income			14,758				5,813				1,129				759				(4,008	)			18,451
Noninterest expense			(45,638	)			(5,924	)			(2,272	)			(726	)			(742	)			(55,302	)
Income before income taxes		$	30,944			$	4,721			$	1,264			$	33			$	(8,478	)		$	28,484
Total assets		$	9,003,443			$	15,127			$	10,660			$	897			$	(117,410	)		$	8,912,717

		As of and for the Three Months Ended September 30, 2005
						Residential				Commercial
		Community				Mortgage				Mortgage				Retail				Other and
		Banking				Banking				Banking				Brokerage				Eliminations				Total
		(Dollars in thousands)
Interest income		$	89,576			$	3,189			$	1,150			$	0			$	859			$	94,774
Interest expense			(39,718	)			0				0				0				(1,968	)			(41,686	)
Net interest income (expense)			49,858				3,189				1,150				0				(1,109	)			53,088
Provision for loan losses			(3,400	)			0				0				0				0				(3,400	)
Noninterest income			11,092				2,865				1,720				964				(3,335	)			13,306
Noninterest expense			(34,344	)			(4,927	)			(1,998	)			(1,041	)			(289	)			(42,599	)
Income before income taxes		$	23,206			$	1,127			$	872			$	(77	)		$	(4,733	)		$	20,395
Total assets		$	6,862,568			$	21,166			$	20,200			$	748			$	(108,634	)		$	6,796,048

5. Segment Information, continued:

		As of and for the Nine Months Ended September 30, 2006
						Residential				Commercial
		Community				Mortgage				Mortgage				Retail				Other and
		Banking				Banking				Banking				Brokerage				Eliminations				Total
		(Dollars in thousands)
Interest income		$	373,600			$	12,074			$	6,670			$	0			$	(1,237	)		$	391,107
Interest expense			(194,288	)			0				0				0				(6,781	)			(201,069	)
Net interest income (expense)			179,312				12,074				6,670				0				(8,018	)			190,038
Provision for loan losses			(13,998	)			0				0				0				0				(13,998	)
Noninterest income			39,690				10,365				3,612				2,602				(9,771	)			46,498
Noninterest expense			(122,485	)			(13,699	)			(6,195	)			(2,197	)			(1,955	)			(146,531	)
Income before income taxes		$	82,519			$	8,740			$	4,087			$	405			$	(19,744	)		$	76,007
Total assets		$	9,003,443			$	15,127			$	10,660			$	897			$	(117,410	)		$	8,912,717

		As of and for the Nine Months Ended September 30, 2005
						Residential				Commercial
		Community				Mortgage				Mortgage				Retail				Other and
		Banking				Banking				Banking				Brokerage				Eliminations				Total
		(Dollars in thousands)
Interest income		$	267,494			$	8,297			$	5,247			$	0			$	858			$	281,896
Interest expense			(116,345	)			0				0				0				(5,831	)			(122,176	)
Net interest income (expense)			151,149				8,297				5,247				0				(4,973	)			159,720
Provision for loan losses			(10,550	)			0				0				0				0				(10,550	)
Noninterest income			39,015				7,446				4,409				2,635				(10,155	)			43,350
Noninterest expense			(102,451	)			(13,311	)			(5,124	)			(2,665	)			(297	)			(123,848	)
Income before income taxes		$	77,163			$	2,432			$	4,532			$	(30	)		$	(15,425	)		$	68,672
Total assets		$	6,862,568			$	21,166			$	20,200			$	748			$	(108,634	)		$	6,796,048

6. Stock Options:

On January 1, 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard No. 123 (R), “Share Based Payment” (“SFAS No. 123 (R)”), became effective for Sterling. As such, stock options issued as compensation are recorded as an expense at their estimated fair value. Prior to SFAS No. 123 (R)’s effective date, Sterling had elected to retain the compensation measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”). Under APB No. 25, compensation cost was recognized at the measurement date of the amount, if any, that the quoted market price of Sterling’s common stock exceeded the option exercise price. Sterling has only granted its common stock options to employees with exercise prices equal to the market price of Sterling’s common stock on the measurement dates. Thus, prior to the implementation of SFAS No. 123 (R), no compensation cost had been recognized.

During the nine months ended September 30, 2006, stock option activity and related information was as follows:

						Weighted				Weighted Average				Aggregate
						Average				Remaining Contractual				Intrinsic Value
		Number				Exercise Price				Life (in years)				(in thousands)
Outstanding, December 31, 2005			1,703,959			$	19.46
Granted			20,000				25.28
Issued in merger			77,258				8.19
Exercised			322,025				14.71
Outstanding, September 30, 2006			1,479,192			$	19.98				5.36			$	18,421
Exercisable, September 30, 2006			1,476,162			$	20.00				5.37			$	18,349

As of September 30, 2006, a total of 436,249 stock options remained available for grant under Sterling’s 2001 and 2003 Long-Term Incentive Plans. These options have terms of four, six or ten years.

During the nine months ended September 30, 2006 and 2005, the fair value of options granted were $8.55 and $0, respectively, and the intrinsic value of options exercised were $4.9 million and $5.3 million, respectively. Stock compensation expense recognized during the nine months ended September 30, 2006 was $182,000. Had SFAS No. 123 (R) been effective during the nine months ended September 30, 2005, $146,000 of stock based compensation expense would have been recognized. The Black-Scholes option-pricing model was used in estimating the fair value of option grants. The weighted average assumptions used are presented in the table below.

		Nine Months Ended
		September 30, 2006
		2006				2005(1)
Expected volatility			31	%			N/A
Expected term (in years)			5.5				N/A
Expected dividend yield			0.87	%			N/A
Risk free interest rate			4.36	%			N/A

7. New Accounting Policies:

In September 2006, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.” Under the provisions of EITF Issue No. 06-4, Sterling will recognize the amount, if any, that is owed current or former employees under split dollar BOLI. Also in September, the EITF Issued No. 06-5, “Accounting for Purchases of Life Insurance - Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4, Accounting for Purchases of Life Insurance.” EITF Issue No. 06-5 requires recognition of various other amounts under insurance contracts. EITF 06-4 is effective January 1, 2008. EITF 06-5 is effective January 1, 2007. Sterling is currently assessing the potential impact of these standards.

In September 2006, FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS No. 158”). SFAS No. 158 requires an employer to recognize the funded status of defined benefit pension and other postretirement benefit plans as an asset or liability. The standard is effective for Sterling as of December 31, 2006. Sterling is currently assessing the impact of this standard and does not expect SFAS No. 158 to have a material effect on Sterling.

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

In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN No. 48”). This pronouncement requires a certain methodology for measuring and reporting uncertain tax positions, as well as disclosures. Adoption may result in a cumulative adjustment to income tax liabilities and retained earnings, if applicable. FIN No. 48 will be effective for Sterling as of January 1, 2007, and is not expected to have a material effect on Sterling.

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets, an amendment of SFAS No. 140” (“SFAS No. 156”). This pronouncement requires the recognition of a servicing asset or liability under specified circumstances, and if practicable, all separately recognized servicing assets and liabilities to be initially measured at fair value. Additionally, the pronouncement allows an entity to choose one of two methods when subsequently measuring its servicing assets and liabilities: the amortization method or the fair value method. The amortization method provided under SFAS No. 140, employs lower of cost or market (“locom”) valuation. The new fair value method allows mark ups, in addition to the mark downs under locom. SFAS No. 156 permits a one-time reclassification of available-for-sale securities to the trading classification. Sterling currently plans to continue to employ the amortization method. Therefore, SFAS No. 156 is not expected to have a material effect on Sterling.

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments,” an amendment of SFAS No. 133 and SFAS No. 140. This statement addresses the accounting for certain hybrid financial instruments (a financial instrument with an embedded derivative) and also clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133. SFAS No. 155 allows combined valuation and accounting. This statement will be effective for Sterling as of January 1, 2007. Sterling is considering implementing the combined valuation approach when applicable, and does not expect the standard to have a material impact on the consolidated financial results.

8. Derivatives and Hedging:

As part of its mortgage banking activities, Sterling issues interest rate lock commitments (“rate locks”) to prospective borrowers on residential one-to-four family mortgage loan applications. Pricing for the sale of these loans is fixed with various qualified investors, such as Fannie Mae, under both non-binding (“best-efforts”) and binding (“mandatory”) delivery programs at or near the time the interest rate is locked with the borrowers. For mandatory delivery programs, Sterling hedges Interest Rate Risk (“IRR”) by entering into offsetting forward sale agreements on MBS with third parties. Risks inherent in mandatory delivery programs include the risk that if Sterling does not close the loans subject to rate locks, it is nevertheless obligated to deliver MBS to the counterparty under the forward sale agreement. Sterling could incur significant costs in acquiring replacement loans or MBS and such costs could have a material adverse effect on mortgage banking operations in future periods. At September 30, 2006, Sterling did not have any loans locked with investors under mandatory delivery programs, nor hold any offsetting forward sale agreements on MBS. At September 30, 2006, Sterling had entered into best efforts forward commitments to sell $90.3 million of mortgage loans.

Rate lock commitments to borrowers and best-effort loan delivery commitments with investors are off-balance-sheet commitments that are considered to be derivatives. Sterling accounts for these commitments by recording their estimated fair value on its balance sheet. At September 30, 2006, Sterling recorded an asset of approximately $775,000 for the estimated fair value of rate locks issued and a liability of approximately $775,000 for the estimated fair value of delivery commitments received. At December 31, 2005, Sterling had loans subject to rate locks under a mandatory delivery program and held off-setting forward sale agreements for MBS. Correspondingly, at December 31, 2005, Sterling recorded an asset of $147,000 for the fair value of rate locks and a liability of $25,000 for the fair value of forward sale agreements.

Sterling enters into interest rate swap derivative contracts with customers. The IRR on these contracts is offset by entering comparable dealer swaps. These contracts are carried at fair value.

9. Cash Dividends:

The board of directors of Sterling from time to time evaluates the payment of cash dividends. The timing and amount of any future dividends will depend upon earnings, cash and capital requirements, the financial condition of Sterling and its subsidiaries, applicable government regulations and other factors deemed relevant by Sterling’s board of directors. Sterling has paid the following historical cash dividends:

Date Paid				Per Share Amount				Total
October 2005				$	0.050			$1.7 million
January 2006					0.055			1.9 million
April 2006					0.060			2.1 million
July 2006					0.065			2.3 million
October 2006					0.070			2.6 million

10. Business Combinations:

On June 4, 2006, Sterling entered into a definitive agreement to acquire FirstBank NW Corp., a Washington corporation (“FirstBank”). Under the terms of the agreement, FirstBank would be merged with and into Sterling, with Sterling being the surviving corporation in the merger. The agreement also provides for the merger of FirstBank’s financial institution subsidiary, FirstBank Northwest, with and into Sterling’s financial institution subsidiary, Sterling Savings Bank, with Sterling Savings Bank being the surviving institution. Under the terms of the agreement, each share of FirstBank common stock would be converted into the right to receive 0.789 shares of Sterling common stock and $2.55 in cash. Based upon the closing price for Sterling’s common stock on June 2, 2006, of $31.19 per share, the consideration is equivalent to $27.16 per share of FirstBank common stock. The transaction, which is valued at approximately $169.6 million, is expected to close in the fourth quarter of 2006, pending receipt of regulatory and FirstBank shareholder approvals and satisfaction of other customary closing conditions.

On July 5, 2006, Sterling completed its acquisition of Lynnwood Financial Group, Inc. (“Lynnwood”), the parent company of Golf Savings Bank, by issuing $15,750,000 in cash, and 1,799,961 shares of Sterling common stock in exchange for all outstanding Lynnwood shares at a ratio of 1.73%. Lynnwood options totaling 34,662 were converted into 77,258 Sterling options, valued at $1.7 million. Lynnwood merged with and into Sterling, with Sterling being the surviving entity in the merger. Lynnwood’s wholly owned subsidiaries, Golf Savings Bank and Golf Escrow Corporation, have become subsidiaries of Sterling. Golf Savings Bank is a Washington state-chartered federally insured savings bank. Golf Savings Bank’s primary focus is the origination of single-family residential mortgage loans. The transaction was valued at approximately $66.3 million. Golf Savings Bank’s strong mortgage banking operations and construction lending portfolio contributed to Sterling’s growth strategy of becoming the leading community bank in the western United States.

As a result of the merger, Sterling acquired approximately $539 million of assets, including approximately $488 million in loans, approximately $488 million of liabilities, including approximately $446 million in deposits, and approximately $51 million in capital. The following summarizes the unaudited proforma results of operations as if the Lynnwood acquisition had occurred on January 1, 2005. Proforma results for the three months ended September 30, 2006 equal reported results, as the entities were combined for the entire period.

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
		(Dollars in thousands, except per share data)
Proforma interest income		$	148,208			$	104,414			$	415,518			$	306,152
Proforma interest expense			78,175				45,470				211,069				130,798
Proforma net interest income			70,033				58,944				204,449				175,354
Proforma net income			19,339				16,286				53,356				52,052
Proforma earnings per share — basic			0.52				0.45				1.45				1.43
Proforma earnings per share — diluted			0.52				0.44				1.43				1.41

On July 31, 2006, a wholly owned subsidiary of INTERVEST acquired the mortgage banking operations, including the geographically diverse commercial servicing portfolio, brand name and investor/customer list, of Mason-McDuffie Financial Corporation (“Mason-McDuffie”), located in northern California. INTERVEST’s mortgage banking business in northern California is now being conducted by Mason-McDuffie. The transaction was valued at approximately $2.7 million, including $1.8 million in cash paid at closing, with the remainder to be paid in Sterling common stock, subject to the terms of a three year earnout. Mason-McDuffie is dedicated to loan brokerage originations and loan servicing. During the fiscal year ended September 30, 2005, Mason-McDuffie’s loan brokerage originations were approximately $180 million.

On September 17, 2006, Sterling entered into a definitive agreement to acquire Northern Empire Bancshares, a California corporation (“Northern Empire”). Under the terms of the agreement, Northern Empire will be merged with and into Sterling, with Sterling being the surviving corporation in the merger. The agreement also provides that Sterling may elect to merge Northern Empire’s financial institution subsidiary, Sonoma National Bank, with and into Sterling’s financial institution subsidiary, Sterling Savings Bank, with Sterling Savings Bank being the surviving institution. Under the terms of the agreement, each share of Northern Empire common stock would be converted into 0.8050 shares of Sterling common stock and $2.71 in cash, subject to certain conditions. The transaction, which is valued at approximately $335 million, is expected to close in the second quarter of 2007, pending Sterling and Northern Empire shareholder and regulatory approval, and satisfaction of other customary closing conditions.

11. Subsequent Event:

In October 2006, Sterling announced a quarterly cash dividend of $0.075 per share, payable on January 12, 2007 to shareholders of record as of December 29, 2006.

PART I — Financial Information (continued)

This report contains forward-looking statements. For a discussion about such statements, including the risks and uncertainties inherent therein, see “Forward-Looking Statements.” Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes presented elsewhere in this report and in Sterling’s 2005 annual report on Form 10-K.

General

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

Sterling provides personalized, quality financial services and “Perfect Fit” banking products to its customers consistent with its “Hometown Helpful” philosophy. Sterling believes that its dedication to personalized service has enabled it to grow both its retail deposit base and its lending portfolio in the western United States. With $8.91 billion in total assets at September 30, 2006, Sterling originates loans and attracts Federal Deposit Insurance Corporation (“FDIC”) insured deposits from the general public through 145 financial service centers located throughout the west. In addition, Sterling originates loans through Golf Savings Bank and Action Mortgage residential loan production offices and through INTERVEST commercial real estate lending offices in the west. Sterling also markets fixed income and equity products, mutual funds, fixed and variable annuities and other financial products through Harbor Financial service representatives located throughout Sterling’s financial service center network.

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

Executive Summary and Highlights

During the three months ended September 30, 2006, Sterling’s net income totaled $19.3 million, or $0.52 per diluted share, compared to $13.9 million, or $0.40 per diluted share for the respective 2005 period. NII and fees and service charges income for the three months ended September 30, 2006 grew by 32% and 24%, respectively, over the comparative 2005 amounts. Mortgage banking operations income also increased by $2.6 million over the 2005 comparative quarter. This growth in net interest income, fees and service charges income and mortgage banking operations income was derived from the July 5, 2006 acquisition of Golf Savings Bank, in addition to continued internal growth. The average yield in the loan portfolio increased due to the loans acquired from Golf Savings Bank, upward repricing in the portfolio, and new production. Fees and service charges income increased due to the success of Sterling’s Balance Shield program, an increase in debit card transactions, treasury management services, and merchant services. Mortgage banking operations income for the three months ended September 30, 2006 increased over the same period in 2005 primarily due to Golf Savings Bank’s production during the quarter. Mortgage banking operations income for the nine months ended September 30, 2006 was lower than the nine months ended September 30, 2005 due to the lower level of loan sales compared to the volume of loan sales in the first and second quarters of 2005, which reflected a higher level of portfolio repositioning. The addition of 330 full time equivalent employees since September 30, 2005 included approximately 250 Golf Savings Bank employees, driving the increase in employee compensation and benefits.

At September 30, 2006, total assets reached a record $8.91 billion, mainly reflecting the continued growth of Sterling’s loan portfolio. Loan originations for the nine months ended September 30, 2006 and 2005 were $3.52 billion and $2.69 billion, respectively, reflecting growth of 31%. The majority of the growth occurred in construction, business and corporate banking lines.

Highlights for the third quarter of 2006 were as follows:

•

Total assets increased 18 percent from December 31, 2005 to a record $8.91 billion. Sterling’s organic growth represented 11 percent of total asset growth.

•

Loan originations of $1.40 billion reflect an increase of 47 percent over the third quarter of 2005. Sterling’s organic growth represented 14 percent of total loan origination growth.

•

Total loans receivable increased to a record $6.24 billion, a 28 percent increase since year end. Sterling’s organic growth represented 19 percent of total loan growth.

•

Total deposits increased to a record $5.95 billion, or 24 percent, since year end. Sterling’s organic growth represented 15 percent of total deposits growth.

•

Fees and Service Charges income increased to $11.5 million, a 24 percent increase over the third quarter of 2005. Sterling’s organic growth represented 17 percent of total fees and service charges growth.

•

Asset quality remained stable, in line with peer averages.

•

The Sterling Board of Directors approved a cash dividend of $0.07 per common share, paid on October 13, 2006 to shareholders of record as of September 29, 2006.

•

Sterling and Northern Empire Bancshares (“Northern Empire”) announced on September 18, 2006 that they have entered into a definitive agreement for the merger of Northern Empire with and into Sterling, pending shareholder and regulatory approvals as well as other customary closing conditions.

•

Sterling Capital Statutory Trust VIII, a subsidiary of Sterling, completed the issuance of $50.0 million of floating rate trust preferred securities on September 20, 2006, bearing an initial rate of 7.02%.

Company Growth

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

On June 4, 2006, Sterling entered into a definitive agreement to acquire FirstBank NW Corp., a Washington corporation (“FirstBank”). Under the terms of the agreement, FirstBank would be merged with and into Sterling, with Sterling being the surviving corporation in the merger. The agreement also provides for the merger of FirstBank’s financial institution subsidiary, FirstBank Northwest, with and into Sterling’s financial institution subsidiary, Sterling Savings Bank, with Sterling Savings Bank being the surviving institution. The transaction, which is valued at approximately $169.6 million, is expected to close in the fourth quarter of 2006, pending receipt of regulatory and FirstBank shareholder approvals and satisfaction of other customary closing conditions.

On July 5, 2006, Sterling completed its acquisition of Lynnwood Financial Group, Inc. (“Lynnwood”), the parent company of Golf Savings Bank, by issuing $15,750,000 in cash and 1,799,961 shares of Sterling common stock in exchange for all outstanding Lynnwood shares. Lynnwood merged with and into Sterling, with Sterling being the surviving entity in the merger. Lynnwood’s wholly owned subsidiaries, Golf Savings Bank and Golf Escrow Corporation, have become subsidiaries of Sterling. Golf Savings Bank is a Washington state-chartered federally insured savings bank. Golf Savings Bank’s primary focus is the origination of single-family residential mortgage loans. Golf Savings Bank’s primary market area is the greater Puget Sound area of Washington State. The transaction was valued at approximately $66.3 million.

On July 31, 2006, a wholly owned subsidiary of INTERVEST acquired the mortgage banking operations, including the geographically diverse commercial servicing portfolio, brand name and investor/customer list, of Mason-McDuffie Financial Corporation (“Mason-McDuffie”), located in northern California. INTERVEST’s mortgage banking business in northern California is now being conducted by Mason-McDuffie. The transaction was valued at approximately $2.7 million, including $1.8 million in cash paid at closing, with the remainder to be paid in Sterling common stock, subject to the terms of a three year earnout. Mason-McDuffie is dedicated to loan brokerage originations and loan servicing. During the fiscal year ended September 30, 2005 Mason-McDuffie’s loan brokerage originations were approximately $180 million.

On September 17, 2006, Sterling entered into a definitive agreement to acquire Northern Empire Bancshares, a California corporation (“Northern Empire”). Under the terms of the agreement, Northern Empire will be merged with and into Sterling, with Sterling being the surviving corporation in the merger. The agreement also provides that Sterling may elect to merge Northern Empire’s financial institution subsidiary, Sonoma National Bank, with and into Sterling’s financial institution subsidiary, Sterling Savings Bank, with Sterling Savings Bank being the surviving institution. Under the terms of the agreement, each share of Northern Empire common stock would be converted into 0.8050 shares of Sterling common stock and $2.71 in cash, subject to certain conditions. The transaction, which is valued at approximately $335 million, is expected to close in the second quarter of 2007, pending Sterling and Northern Empire shareholder and regulatory approval, and satisfaction of other customary closing conditions.

Critical Accounting Policies

The accounting and reporting policies of Sterling conform to accounting principles generally accepted in the United States of America (“GAAP”) and to general practices within the banking industry. The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Sterling’s management has identified the accounting policies described below as those that, due to the

judgments, estimates and assumptions inherent in those policies are critical to an understanding of Sterling’s Consolidated Financial Statements and Management’s Discussion and Analysis.

Income Recognition. Sterling recognizes interest income by methods that conform to general accounting practices within the banking industry. In the event management believes collection of all or a portion of contractual interest on a loan has become doubtful, which generally occurs after the loan is 90 days past due, Sterling discontinues the accrual of interest and any previously accrued interest recognized in income deemed uncollectible is reversed. Interest received on nonperforming loans is included in income only if principal recovery is reasonably assured. A nonperforming loan is restored to accrual status when it is brought current, has performed in accordance with contractual terms for a reasonable period of time, and the collectibility of the total contractual principal and interest is no longer in doubt.

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

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

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

While management uses available information to provide for loan losses, the ultimate collectibility of a substantial portion of the loan portfolio and the need for future additions to the allowance will be influenced by changes in economic conditions and other relevant factors. A slowdown in economic activity could adversely affect cash flows for both commercial and individual borrowers, which may result in increases in nonperforming assets, delinquencies and losses on loans. There can be no assurance that the allowance for loan losses will be adequate to cover all losses, but management believes the allowance for loan losses was adequate at September 30, 2006.

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

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

Management determines the appropriate classification of investment securities at the time of purchase. Held-to-maturity securities are those securities that Sterling has the positive intent and ability to hold to maturity and are

recorded at amortized cost. Available-for-sale securities are those securities that would be available to be sold in the future in response to Sterling’s liquidity needs, changes in market interest rates, and asset-liability management strategies, among others. Available-for-sale securities are reported at fair value, with unrealized holding gains and losses reported in shareholders’ equity as a separate component of other comprehensive income, net of applicable deferred income taxes.

Management evaluates investment securities for other-than-temporary declines in fair value on a quarterly basis. If the fair value of investment securities falls below their amortized cost and the decline is deemed to be other-than-temporary, the securities will be written down to current market value, resulting in a loss recorded in the income statement and the establishment of a new basis. During the three months ended September 30, 2006, there were no investment securities that management identified to be other-than-temporarily impaired, because the decline in fair value was attributable to changes in interest rates and not credit quality, and because Sterling has the ability and intent to hold these investments until a recovery in market price occurs, or until maturity. Realized losses could occur in future periods due to a change in management’s intent to hold the investments to maturity, a change in management’s assessment of credit risk, or a change in regulatory or accounting requirements.

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

Sterling’s management performed the annual test of its goodwill and other intangible assets as of June 30, 2006, and concluded that the recorded values were not impaired. There are many assumptions and estimates underlying the determination of impairment. Another estimate using different but still reasonable assumptions could produce a significantly different result. Additionally, future events could cause management to conclude that Sterling’s goodwill is impaired, which would result in Sterling recording an impairment loss. Any resulting impairment loss could have a material adverse impact on Sterling’s financial condition and results of operations. Other intangible assets consisting of core-deposit intangibles with definite lives are amortized over the estimated life of the acquired depositor relationships (generally eight to ten years).

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

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

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

Sterling uses an estimate of future earnings to support its position that the benefit of its net deferred taxes will be realized. If future pre-tax income should prove nonexistent or less than the amount of temporary differences giving

rise to the net deferred tax assets within the tax years to which they may be applied, the assets will not be realized and Sterling’s net income will be reduced.

Results of Operations

Overview. Sterling recorded net income of $19.3 million, or $0.52 per diluted share, for the three months ended September 30, 2006, compared with net income of $13.9 million, or $0.40 per diluted share, for the three months ended September 30, 2005. Net income for the nine months ended September 30, 2006 was $51.7 million, or $1.44 per diluted share, compared with net income of $45.8 million, or $1.31 per diluted share, for the nine months ended September 30, 2005. The increase in net income mainly reflected an increase in net interest income.

The annualized return on average assets (“ROA”) was 0.89% and 0.81% for the three months ended September 30, 2006 and 2005, respectively. The annualized return on average equity (“ROE”) was 13.4% and 10.8% for the three months ended September 30, 2006 and 2005, respectively. The increase in ROA and ROE compared to 2005 was due to growth of net income outpacing increases in assets and equity.

Net Interest Income. The most significant component of earnings for a financial institution typically is NII, which is the difference between interest income, primarily from loan, MBS and investment securities portfolios, and interest expense, primarily on deposits and borrowings. During the three months ended September 30, 2006 and 2005, NII was $70.0 million and $53.1 million, respectively, an increase of 32%. During the nine months ended September 30, 2006 and 2005, NII was $190.0 million and $159.7 million, respectively, an increase of 19%. The increase in NII was mainly due to increases in average loan volumes.

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

The following table presents the composition of the change in NII for the periods presented. For each category of interest-earning assets and interest-bearing liabilities, the following table provides information on changes attributable to:

•

Volume – changes in volume multiplied by comparative period rate;

•

Rate – changes in rate multiplied by comparative period volume; and

•

Rate/volume – changes in rate multiplied by changes in volume.

		Three Months Ended September 30,																Nine Months Ended September 30,
		2006 vs. 2005																2006 vs. 2005
		Increase (Decrease) Due to:																Increase (Decrease) Due to:
										Rate/																Rate/
		Volume				Rate				Volume				Total				Volume				Rate				Volume				Total
		(Dollars in thousands)																(Dollars in thousands)
Rate/volume analysis:
Interest income:
Loans		$	32,546			$	13,051			$	6,582			$	52,179			$	56,496			$	39,944			$	10,544			$	106,984
MBS			(372	)			1,263				(22	)			869				(1,403	)			3,219				(69	)			1,747
Investments and cash equivalents			648				(130	)			(132	)			386				884				(287	)			(117	)			480
Total interest income			32,822				14,184				6,428				53,434				55,977				42,876				10,358				109,211
Interest expense:
Deposits			12,147				10,539				5,140				27,826				17,942				35,972				10,203				64,117
Borrowings			2,132				5,834				697				8,663				(3,034	)			18,777				(967	)			14,776
Total interest expense			14,279				16,373				5,837				36,489				14,908				54,749				9,236				78,893
Net changes in NII		$	18,543			$	(2,189	)		$	591			$	16,945			$	41,069			$	(11,873	)		$	1,122			$	30,318