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, 2008

OR

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

FOR THE TRANSITION PERIOD FROM                      TO                     .

Commission File Number.....0-20800

STERLING FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

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

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

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

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

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. (Check one):

Large accelerated filer þ		Accelerated filer o		Non-accelerated filer o (Do not check if a smaller reporting company)		Smaller reporting company 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, 2008
Common Stock ($1.00 par value)		52,133,798

 

 

STERLING FINANCIAL CORPORATION

FORM 10-Q
For the Quarter Ended September 30, 2008

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			18
Item 3 Quantitative and Qualitative Disclosures About Market Risk			37
Item 4 Controls and Procedures			37
PART II — Other Information			39
Item 1 Legal Proceedings			39
Item 1a Risk Factors			39
Item 2 Unregistered Sales of Equity Securities and Use of Proceeds			40
Item 3 Defaults Upon Senior Securities			40
Item 4 Submission of Matters to a Vote of Security Holders			40
Item 5 Other Information			40
Item 6 Exhibits			40
Signatures			41
EX-3.1
EX-31.1
EX-31.2
EX-32.1
EX-32.2

PART I — Financial Information

STERLING FINANCIAL CORPORATION

		September 30,				December 31,
		2008				2007
		(Dollars in thousands)
ASSETS:
Cash and cash equivalents:
Interest bearing		$	85			$	10,042
Non-interest bearing			128,393				184,436
Total cash and cash equivalents			128,478				194,478
Restricted cash			1,050				1,100
Investment securities and mortgage-backed securities (''MBS''):
Available for sale			2,100,880				1,853,271
Held to maturity			177,519				132,793
Loans receivable, net			9,074,911				8,948,307
Loans held for sale ($84,395 at fair value as of September 30, 2008)			86,090				55,840
Accrued interest receivable			57,005				63,649
Real estate owned and other collateralized assets, net			54,795				11,075
Office properties and equipment, net			91,138				93,467
Bank-owned life insurance (''BOLI'')			156,271				150,825
Goodwill			451,323				453,136
Other intangible assets			27,950				31,627
Mortgage servicing rights, net			7,392				9,042
Prepaid expenses and other assets, net			208,107				151,165
Total assets		$	12,622,909			$	12,149,775
LIABILITIES:
Deposits		$	8,073,303			$	7,677,772
Advances from Federal Home Loan Bank (''FHLB'')			1,787,264				1,687,989
Securities sold subject to repurchase agreements and funds purchased			1,178,262				1,178,845
Other borrowings			248,275				273,015
Cashiers checks issued and payable			13,752				764
Borrowers' reserves for taxes and insurance			3,727				1,765
Accrued interest payable			37,742				40,209
Accrued expenses and other liabilities			100,157				104,086
Total liabilities			11,442,482				10,964,445
SHAREHOLDERS' EQUITY:
Preferred stock, $1 par value; 10,000,000 shares authorized; no shares issued and outstanding			0				0
Common stock, $1 par value; 100,000,000 shares authorized; 52,131,757 and 51,456,461 shares issued and outstanding			52,132				51,456
Additional paid-in capital			897,466				892,028
Accumulated other comprehensive loss:
Unrealized losses on investment securities and MBS available-for-sale, net of deferred income taxes of $18,112 and $10,518			(30,879	)			(17,967	)
Retained earnings			261,708				259,813
Total shareholders' equity			1,180,427				1,185,330
Total liabilities and shareholders' equity		$	12,622,909			$	12,149,775

See notes to consolidated financial statements.

STERLING FINANCIAL CORPORATION

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
		(Dollars in thousands, except per share data)
Interest income:
Loans		$	147,585			$	179,132			$	461,976			$	504,720
MBS			25,219				18,882				75,304				58,706
Investments and cash equivalents			3,523				1,904				8,672				5,455
Total interest income			176,327				199,918				545,952				568,881
Interest expense:
Deposits			57,101				71,489				177,409				205,875
Short-term borrowings			3,061				6,690				15,900				26,095
Long-term borrowings			26,157				28,075				76,429				73,591
Total interest expense			86,319				106,254				269,738				305,561
Net interest income			90,008				93,664				276,214				263,320
Provision for credit losses			(36,950	)			(3,888	)			(105,080	)			(12,088	)
Net interest income after provision for credit losses			53,058				89,776				171,134				251,232
Non-interest income:
Fees and service charges			15,327				14,966				45,490				40,852
Mortgage banking operations			6,434				7,314				20,859				25,979
Loan servicing fees			737				366				1,286				1,459
Real estate owned and other collateralized assets operations			102				223				(242	)			85
BOLI			1,362				1,553				4,575				4,817
Other			(943	)			(215	)			(2,289	)			(759	)
Total non-interest income			23,019				24,207				69,679				72,433
Non-interest expenses			71,520				74,104				216,074				209,664
Income before income taxes			4,557				39,879				24,739				114,001
Income tax (provision) benefit			441				(13,349	)			(5,190	)			(37,569	)
Net income		$	4,998			$	26,530			$	19,549			$	76,432
Earnings per share — basic		$	0.10			$	0.52			$	0.38			$	1.55
Earnings per share — diluted		$	0.10			$	0.51			$	0.38			$	1.54
Weighted average shares outstanding — basic			51,821,446				51,279,114				51,678,981				49,257,951
Weighted average shares outstanding — diluted			52,006,215				51,660,186				51,892,900				49,768,308

See notes to consolidated financial statements.

STERLING FINANCIAL CORPORATION

		Nine Months Ended
		September 30,
		2008				2007
		(Dollars in thousands)
Cash flows from operating activities:
Net income		$	19,549			$	76,432
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for credit losses			105,080				12,088
Accretion of deferred gain on sale of branches			(603	)			(536	)
Net gain on sales of loans, investment securities and MBS			(14,883	)			(16,499	)
Stock based compensation			1,901				1,013
Excess tax benefit from stock based compensation			(844	)			(1,419	)
Stock issuances relating to 401(k) match			1,979				1,637
Other gains and losses			3,049				3,024
Increase in cash surrender value of BOLI			(5,091	)			(4,817	)
Depreciation and amortization			18,620				18,184
Change in:
Accrued interest receivable			6,644				(3,117	)
Prepaid expenses and other assets			(46,908	)			(10,027	)
Cashiers checks issued and payable			12,988				(16,867	)
Accrued interest payable			(2,467	)			(2,664	)
Accrued expenses and other liabilities			(5,705	)			7,094
Proceeds from sales of loans originated for sale			868,126				988,255
Loans originated for sale			(853,166	)			(975,871	)
Net cash provided by operating activities			108,269				75,910
Cash flows from investing activities:
Change in restricted cash			50				50
Loans funded and purchased			(3,048,586	)			(3,702,199	)
Loan principal received			2,733,861				3,122,955
Proceeds from sales of other loans			(77	)			112,651
Purchase of investment securities			(644,735	)			(79,941	)
Proceeds from maturities of investment securities			630,656				38,580
Proceeds from sale of investments			0				5,609
Net cash and cash equivalents acquired			0				92,419
Purchase of BOLI			0				0
Purchase of MBS			(524,265	)			(120,419	)
Principal payments on MBS			219,442				183,899
Purchase of office properties and equipment			(8,417	)			(10,806	)
Sales of office properties and equipment			73				3,810
Improvements and other changes to real estate owned			1,923				30
Proceeds from sales and liquidation of real estate owned			6,197				1,348
Net cash provided by (used in) investing activities			(633,878	)			(352,014	)

See notes to consolidated financial statements.

		Nine Months Ended
		September 30,
		2008				2007
		(Dollars in thousands)
Cash flows from financing activities:
Net change in transaction and savings deposits		$	(293,667	)		$	105,673
Proceeds from issuance of time deposits			3,904,739				3,010,268
Payments for maturing time deposits			(3,388,151	)			(3,280,346	)
Interest credited to deposits			172,610				190,115
Advances from FHLB			780,245				1,517,744
Repayment of advances from FHLB			(680,505	)			(1,630,642	)
Net change in securities sold subject to repurchase agreements and funds purchased			(583	)			324,789
Proceeds from other borrowings			0				69,392
Repayment of other borrowings			(24,000	)			(36,403	)
Proceeds from exercise of stock options			1,390				3,546
Excess tax benefit from stock based compensation			844				1,419
Cash dividends paid to shareholders			(15,275	)			(11,635	)
Other			1,962				875
Net cash provided by (used in) financing activities			459,609				264,795
Net change in cash and cash equivalents			(66,000	)			(11,309	)
Cash and cash equivalents, beginning of period			194,478				178,565
Cash and cash equivalents, end of period		$	128,478			$	167,256
Supplemental disclosures:
Cash paid during the period for:
Interest		$	272,205			$	306,252
Income taxes			15,968				35,902
Noncash financing and investing activities:
Loans converted into real estate owned and other collateralized assets			51,840				753
Common stock issued upon business combination			0				8,927
Common stock cash dividends accrued			5,211				4,611
Deferred gain on sale of branches			0				804

See notes to consolidated financial statements.

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
		(Dollars in thousands)
Net income		$	4,998			$	26,530			$	19,549			$	76,432
Other comprehensive income:
Change in unrealized losses on investment securities and MBS available-for-sale			2,116				20,482				(20,506	)			2,021
Less deferred income taxes			(780	)			(7,575	)			7,594				(738	)
Net other comprehensive income (loss)			1,336				12,907				(12,912	)			1,283
Comprehensive income		$	6,334			$	39,437			$	6,637			$	77,715

See notes to consolidated financial statements.

Notes to Consolidated Financial Statements

1. Basis of Presentation:

The foregoing unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X as promulgated by the Securities and Exchange Commission. Accordingly, these financial statements do not include all of the disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements as disclosed in the annual report on Form 10-K for the year ended December 31, 2007. In the opinion of management, the unaudited interim consolidated financial statements furnished herein include all adjustments, all of which are of a normal recurring nature, necessary for a fair statement of the results for the interim periods presented.

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

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

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 recognizes the amount that is owed current or former employees under split dollar BOLI. Sterling adopted the EITF 06-4 effective January 1, 2008, which resulted in a cumulative charge of $2.1 million to retained earnings.

In September 2006, the Financial Accounting Standards Board (''FASB'') issued Statement of Financial Accounting Standards (''FAS'') No. 157, ''Fair Value Measurements'' (''FAS 157''). FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. In September 2008, FASB Staff Position (''FSP'') FAS 157-3, ''Determining the Fair Value of Financial Assets when the Market for that Asset is not Marketable,'' provided additional valuation guidance for illiquid and distressed market conditions. In February 2007, FASB issued FAS 159, ''The Fair Value Option for Financial Assets and Financial Liabilities'' (''FAS 159''). FAS 159 provides a fair value measurement election for many financial instruments, on an instrument by instrument basis. Both FAS 157 and 159 became effective for Sterling as of January 1, 2008. See Note 10 for a discussion of their impact. Sterling applied FAS 159 to its loans held for sale in order to match changes in the value of the loans with the value of their economic hedges without having to apply complex hedge accounting.

In November 2007, the SEC issued Staff Accounting Bulletin 109, ''Written Loan Commitments Recorded at Fair Value Through Earnings,'' (''SAB 109'') regarding the valuation of loan commitments. SAB 109 supersedes SAB 105, and states that in measuring the fair value of a derivative loan commitment, the expected net future cash flows related to the associated servicing of the loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. SAB 109 was effective for Sterling as of January 1, 2008. See Note 9 of ''Notes to Consolidated Financial Statements.''

In March 2008, the FASB issued FAS 161, ''Disclosures about Derivative Instruments and Hedging Activities,'' an amendment of FAS 133. FAS 161 requires enhanced disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under FAS 133 and related interpretations, and how derivative instruments and related hedged items affect an entity's financial position, financial performance, and cash flows. FAS 161 is effective for Sterling as of December 31, 2008. Sterling is currently evaluating the impact of FAS 161.

2. Allowance for Credit Losses:

The following is an analysis of the changes in the allowances for credit losses (in thousands):

		Nine Months Ended September 30,
		2008				2007
Allowance for credit losses
Allowance — loans, January 1		$	111,026			$	77,849
Allowance for losses on loans acquired			0				15,294
Provision			105,081				11,838
Amounts written off			(40,230	)			(3,429	)
Recoveries			1,433				696
Transfers			(3	)			(206	)
Allowance — loans, September 30			177,307				102,042
Allowance — unfunded commitments, January 1			6,306				5,840
Acquired			0				0
Provision			53				258
Amounts written off			(6	)			0
Transfers			12				206
Allowance — unfunded commitments, September 30			6,365				6,304
Total credit allowance		$	183,672			$	108,346

Sterling recorded a provision for credit losses of $105.1 million and $12.1 million for the nine months ended September 30, 2008 and 2007, respectively. The increase in the provision for credit losses was in response to an increase in the level of classified loans. At September 30, 2008, Sterling's total classified assets were 5.32% of total assets, compared with 1.84% of total assets at September 30, 2007. Sterling, like many other financial institutions, has experienced deterioration in the credit quality of residential construction loans due to declining market values and weakness in housing sales in certain of its markets.

Sterling's management is currently discussing with its banking regulators whether it is appropriate to include potential cash flows from guarantors in its loan impairment analysis. In addition, Sterling is also discussing whether potential losses identified through impairment analysis should be identified as specific loan loss allowances or should be charged off as confirmed loan losses. The outcome of these discussions cannot be determined at this time and there can be no assurance that Sterling will not be required to increase its loan loss allowance, loan loss provision and reported loan charge-offs for 2008, which could negatively impact Sterling's earnings.

3. Goodwill and Other Intangible Assets:

As of September 30, 2008 and December 31, 2007, Sterling had goodwill and other intangible assets totaling $479.3 million and $484.8 million, respectively. Goodwill represents the difference between the value of consideration paid and the fair value of the net assets received in a business combination. Other intangible assets represent acquired customer depository relationships. Intangible assets are periodically assessed for impairment. Sterling's management performed an annual test of its goodwill and other intangible assets as of June 30, 2008, and concluded that the recorded values were not impaired, based on a discounted cash flows methodology as allowed under FAS 142. Sterling's management completed this analysis during the third quarter. Given current market conditions, Sterling will monitor its goodwill value and impairment indicators on a quarterly basis. There are many assumptions and estimates underlying the determination of impairment. Future events could cause management to conclude that Sterling's goodwill is impaired, which would result in Sterling recording an impairment loss of all or a portion of goodwill. Any resulting impairment loss could have a material adverse impact on Sterling's financial condition and results of operations.

4. Other Borrowings:

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

		September 30,				December 31,
		2008				2007
Junior subordinated debentures		$	245,275			$	270,015
Other			3,000				3,000
Total other borrowings		$	248,275			$	273,015

Sterling raises capital from time to time through the formation of trust subsidiaries (''Capital Trusts''), which issue capital securities (''Trust Preferred Securities'') to investors. The 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 semiannually.

Details of the Trust Preferred Securities are as follows:

Maturity

Rate at September 30,

Amount (in

Subsidiary Issuer

Issue Date

Date

Call Date

2008

Thousands)

Sterling Capital Trust IX

July 2007

Oct 2037

N/A

Floating

4.19

%

$

46,392

Sterling Capital Trust VIII

Sept 2006

Sept 2036

N/A

Floating

4.45

51,547

Sterling Capital Trust VII

June 2006

June 2036

N/A

Floating

4.34

56,702

Lynnwood Capital Trust II

June 2005

June 2035

June 2010

Floating

4.62

10,310

Sterling Capital Trust VI

June 2003

Sept 2033

Sept 2008

Floating

6.02

10,310

Sterling Capital Statutory Trust V

May 2003

May 2033

June 2008

Floating

6.73

20,619

Sterling Capital Trust IV

May 2003

May 2033

May 2008

Floating

5.95

10,310

Sterling Capital Trust III

April 2003

April 2033

April 2008

Floating

6.05

14,433

Lynnwood Capital Trust I

Mar 2003

Mar 2033

Mar 2007

Floating

6.63

9,470

Klamath First Capital Trust I

July 2001

July 2031

June 2006

Floating

6.88

15,182

5.03

%*

$

245,275

On January 25, 2008, Sterling redeemed $24.0 million of Trust Preferred Securities that carried a 10.25% fixed-rate coupon. In September 2008, Sterling terminated its revolving credit agreement with Wells Fargo Bank, N.A. because Sterling had not used the facility during 2008 and the cost of maintaining the facility outweighed the benefit of having it available.

5. Earnings Per Share:

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

		Three Months Ended September 30,
		2008												2007
		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		$	4,998				51,821,446			$	0.10			$	26,530				51,279,114			$	0.52
Effect of dilutive securities:
Common stock options and restricted shares			0				184,769				0.00				0				381,072				(0.01	)
Diluted computations		$	4,998				52,006,215			$	0.10			$	26,530				51,660,186			$	0.51
Antidilutive options not included in diluted earnings per share							1,823,738												735,749

		Nine Months Ended September 30,
		2008												2007
		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		$	19,549				51,678,981			$	0.38			$	76,432				49,257,951			$	1.55
Effect of dilutive securities:
Common stock options and restricted shares			0				213,919				0.00				0				510,357				(0.01	)
Diluted computations		$	19,549				51,892,900			$	0.38			$	76,432				49,768,308			$	1.54
Antidilutive options not included in diluted earnings per share							1,700,224												281,396

6. 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,
		2008				2007				2008				2007
		(Dollars in thousands)
Employee compensation and benefits		$	39,851			$	41,114			$	121,874			$	118,348
Occupancy and equipment			10,829				10,767				33,054				32,915
Data processing			5,179				4,833				15,665				13,206
Depreciation			3,445				3,387				10,516				9,923
Advertising			3,158				3,289				8,975				9,245
Insurance			1,869				1,338				5,507				2,246
Travel and entertainment			1,586				2,022				5,032				5,663
Amortization of core deposit intangibles			1,225				1,225				3,677				3,492
Legal and accounting			560				591				2,097				1,814
Goodwill litigation costs			105				1,525				360				2,837
Merger and acquisition costs			18				263				200				1,883
Other			3,695				3,750				9,117				8,092
Total		$	71,520			$	74,104			$	216,074			$	209,664

Quarterly non-interest expense decreased as compared to 2007, as a result of ongoing cost saving initiatives, while the nine month increase primarily reflects overall company growth and increases in FDIC deposit insurance premiums. These deposit insurance premiums are anticipated to increase further as a result of recent regulatory revisions.

7. Segment Information:

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

•

The Community Banking segment provides traditional bank services through the retail and commercial banking groups of Sterling's subsidiary, Sterling Savings Bank.

•

The Residential Construction Lending segment originates and services loans through the real estate division of Sterling's subsidiary, Sterling Savings Bank.

•

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

•

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

During 2008, the operations of Sterling Savings Bank's subsidiary, Action Mortgage Company, were realigned into the real estate division of Sterling Savings Bank, and the operations of Sterling Savings Bank's subsidiary, Harbor Financial Services, Inc., were moved into the wealth management department of Sterling Savings Bank. The financial results for the real estate division are reflected in the Residential Construction Lending segment, while the wealth management department's financial results are included in the Community Banking segment. For comparability purposes, prior period segment information has been restated to reflect this realignment.

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, 2008
						Residential				Residential				Commercial
		Community				Construction				Mortgage				Mortgage				Other and
		Banking				Lending				Banking				Banking				Eliminations				Total
		(Dollars in thousands)
Interest income		$	140,776			$	23,178			$	7,407			$	4,766			$	200			$	176,327
Interest expense			(64,739	)			(14,529	)			(4,144	)			0				(2,907	)			(86,319	)
Net interest income (expense)			76,037				8,649				3,263				4,766				(2,707	)			90,008
Provision for credit losses			(25,106	)			(10,894	)			(950	)			0				0				(36,950	)
Noninterest income			17,895				1,160				5,417				926				(2,379	)			23,019
Noninterest expense			(57,470	)			(4,040	)			(7,036	)			(2,276	)			(698	)			(71,520	)
Income before income taxes		$	11,356			$	(5,125	)		$	694			$	3,416			$	(5,784	)		$	4,557
Total assets		$	10,537,444			$	1,620,553			$	495,513				12,921				(43,522	)		$	12,622,909

		As of and for the Three Months Ended September 30, 2007
						Residential				Residential				Commercial
		Community				Construction				Mortgage				Mortgage				Other and
		Banking				Lending				Banking				Banking				Eliminations				Total
		(Dollars in thousands)
Interest income		$	140,006			$	50,902			$	6,636			$	2,309			$	65			$	199,918
Interest expense			(68,103	)			(29,533	)			(3,908	)			0				(4,710	)			(106,254	)
Net interest income (expense)			71,903				21,369				2,728				2,309				(4,645	)			93,664
Provision for credit losses			15,320				(19,095	)			(113	)			0				0				(3,888	)
Noninterest income			21,398				1,577				4,655				1,751				(5,174	)			24,207
Noninterest expense			(60,107	)			(2,987	)			(7,584	)			(2,881	)			(545	)			(74,104	)
Income before income taxes		$	48,514			$	864			$	(314	)		$	1,179			$	(10,364	)		$	39,879
Total assets		$	9,643,825			$	1,808,948			$	385,493			$	10,370			$	(101,721	)		$	11,746,915

		As of and for the Nine Months Ended September 30, 2008
						Residential				Residential				Commercial
		Community				Construction				Mortgage				Mortgage				Other and
		Banking				Lending				Banking				Banking				Eliminations				Total
		(Dollars in thousands)
Interest income		$	424,878			$	84,280			$	23,577			$	12,690			$	527			$	545,952
Interest expense			(197,149	)			(49,276	)			(13,504	)			0				(9,809	)			(269,738	)
Net interest income (expense)			227,729				35,004				10,073				12,690				(9,282	)			276,214
Provision for credit losses			(53,900	)			(48,150	)			(3,030	)			0				0				(105,080	)
Noninterest income			51,894				3,318				17,537				2,849				(5,919	)			69,679
Noninterest expense			(175,723	)			(9,942	)			(20,300	)			(7,106	)			(3,003	)			(216,074	)
Income before income taxes		$	50,000			$	(19,770	)		$	4,280			$	8,433			$	(18,204	)		$	24,739
Total assets		$	10,537,444			$	1,620,553			$	495,513			$	12,921			$	(43,522	)		$	12,622,909

		As of and for the Nine Months Ended September 30, 2007
						Residential				Residential				Commercial
		Community				Construction				Mortgage				Mortgage				Other and
		Banking				Lending				Banking				Banking				Eliminations				Total
		(Dollars in thousands)
Interest income		$	408,384			$	137,248			$	16,626			$	6,544			$	79			$	568,881
Interest expense			(204,029	)			(77,808	)			(10,159	)			0				(13,565	)			(305,561	)
Net interest income (expense)			204,355				59,440				6,467				6,544				(13,486	)			263,320
Provision for credit losses			13,574				(25,399	)			(263	)			0				0				(12,088	)
Noninterest income			61,231				5,328				15,788				5,925				(15,839	)			72,433
Noninterest expense			(168,137	)			(7,685	)			(23,211	)			(8,210	)			(2,421	)			(209,664	)
Income before income taxes		$	111,023			$	31,684			$	(1,219	)		$	4,259			$	(31,746	)		$	114,001
Total assets		$	9,643,825			$	1,808,948			$	385,493			$	10,370			$	(101,721	)		$	11,746,915

8. Stock Based Compensation:

The following is a summary of stock option and restricted stock activity during the nine months ended September 30, 2008:

		Stock Options								Restricted Stock
						Weighted
						Average								Weighted
						Exercise								Average
		Number				Price				Number				Grant Price
Balance, January 1, 2008			2,067,401			$	21.13				85,000			$	33.17
Granted			254,000				17.72				222,000				16.42
Exercised / vested			(237,078	)			5.86				(21,250	)			33.17
Cancelled / expired			(86,986	)			22.04				0				0.00
Outstanding, September 30, 2008			1,997,337			$	22.45				285,750			$	20.16
Exercisable, September 30, 2008			1,514,587			$	21.64

At September 30, 2008, the weighted average remaining contractual life and the aggregate intrinsic value of stock options outstanding was 4.6 years and ($15.9) million, respectively, and exercisable was 4.2 years and ($10.8) million, respectively, and at December 31, 2007, was 4.6 years and ($9.0) million, respectively, and 4.3 years and ($3.7) million, respectively. As of September 30, 2008, a total of 1,618,235 shares remained available for grant under Sterling's 2001, 2003 and 2007 Long-Term Incentive Plans. The stock options granted under these plans have terms of four, six, eight or ten years. The stock options and restricted shares granted during 2008 have four year vesting schedules. During the nine months ended September 30, 2008 and 2007, the intrinsic value of options exercised were $2.5 million and $6.2 million, respectively, and fair value of options granted were $1.1 million and $3.4 million, respectively. The Black-Scholes option-pricing model was used in estimating the fair value of option grants. The weighted average assumptions used were:

		Nine Months Ended
		September 30,
		2008				2007
Expected volatility			30% - 33	%			26% - 29	%
Expected term (in years)			4.3				4.7 - 6.0
Expected dividend yield			2.14% - 3.32	%			0.90% - 1.47	%
Risk free interest rate			2.93% - 3.11	%			4.65% - 4.80	%

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

		Nine Months Ended
		September 30,
		2008				2007
		(Dollars in thousands)
Stock based compensation expense:
Stock options		$	816			$	543
Restricted stock			1,085				470
Total		$	1,901			$	1,013

As of September 30, 2008, unrecognized equity compensation expense totaled $7.5 million, as the underlying outstanding awards had not yet been earned. This amount will be recognized over a weighted average period of 2.8 years. During 2008, a total of 22,500 stock options were forfeited. An increase in forfeitures would lower the amount of future equity compensation expense to be recognized.

9. Derivatives and Hedging:

As part of its mortgage banking activities, Sterling issues interest rate lock commitments to prospective borrowers on residential mortgage loan applications. Pricing for the sale of these loans is fixed with various qualified investors under both non-binding (''best-efforts'') and binding (''mandatory'') delivery programs. For mandatory delivery programs, Sterling hedges interest rate risk 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 interest rate lock commitments, 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. See Note 10 of ''Notes to Consolidated Financial Statements.''

Interest rate lock commitments and loan delivery commitments are off balance sheet commitments that are considered to be derivatives. As of September 30, 2008, Sterling had interest rate lock commitments of $28.1 million and $33.0 million of warehouse loans held for sale that were not committed to investors, Sterling held offsetting forward sale agreements on MBS valued at $56.0 million. In addition Sterling had mandatory delivery commitments to sell mortgage loans to investors valued at $6.1 million as of September 30, 2008. As of December 31, 2007, Sterling did not have any loans subject to interest rate lock commitments under mandatory delivery programs. As of September 30, 2008 and December 31, 2007, Sterling had entered into best efforts forward commitments to sell $82.8 million and $41.3 million of mortgage loans, respectively.

Sterling enters into interest rate swap derivative contracts with customers. The interest rate risk on these contracts is offset by entering into comparable broker dealer swaps. These contracts are carried as an offsetting asset and liability at fair value, and as of September 30, 2008 and December 31, 2007, were $2.3 million and $1.6 million, respectively.

10. Fair Value:

On January 1, 2008, Sterling adopted FAS 159, which gives companies the option of carrying their financial assets and liabilities at fair value and can be implemented on all or individually selected financial instruments. Effective January 1, 2008, Sterling elected to apply FAS 159 on newly originated loans held for sale under mandatory delivery programs. After analyzing the effects of FAS 159 on held for sale loans, Sterling elected to apply FAS 159 to all newly originated held for sale loans effective April 1, 2008. The fair value election was made to match changes in the value of these loans with the value of their economic hedges. Loan origination fees, costs and servicing rights, which were previously deferred on these loans, are now recognized as part of the loan value at origination. There was no transition adjustment upon adoption.

On January 1, 2008, FAS 157 became effective for Sterling. This standard establishes a framework for defining and measuring fair value. The standard requires that one of three valuation methods be used to determine fair market value: the market approach, the income approach or the cost approach. To increase consistency and comparability in fair value measurements and related disclosures, the standard also creates a fair value hierarchy to prioritize the inputs to these valuation methods into the following three levels:

•

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

•

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

•

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

The following disclosure requirements under FAS 157 are applicable to financial assets and liabilities, and as of January 1, 2009, will be expanded to include nonfinancial assets and liabilities.

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

		September 30,
		2008				Level 1				Level 2				Level 3
						(Dollars in thousands)
Investment securities and mortgage-backed securities available for sale		$	2,100,880			$	0			$	2,100,880			$	0
Loans held for sale			84,395				0				84,395				0
Other assets — derivatives			3,814				0				1,476				2,338
Total assets		$	2,189,089			$	0			$	2,186,751			$	2,338
Other liabilities — derivatives		$	2,701			$	0			$	363			$	2,338

Investments and mortgage-backed securities have been valued using a matrix pricing technique based on quoted prices for similar instruments, while loans held for sale have been valued using investor quoted pricing inputs. Level 2 derivatives represent mortgage banking interest rate lock and loan delivery commitments, while level 3 derivatives represent interest rate swaps. See Note 9 for a further discussion of these derivatives. Changes in the fair value of available-for-sale securities are recorded on the balance sheet under accumulated-other-comprehensive income, while gains and losses from sales are recognized as income. The difference between the aggregate fair value and the aggregate unpaid principal balance of loans held for sale that are carried at fair value under FAS 159 was $813,000 as of September 30, 2008. Changes in fair value relating to these loans were included in earnings as follows:

		Nine Months Ended
		September 30,
		(Dollars in thousands)
Mortgage banking operations		$	813

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis. Sterling may be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis from application of lower of cost or market (''LOCOM'') accounting or write-downs of individual assets. For these financial assets for which a fair value adjustment was recorded during the period, the following table presents the adjustment and the carrying value at period end:

																		Losses During
																		the Nine Months
																		Ended
		Total Carrying																September 30,
		Value				Level 1				Level 2				Level 3				2008
						(Dollars in thousands)
Loans		$	76,759			$	0			$	76,759			$	0			$	(35,816	)
Mortgage servicing rights			4,062				0				4,062				0				(462	)
Real estate owned			45,139				0				45,139				0				(27,635	)

The loan loss disclosed above represents the amount of the specific reserve that was allocated to impaired loans during the period, and is included in the provision for credit losses. Mortgage servicing rights were written down mainly due to an acceleration of mortgage prepayments. Sterling carries its mortgage servicing rights at LOCOM,

and as such, they are measured at fair value on a nonrecurring basis. The real estate owned charge during the period represents the writedowns taken at foreclosure that were charged to the loan loss allowance.

11. Cash Dividends:

The following table presents the amount of dividends paid during the three and nine months ended September 30, 2008 and 2007, respectively:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
		(Dollars in thousands, except per share amounts)
Total amount		$	5,201			$	4,389			$	15,275			$	11,635
Per share amount			0.100				0.085				0.295				0.240
Payout ratio			104	%			17	%			78	%			15	%

On October 10, 2008, Sterling paid a quarterly cash dividend of $0.10 per share of common stock to shareholders of record as of September 30, 2008.

12. Goodwill Lawsuit:

In April 2008, the U.S. Government appealed the U.S. Court of Federal Claim's February 19, 2008 ruling that awarded damages to Sterling in the amount of $1.05 million resulting from Sterling's lawsuit against the U.S. Government for breach of contract with respect to the loss of goodwill treatment and other matters relating to Sterling's past acquisitions of troubled thrift institutions. Sterling filed a notice of cross appeal. The Government subsequently withdrew its appeal, leaving as the sole issue for appellate consideration the sufficiency of the damages award to Sterling. Sterling and the Government have agreed to mediate this issue with a different judge of the U.S. Court of Federal Claims acting as a neutral mediator. The mediation is set to begin in late November, 2008. It is not possible to predict whether, or at what amount, the parties may come to terms of settlement.

13. Subsequent Event:

Troubled Assets Relief Program

On October 3, 2008, in response to upheaval within the financial markets, the President signed into law the Emergency Economic Stabilization Act of 2008 (the ''Act''), which authorized the United States Department of Treasury (the ''UST'') to establish the Troubled Assets Relief Program (''TARP'') to purchase ''troubled assets'' held by financial institutions. Under the TARP program the UST is authorized to purchase, and to make and fund commitments to purchase, troubled assets from any financial institution, on such terms and conditions as are determined by the UST. The purpose of this program is to restore confidence and stability to the financial markets and to encourage the flow of credit within the financial system.

On October 14, 2008, the UST announced the terms of the TARP Capital Purchase Program (''CPP''), through which the UST will make capital investments in banking institutions by purchasing senior preferred shares.

The terms of the CPP program are standardized and any qualifying financial institution may elect to participate by notifying its federal banking agency by November 14, 2008, 5:00 p.m. Only institutions determined to be eligible for CPP by the UST and the financial institution's primary federal regulator will be allowed to participate. Once the eligible institutions are selected, the UST will determine the allocations of capital to each institution and has announced that it will fund the purchase of the preferred stock no later than December 31, 2008.

The terms of the CPP program have been announced as follows:

Participating institutions will be required to subscribe for no less than the minimum subscription amount of 1 percent of their risk-weighted assets. The maximum subscription amount to be allowed is the lesser of $25 billion or 3 percent of risk-weighted assets.

The senior preferred shares to be issued to the UST pursuant to the program will qualify as Tier 1 capital and will rank senior to common stock. The senior preferred shares will be pari passu, or equal in priority to, existing preferred shares, other than preferred shares which by their terms rank junior to any other existing preferred shares. The senior preferred shares will pay a cumulative dividend rate of 5 percent per annum for the first five years and will reset to a rate of 9 percent per annum after year five. The senior preferred shares will generally be non-voting, but will retain class voting rights on matters that could adversely affect the shares. The senior preferred shares will be callable at par after three years. Prior to the end of three years, the senior preferred shares may be redeemed with the proceeds from a qualifying equity offering of any Tier 1 perpetual preferred or common stock. The UST may also transfer the senior preferred shares to a third party at any time.

In conjunction with the purchase of senior preferred shares, the UST will receive warrants to purchase common stock with an aggregate market price equal to 15 percent of the senior preferred investment. The per share exercise price of the shares underlying the warrants will be the market price of the participating institution's common stock at the time of issuance, calculated on a 20-trading day trailing average.

Companies participating in the program are required to adopt the UST standards for executive compensation and corporate governance, for the period during which the UST holds equity issued under this program. These standards generally apply to the chief executive officer, chief financial officer, plus the next three most highly compensated executive officers. These standards require participating institutions to: (1) ensure that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (2) require clawback of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate; (3) prohibit making any golden parachute payment to a senior executive based on the Internal Revenue Code provision; and (4) agree not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive.

Sterling's management believes that Sterling is eligible to participate in the CPP program and has submitted a preliminary application to the Federal Reserve and the FDIC seeking their recommendation that the UST approve Sterling's participation. There can be no assurance whether or not Sterling will be deemed eligible to participate by the Federal Reserve, the FDIC or the UST.

PART I — Financial Information (continued)

STERLING FINANCIAL CORPORATION
September 30, 2008

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 2007 annual report on Form 10-K.

General

Sterling Financial Corporation (''Sterling'') is a bank holding company, organized under the laws of Washington in 1992. The principal operating subsidiaries of Sterling are Sterling Savings Bank and Golf Savings Bank. The principal operating subsidiary of Sterling Savings Bank is INTERVEST-Mortgage Investment Company (''INTERVEST''). During 2008, the operations of Sterling Savings Bank's subsidiary, Action Mortgage Company, were realigned into the real estate division of Sterling Savings Bank, and the operations of Sterling Savings Bank's subsidiary, Harbor Financial Services, Inc., were moved into the wealth management department of Sterling Savings Bank. 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 and sale of residential mortgage loans.

Sterling provides personalized, quality financial services and ''Perfect Fit'' banking products to its customers consistent with its ''Hometown Helpful'' philosophy. Sterling believes that its dedication to personalized service has enabled it to grow both its retail deposit base and its lending portfolio in the western United States. With $12.6 billion in total assets as of September 30, 2008, Sterling originates loans and attracts Federal Deposit Insurance Corporation (''FDIC'') insured deposits from the general public through 179 depository banking offices located in Washington, Oregon, California, Idaho and Montana. In addition, Sterling originates loans through Golf Savings Bank and Sterling Savings Bank residential loan production offices, and through INTERVEST commercial real estate lending offices throughout the western United States. Sterling also markets fixed income and equity products, mutual funds, fixed and variable annuities and other financial products through wealth management representatives located throughout Sterling's financial service center network.

Sterling continues to implement its strategy to become the leading community bank in the western United States by increasing its commercial and consumer customer relationships that can provide a wider variety of lending opportunities, as well as increasing its commercial and 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 (the difference between the interest earned on loans and investments and the interest paid on deposits and borrowings) and will increase other fee income, although there can be no assurance in this regard. Sterling's revenues are derived primarily from interest earned on loans and mortgage-backed securities (''MBS''), fees and service charges, and mortgage banking operations. 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 (the ''Federal Reserve''), the FDIC and the Washington State Department of Financial Institutions.

Executive Summary and Highlights

Sterling's earnings per share and performance ratios for 2008 were impacted by the major disruption in the housing market which has resulted in Sterling recording a credit provision that was higher than the provision recorded during 2007. During the first nine months of 2008, Sterling has recorded a $105.1 million provision for credit losses compared with $12.1 million for the same period a year ago. This increase stems from higher levels of non-performing and classified assets, as disruptions in the financial and real estate markets have resulted in the exhaustion of liquidity reserves for some of Sterling's borrowers. As of September 30, 2008, non-performing assets were $436.7 million versus $135.2 million at December 31, 2007, and $61.8 million at September 30, 2007. Sterling's capital and liquidity sources remain strong, as well as the performance of its retail and commercial banking groups. Net interest income for the first nine months of 2008 was $276.2 million, versus $263.3 million for the nine months ended September 30, 2007.

Highlights at September 30, 2008 as compared to September 30, 2007 were as follows:

•

Capital ratios remain above ''well-capitalized'' levels at 11.0%.

•

Available liquidity rose to over $3.0 billion.

•

Net interest income was $90.0 million.

•

Fees and service charges income grew 2% to $15.3 million.

•

Total deposits gained 4% to a record $8.07 billion.

•

Quarterly cash dividend was maintained at $0.10 per share.

•

Tangible book value per share increased 3% to $13.45.

Company Growth

Sterling intends to continue to pursue a long-term aggressive growth strategy to become the leading community bank in the western United States. In addition to continued organic growth, this strategy may include acquiring other financial businesses or branches thereof, or other substantial assets or deposit liabilities. There is no assurance that Sterling will be successful in completing any such acquisitions.

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

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.

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 collectability of the total contractual principal and interest is no longer in doubt.

Allowance for Credit Losses. The allowance for credit losses is composed of the allowance for loan losses and the reserve for unfunded credit commitments. In general, determining the amount of the allowance requires significant judgment and the use of estimates by management. Sterling maintains an allowance for credit 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 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 credit 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 nonperforming 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, consumer 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 collectability 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. While Sterling did not participate in the lending practices that led up to the credit crisis, the effects of the current economic slow down has resulted in an increase in delinquencies and nonperforming assets in Sterling's residential construction portfolio. A further slowdown in economic activity could have additional adverse affects on cash flows for both commercial and individual borrowers, which may result in further increases in nonperforming assets, delinquencies and losses on loans. There can be no assurance that the allowance for credit losses will be adequate to cover all losses, but management believes the allowance for credit losses was adequate at September 30, 2008.

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 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 other factors. 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 period ended September 30, 2008, there were no investment securities that management identified to be other-than-temporarily impaired, because the decline in fair value was attributable to changes in interest rates and not credit quality, and because Sterling has the ability and intent to hold these investments until a recovery in market price occurs, or until maturity. Realized losses could occur in future periods due to a change in management's intent to hold the investments to recovery, a change in management's assessment of credit risk, or a change in regulatory or accounting requirements.

Fair Value of Financial Instruments. Sterling's available-for-sale securities portfolio totaled $2.10 billion and $1.85 billion as of September 30, 2008 and December 31, 2007, respectively, and were the most substantial of Sterling's financial instruments that are carried at fair value. These securities are valued using a pricing service's matrix technique based on quoted prices for similar instruments, which Sterling validates with non-binding broker quotes.

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

Sterling's management performed an annual test of its goodwill and other intangible assets as of June 30, 2008, and concluded that the recorded values were not impaired, based on present value discounted cash flow as allowed by FAS 142. Sterling's management completed this analysis during the third quarter. Given current market conditions, Sterling will monitor its goodwill value and impairment indicators on a quarterly basis. There are many assumptions and estimates underlying the determination of impairment. Future events could cause management to conclude that Sterling's goodwill or other intangible assets are impaired, which would result in Sterling recording an impairment loss of all or a portion of the goodwill balance. 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 on a straight line basis 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.

Loans Held for Sale. On January 1, 2008, Sterling adopted the fair value election available under FAS 159 for newly originated loans held for sale under mandatory delivery programs. Effective April 1, 2008 Sterling expanded its adoption of FAS 159 to all newly originated loans held for sale. The fair value election was made to match changes in the value of these loans with the value of their economic hedges without having to apply complex hedge accounting. Loan origination fees, costs and servicing rights are recognized as part of the loan value at origination. This value is based on quoted prices for similar instruments in both active and inactive markets, therefore, these loans are classified as level 2.

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. Penalties and interest associated with any potential estimate variances would be included in income tax expense on the Consolidated Statement of Income.

Sterling uses an estimate of future earnings to support its position that the benefit of its net deferred tax assets will be realized. If future taxable income should prove nonexistent or less than the amount of temporary differences giving rise to the net deferred tax assets within the tax years to which they may be applied, the assets will not be realized and Sterling's net income will be reduced.

Results of Operations

Overview. Sterling recorded net income of $5.0 million, or $0.10 per diluted share, for the three months ended September 30, 2008, compared with net income of $26.5 million, or $0.51 per diluted share, for the three months ended September 30, 2007. Net income for the nine months ended September 30, 2008 was $19.5 million, or $0.38 per diluted share, compared to $76.4 million, or $1.54 for the same period in 2007. The annualized return on average assets was 0.16% and 0.91% for the three months ended September 30, 2008 and 2007, respectively. The annualized return on average equity was 1.7% and 9.3% for the three months ended September 30, 2008 and 2007, respectively. The year over year decrease in net income and performance ratios primarily reflected an increased credit provision in response to an increase in the level of classified loans, particularly in the residential construction portfolio.

Net Interest Income. The most significant component of earnings for a financial institution typically is net interest income, 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, 2008 and 2007, net interest income was $90.0 million and $93.7 million, respectively, a decrease of 4%. Net interest income for the nine months ended September 30, 2008 increased 5% to $276.2 million from $263.3 million for the nine months ended September 30, 2007. The decrease in net interest income

during the three month comparative period was due to the increase in nonperforming loans, while the increase in net interest income during the nine month comparative period was caused by the growth in loan balances having a greater effect than the increase in nonperforming loans.

Changes in Sterling's net interest income are a function of changes in both rates and volumes of interest-earning assets and interest-bearing liabilities. Net interest margin refers to net interest income 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 net interest income, on a tax equivalent basis, for the periods presented. Municipal loan and bond interest income are presented gross of their applicable tax savings. For each category of interest-earning assets and interest-bearing liabilities, the following table provides information on changes attributable to:

•  Volume — changes in volume multiplied by comparative period rate;

•

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

•

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

		Three Months Ended September 30,																Nine Months Ended September 30,
		2008 vs. 2007																2008 vs. 2007
		Increase (Decrease) Due to:																Increase (Decrease) Due to:
										Rate/																Rate/
		Volume				Rate				Volume				Total				Volume				Rate				Volume				Total
														(Dollars in thousands)
Rate/volume analysis:
Interest income:
Loans		$	11,310			$	(39,789	)		$	(3,067	)		$	(31,546	)		$	58,792			$	(91,262	)		$	(10,243	)		$	(42,713	)
MBS			5,050				1,056				232				6,338				13,228				2,707				664				16,599
Investments and cash equivalents			2,146				(158	)			(138	)			1,850				3,377				455				216				4,048
Total interest income			18,506				(38,891	)			(2,973	)			(23,358	)			75,397				(88,100	)			(9,363	)			(22,066	)
Interest expense:
Deposits			6,833				(19,532	)			(1,688	)			(14,387	)			20,964				(45,433	)			(3,996	)			(28,465	)
Borrowings			8,565				(11,240	)			(2,872	)			(5,547	)			31,345				(29,520	)			(9,182	)			(7,357	)
Total interest expense			15,398				(30,772	)			(4,560	)			(19,934	)			52,309				(74,953	)			(13,178	)			(35,822	)
Changes in net interest income		$	3,108			$	(8,119	)		$	1,587			$	(3,424	)		$	23,088			$	(13,147	)		$	3,815			$	13,756