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CFS Bancorp 10-K 2010
cfsbancorp_10k.htm


UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
___________________________________

FORM 10-K
___________________________________
 
þ       ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended: December 31, 2009
 
OR
 
o       TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File No.: 0-24611
 
CFS Bancorp, Inc.
(Exact name of registrant as specified in its charter)
 
Indiana 35-2042093
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
  
707 Ridge Road  
Munster, Indiana 46321
(Address of Principal Executive Offices) (Zip Code)

Registrant’s telephone number, including area code:
(219) 836-5500
 
Securities registered pursuant to Section 12(b) of the Act:
Not Applicable
 
Securities registered pursuant to Section 12(g) of the Act:
 
Common Stock (par value $0.01 per share)
(Title of Class)
 
     Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o  No þ
 
     Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.  Yes o  No þ
 
     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 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 has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o  No o
 
     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  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 definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
      Large accelerated filer o Accelerated filer o Non-accelerated filer o Smaller reporting company þ

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o  No þ
 
     As of June 30, 2009, the aggregate value of the 10,764,458 shares of Common Stock of the Registrant outstanding on such date, which excludes 519,393 shares held by affiliates of the Registrant as a group, was approximately $43.3 million. This figure is based on the closing sale price of $4.23 per share of the Registrant’s Common Stock reported on the NASDAQ Global Market on June 30, 2009.
 
     Number of shares of Common Stock outstanding as of March 1, 2010: 10,819,635
 
DOCUMENTS INCORPORATED BY REFERENCE
 
     Portions of the definitive proxy statement for the 2010 Annual Meeting of Shareholders are incorporated by reference into Part III.
 




CFS BANCORP, INC. AND SUBSIDIARIES
 
FORM 10-K
 
INDEX
 
            Page
  PART I.
Item 1. Business 3
Item 1A. Risk Factors 19
Item 1B. Unresolved Staff Comments 24
Item 2. Properties 24
Item 3. Legal Proceedings 24
Item 4. Reserved 24
 
PART II.
Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters, and Issuer
       Purchases of Equity Securities 24
Item 6. Selected Financial Data 26
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 27
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 58
Item 8. Financial Statements and Supplementary Data 61
Item 9. Changes in and Disagreements with Accountants on Accounting and
       Financial Disclosure 95
Item 9A(T). Controls and Procedures 95
Item 9B. Other Information 96
 
PART III.
Item 10. Directors, Executive Officers, and Corporate Governance 96
Item 11. Executive Compensation 96
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related
       Shareholder Matters 96
Item 13. Certain Relationships and Related Transactions and Director Independence 97
Item 14. Principal Accounting Fees and Services 97
 
PART IV.
Item 15. Exhibits and Financial Statement Schedules 97
Signature Page 99
Certifications for Principal Executive Officer and Principal Financial Officer 102



     Certain statements contained in this Annual Report on Form 10-K, in other filings with the U.S. Securities and Exchange Commission (SEC), and in the Company’s press releases or other shareholder communications are “forward-looking statements,” within the meaning of the Private Securities Litigation Reform Act of 1995. Generally, these statements relate to business plans or strategies; projections involving anticipated revenues, earnings, profitability, or other aspects of operating results; or other future developments in our affairs or the industry in which we conduct business. Forward-looking statements may be identified by reference to a future period or periods or by the use of forward-looking terminology such as “anticipate,” “believe,” “estimate,” “expect,” “indicate,” “intend,” “plan,” “should,” “would be,” “will,” “intend to,” “project,” or similar expressions or the negative thereof.
 
     We wish to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made. We also advise readers that various factors, including regional and national economic conditions, changes in levels of market interest rates, credit and other risks which are inherent in our lending and investment activities, legislative changes, changes in the cost of funds, demand for loan products and financial services, changes in accounting principles, ability to realize deferred tax assets, competitive and regulatory factors, and successful execution of our strategy and our Strategic Growth and Diversification Plan could affect our financial performance and could cause actual results for future periods to differ materially from those anticipated or projected. For further discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements see “Item 1A. Risk Factors” of this Annual Report on Form 10-K. Such forward-looking statements reflect our current views with respect to future events and are subject to certain risks, uncertainties, assumptions, and changes in circumstances. Forward-looking statements are not guarantees of future performance or outcomes, and actual results or events may differ materially from those included in these statements. We do not undertake, and specifically disclaim any obligation, to update any forward-looking statements to reflect occurrences, unanticipated events, or circumstances after the date of such statements.
 
PART I.
 
ITEM 1. BUSINESS
 
GENERAL
 
     CFS Bancorp, Inc. (the Company) is a registered unitary savings and loan holding company incorporated under the laws of the State of Indiana. We operate in one operating segment, community banking. We were formed in March 1998 and operate one wholly-owned subsidiary, Citizens Financial Bank (the Bank), and were formed to facilitate the Bank’s July 1998 conversion from a federally-chartered mutual savings bank to a federally-chartered stock savings bank (the Conversion). In conjunction with the Conversion, we completed an initial public offering of our common stock. Pursuant to shareholder approval, in 2005, the Company changed its state of incorporation from Delaware to Indiana. The change was effectuated through a merger of the Delaware corporation with a wholly-owned Indiana subsidiary formed for that purpose. We are subject to the primary oversight and examination by the Office of Thrift Supervision (OTS). See “Regulation – Regulation of Savings and Loan Holding Companies” below in this “Business” section.
 
     We employed 312 full-time equivalent employees at December 31, 2009. Our executive officers and those of the Bank are substantially identical. We do not own or lease any property but instead use the premises, equipment and furniture of the Bank. We do not employ any persons other than officers who are also officers of the Bank. In addition, we utilize the support staff of the Bank from time to time. We are responsible for the overall conduct, direction, and performance of the Bank and provide various services, establish company-wide policies and procedures, and provide other resources as needed, including capital to the Bank.
 
     The Bank was originally organized in 1934 and currently conducts its business from its executive offices in Munster, Indiana, as well as 23 banking centers located in Lake and Porter counties in northwest Indiana and Cook, DuPage and Will counties in Illinois. The Bank also maintained an Operations Center in Highland, Indiana which was dedicated to its Customer Call Center and other back office operations. The lease for the Operations Center expired on December 31, 2009 and was not renewed. Employees who formerly worked at the Operations Center were transferred to other space currently owned or leased by the Bank.
 
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     In recent years, we have transitioned our business model from a traditional savings and loan engaged primarily in one-to-four family residential mortgage lending to a more diversified consumer and business banking model while retaining our emphasis on high-quality personalized client service.
 
     We offer a wide variety of checking, savings, and other deposit accounts. We also offer investment services and securities brokerage targeted to individuals, families, and small- to medium-sized businesses in our primary market areas through a non-affiliated third-party provider. We have increased our business product offerings over the past few years to enhance our opportunity to serve the business segment and cash management needs of our client base. These products include public fund deposits, a full array of sweep products including repurchase sweep accounts, zero balance accounts, remote deposit capture and merchant services, business overdraft privilege, business on-line banking, and other cash management related services.
 
     Our 23 banking centers are responsible for the delivery of retail and small business loan and deposit products and services in the communities we serve. Banking Center Managers and their staffs utilize a relationship focused, client centric approach in identifying opportunities and meeting the needs and exceeding the expectations of our clients. By providing high-quality personalized client service and solutions, the Banking Centers enhance our ability to improve our market share.
 
     Our Business Banking Group is primarily responsible for developing relationships with small- to medium-sized businesses within the communities we serve by providing various loan, deposit, and cash management products and services. A seasoned team of Business Relationship Managers and an experienced credit team analyze overall relationship opportunities to ensure the proper assessment of inherent risks and utilize various loan structures to appropriately manage those risks.
 
     We periodically evaluate potential acquisitions and de novo branching opportunities to strengthen our overall market presence. We target areas that we believe are not yet fully served by other banking organizations, offer an attractive deposit base or potential business growth opportunities, and complement our existing market territory. We opened a new banking center in St. John, Indiana in September 2009. The banking center is a free-standing building built on land that is leased for 20 years and is part of a new shopping center development. In addition, we are planning a second free-standing full service banking facility in Crown Point, Indiana with an anticipated opening date in late 2011 as well as relocating our existing banking facility in Harvey, Illinois with an anticipated opening date in mid-2010. Both of these facilities are to be built on land we currently own. We also own land for a new banking center in Bolingbrook, Illinois, and intend to relocate our existing banking center in Flossmoor, Illinois, to a free-standing full service banking facility. At this time, due to deteriorating market conditions, we have delayed construction on these two properties indefinitely.
 
     The Bank’s revenue is primarily derived from interest on loans and investment securities and fee-based income. The Bank’s operations are significantly impacted by current economic conditions, the regulations of the OTS, the monetary policy of the federal government, including the Board of Governors of the Federal Reserve System (FRB), and governmental tax policies and budgetary matters. The Bank’s revenue is largely dependent on net interest income, which is the difference between interest earned on interest-earning assets and the interest expense paid on interest-bearing liabilities.
 
AVAILABLE INFORMATION
 
     We are a public company and file annual, quarterly and other reports, proxy statements, and other information with the Securities and Exchange Commission (SEC). We make available our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act free of charge, on our website, www.citz.com, under the “Investor Relations” section. These documents are available as soon as reasonably practicable after they are filed or furnished to the SEC.
 
CORPORATE GOVERNANCE
 
     We have established certain committees of our Board of Directors, specifically Executive, Audit, Compensation, and Corporate Governance and Nominating Committees. The duties of the Executive Committee are set forth in the Board resolution that authorized the committee. The charters of the Audit, Compensation, and Corporate Governance and Nominating Committees as well as our Code of Conduct and Ethics can be found on our website listed above. The information is also available in printed form to any shareholder who requests it by writing to us in care of our Vice President – Corporate Secretary, 707 Ridge Road, Munster, Indiana 46321.
 
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MARKET AREA AND COMPETITION
 
     We maintain 23 banking centers in Lake and Porter counties in northwest Indiana and in Cook, DuPage, and Will counties in Illinois. All areas served are part of the Chicago Metropolitan Statistical Area.
 
     We have historically concentrated our efforts in the markets surrounding our offices. Prior to 2008, we had also invested in areas outside of our market through the direct origination of commercial loans and the purchase of commercial syndication and participation loans. Our market area reflects diverse socio-economic factors. Historically, the market area in northwest Indiana and the south-suburban areas of Chicago were heavily dependent on manufacturing. While manufacturing is still an important component of the local economies, service-related industries have become increasingly more significant to the region in the last decade. The local economies are affected by the interrelation with Chicago as well as suburban business centers in the area.
 
     We face significant competition both in making loans and in attracting deposits. The Chicago metropolitan area is one of the largest money centers and the market for deposit funds is one of the most competitive in the United States. The competition for loans comes principally from commercial banks, other savings banks, savings associations, and to a lesser degree, mortgage-banking companies, conduit lenders, and insurance companies. The most direct competition for deposits has historically come from savings banks, commercial banks, and credit unions. We face additional competition for deposits from short-term money market funds, other corporate and government securities funds, and other non-depository financial institutions such as brokerage firms and insurance companies.
 
LENDING ACTIVITIES
 
General
 
     We originate commercial and retail loans. Included in the commercial loan portfolio are commercial and industrial, commercial real estate (owner occupied, non-owner occupied, and multifamily), and construction and land development loans. The retail loan portfolio includes one-to-four family residential mortgage, construction and lot, and consumer loans including home equity loans, home equity lines of credit (HELOCs), auto loans, and other consumer loans. See the loans receivable composition table in “Loans” within “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Annual Report on Form 10-K.
 
     We have also invested, on a participating basis, in loans originated by other lenders and loan syndications. We apply the same underwriting guidelines applicable to loans we originate when considering investing in these loans. At December 31, 2009, we had syndications and purchased participations totaling $52.4 million, of which $17.3 million were to borrowers located outside of our market area. See total participation and syndication loans by state in “Loans” within “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Annual Report on Form 10-K. We have historically invested in syndications and participations to supplement the direct origination of our commercial loan portfolio. During 2007, we experienced margin contraction and detected credit risks in excess of our risk tolerances in the opportunities being presented in this portion of our loan portfolio. As a result, we stopped purchasing new syndications and participations in the second quarter of 2007.
 
     Our lending strategy seeks to diversify our portfolio in an effort to limit risks associated with any particular loan type or industry while building a quality loan portfolio. We have established specific collateral concentration limits in a manner we believe will not hamper our relationship managers in the pursuit of new business opportunities in a variety of sectors. Our commercial loan underwriting focuses on the cash flow from business operations, the financial strength of the borrower and guarantors, and the underlying collateral. We have tested and implemented loan grading matrices for commercial and industrial loans and commercial real estate loans. The grading criteria is based on core credit attributes that emphasize cash flow, trends, collateral, and guarantor liquidity and removes subjective criteria and bias. We have made the use of these matrices a requirement for all commercial loans.
 
     We utilize secondary market standards for underwriting one-to-four family residential mortgage loans which facilitate our ability to sell these loans into the secondary market if deemed necessary in the future. Secondary market requirements place limitations on debt-to-income ratios and loan size among other factors. As part of the underwriting process, we evaluate, among other things, the applicant’s credit history, income, employment stability, repayment capacity, and collateral. Since 2008, we have retained the one-to-four family residential mortgage loans we originated.
 
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     We utilize a risk-based lending approach for underwriting our home equity products and other consumer loans. This approach evaluates the applicant’s credit score, debt-to-income ratio, and the collateral value and tiers the interest rates based upon the evaluation of these attributes.
 
     The types of loans that we may originate are subject to federal and state laws and regulations. Interest rates charged on loans are affected principally by the inherent risks involved, demand for such loans, the supply of money available for lending purposes, and the rates offered by our competitors on such loans. These factors are, in turn, affected by current economic conditions, the monetary policy of the federal government, including the FRB, and governmental tax policies and budgetary matters.
 
     Certain officers have been authorized by the Board of Directors to approve loans up to specific designated amounts. The Loan Committee meets weekly and reviews any loans that exceed individual loan approval limits. As part of its monthly review, the Board of Directors reviews the Loan Committee minutes.
 
     A federal savings bank generally may not make loans to one borrower and related entities in an amount which exceeds 15% of its unimpaired capital and surplus (or approximately $15.8 million in our case at December 31, 2009), although loans in an amount equal to an additional 10% of unimpaired capital and surplus may be made to a borrower if the loans are fully secured by readily marketable securities.
 
     We are also required to monitor our aggregate loans to corporate groups. These are loans that are made to individual entities that have a similar ownership group but are not considered to be a common enterprise. While the individual loans are secured by separate properties and underwritten based on separate cash flows, the entities may all be owned or controlled by one individual or a group of individuals. We are required by regulation to limit our aggregate loans to any corporate group to 50% of Tier 1 capital. At December 31, 2009, Tier 1 capital was $95.1 million. Our two largest corporate group relationships at December 31, 2009 equaled $22.0 million and $14.8 million, respectively. Both of these relationships are well below the group limit of $47.5 million and are performing in accordance with their terms.
 
COMMERCIAL LENDING
 
General
 
     Our commercial lending portfolio includes commercial and industrial, commercial real estate (owner occupied, non-owner occupied, and multifamily), and construction and land development loans. The business banking group is responsible for growing our commercial loan portfolio by generating small- to medium-sized business relationships, which includes cross-selling all bank products and services. Our short-term and revolving commercial loans generally have variable interest rates indexed to the Wall Street Journal prime lending rate, the London Interbank Offered Rate (LIBOR), the Federal Home Loan Bank of Indianapolis (FHLB–IN) rate, or the three- or five-year U.S. Treasury obligations. Our longer term amortizing loans generally have balloon dates of three to five years, which allows us to reprice the loans based on current market conditions and changes in the asset quality.
 
Commercial and Industrial Loans
 
     We continue our strategic focus to shift from commercial real estate to commercial and industrial lending. Our focus is small- and medium-sized business relationships, which are generally secured by business assets including accounts receivable, inventory, and equipment and typically include the personal guarantees of the principals of the business. On occasion, these loans will include a borrowing base and/or additional real estate as collateral to enhance our security as well as the borrower’s commitment to the loan. The commercial and industrial loans undergo an underwriting process similar to the other types of commercial lending we offer; however, these loans tend to have different risks associated with them since repayment is generally based on the cash flows generated from the borrower’s business cycle. As of December 31, 2009, the average outstanding balance of commercial and industrial loans was approximately $181,000.
 
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Commercial Real Estate
 
     The commercial loan portfolio also includes loans secured by commercial real estate. As of December 31, 2007, the commercial real estate portfolio was segmented into owner occupied, non-owner occupied, and multifamily loans. The reclassification was completed to provide better disclosure of the types of commercial real estate loan concentrations held within our portfolio.
 
     Commercial real estate loans generally have three to ten year terms with an amortization period of 25 years or less. We offer fixed interest rate loans and variable rate loans with fixed interest rates for the initial three or five year period which then adjust at each three or five year interval to a designated index, such as the prime lending rate, LIBOR, FHLB–IN rate, or U.S. Treasury obligations, plus a stipulated margin for the remainder of the term. Commercial real estate loans generally have shorter terms to maturity and higher yields than our one-to-four family residential mortgage loans. Upon closing, we usually receive fees between 0.25% and 1% (subject to competitive conditions) of the principal loan balance. These loans may be subject to prepayment penalties. We generally obtain personal guarantees for commercial real estate loans from any principal owning 20% or more of the business.
 
     We evaluate various aspects of commercial real estate loans in an effort to manage credit risk to an acceptable risk tolerance level. In underwriting these loans, consideration is given to the stability of the property’s cash flow, future operating projections, management experience, current and projected occupancy, location, and physical condition. In addition, we generally perform sensitivity analysis on cash flows utilizing various occupancy and interest rate assumptions when underwriting the loans to determine how different scenarios may impact the borrowers’ ability to repay the loans. We have generally imposed a debt service coverage ratio (the ratio of net income before interest, depreciation, and debt payments to debt service) of not less than 110% for commercial real estate loans. The loan-to-value ratios are generally less than 80% at time of origination. The underwriting analysis includes a review of the financial condition of borrowers and guarantors as well as cash flows from global resources. An appraisal report is prepared by an independent appraiser commissioned by us to determine property values based upon current market conditions. We review all appraisal reports and any necessary environmental site assessments before the loan closes.
 
     Commercial real estate lending entails substantial risks because these loans often involve large loan balances to single borrowers and the payment experience on these loans is typically dependent on the successful operation of the project or business. These risks can also be significantly affected by supply and demand conditions in the local market for apartments, offices, warehouses, or other commercial space. We attempt to mitigate our risk exposure by considering properties with existing operating history that can be analyzed, requiring conservative debt coverage ratios, and periodically monitoring the operation and physical condition of the collateral as well as the business occupying the property.
 
     Commercial real estate owner occupied loans are generally a borrower purchased building where the borrower occupies at least 50% of the space with the primary source of repayment dependent on sources other than the underlying collateral. These types of loans are secured by properties housing the owner’s business such as light industrial/warehouses, restaurants, single tenant office properties, multi-tenant office properties, and professional office properties. At December 31, 2009, the average outstanding balance of commercial real estate owner occupied loans approximated $511,000.
 
     Commercial real estate non-owner occupied loans are generally loans collateralized by commercial income-producing properties such as office buildings, retail shopping centers, mixed-use commercial buildings, and properties used in the hospitality industry. We generally obtain the personal guarantees of the borrower to help mitigate the risk associated with this type of lending. At December 31, 2009, the average outstanding balance of commercial real estate non-owner occupied loans approximated $810,000.
 
     Commercial real estate multifamily loans include loans to purchase or refinance residential rental properties with five or more units such as apartments, town homes, and nursing homes. In 2008, we hired an experienced relationship manager to focus solely on growing the multifamily loan portfolio. Our emphasis is to originate multifamily loans collateralized by properties with 24 units or less. At December 31, 2009, the average outstanding balance of commercial real estate multifamily loans approximated $589,000.
 
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Construction and Land Development Loans
 
     We provide construction loans for various commercial real estate and multifamily residential projects. We also originate loans to developers for the purpose of developing the land (e.g., roads, sewer, and water) for sale. Due to the higher degree of risk and the current lack of activity in the housing and land development markets, we began to reduce our exposure to this type of lending during 2008 and expect this trend will continue.
 
     Construction and land development loans are secured by a mortgage on the property which is generally limited to the lesser of 80% of its appraised value or 85% of its cost less developer profit, overhead, and interest reserves. This type of loan is typically made for a period of up to three years. We require monthly interest payments during the loan’s term. The principal balance of the loan is reduced as units are sold or at maturity upon the borrower obtaining permanent financing. In addition, we generally obtain personal guarantees from the borrower’s principals for construction and land development loans.
 
     The loan underwriting and processing procedures require a property appraisal by an approved independent appraiser and each construction and development loan is reviewed by independent architects, engineers, or other qualified third parties for verification of costs. Disbursements during the construction phase are based on regular on-site inspections and approved certifications. In the case of construction loans on commercial projects where we provide the permanent financing, we usually require executed lease commitments on some portion of the property under construction from qualified tenants. In addition, we primarily provide residential and commercial construction lending within our market area.
 
     Construction and land development financing is generally considered to involve a higher degree of risk of loss than long-term financing on improved, owner occupied real estate. The risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property’s value at completion of construction or development, the estimated cost (including interest) of construction, and the absorption rate of unit sales utilized in the original appraisal report. If the estimate of construction cost proves to be inaccurate, we typically require the borrower to inject cash equity to cover any shortfall. If the borrower is unable to cover a shortfall, we may then need to advance funds beyond the amount originally committed to ensure completion of the development.
 
     In evaluating any new originations of construction and development loans, we generally consider evidence of the availability of permanent financing or a takeout commitment to the borrower, the reputation of the borrower and the contractor, the amount of the borrower’s equity in the project, independent valuations and reviews of cost estimates, pre-construction sale or leasing information, and cash flow projections of the borrower. To reduce the inherent risks, we may require performance bonds in the amount of the construction contract and generally obtain personal guarantees from the principals of the borrower.
 
     As of December 31, 2007, we reclassified certain construction and lot loans where the loan was related to the construction of a one-to-four family residence. These loans generally convert to permanent mortgage loans upon the completion of the project. As a result of the reclassification, these loans are included in our retail loan portfolio. At December 31, 2009, the average outstanding balance of commercial construction and land development loans was approximately $832,000.
 
RETAIL LENDING
 
General
 
     The retail lending program includes one-to-four family residential loans, home equity loans, HELOCs, one-to-four family residential construction and lot loans, auto loans, and other consumer loans. At the beginning of 2008, we shifted our strategic focus relating to the origination of residential loans from commissioned originators focused on loan originations to salaried senior personal bankers focused on relationship development. We currently employ three senior personal bankers responsible for the origination of retail loans within our geographic footprint as well as the sale of other products and services. Previously, our primary focus was originating fixed-rate loans and selling them in the secondary market and retaining variable-rate retail products; however, we currently retain all of the one-to-four family residential loans we originate.
 
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One-to-Four Family Residential Loans
 
     All of our one-to-four family residential mortgage loans consist of conventional loans. Conventional loans are neither insured by the Federal Housing Administration (FHA) nor partially guaranteed by the Department of Veterans Affairs (VA). The vast majority of our one-to-four family residential mortgage loans are secured by properties located in our market areas.
 
     Our current maximum loan-to-value (LTV) ratio for these loans is generally 80% of the lesser of the secured property’s sales price or appraised value. We had offered loans until September 2008 with a maximum LTV of 95% while generally requiring private mortgage insurance on the portion of the principal amount that exceeded 80% of the appraised value. We were not an active originator of sub-prime or “Alt-A” loans and have not originated option adjustable-rate mortgages or negative amortization loans.
 
     Our residential mortgage loans have either fixed interest rates or variable interest rates which adjust periodically during the term of the loan. Fixed-rate loans generally have maturities between 10 and 30 years and are fully amortizing with monthly loan payments sufficient to repay the total amount of the loan and interest by the maturity date. We do not originate non-amortizing one-to-four family residential loans. Substantially all of our one-to-four family residential mortgage loans contain due-on-sale clauses, which permit us to declare the unpaid balance to be due and payable upon the sale or transfer of any interest in the property securing the loan without our prior approval. We enforce such due-on-sale clauses.
 
     Our fixed-rate loans are generally originated under terms, conditions, and documentation which permit them to be sold in the secondary market if we should elect to do so. At December 31, 2009, $104.5 million, or 56.4%, of our one-to-four family residential mortgage loans were fixed-rate loans.
 
     The adjustable-rate one-to-four family residential mortgage (ARM) loans currently offered have interest rates which are fixed for the initial three- or five-year period and then adjust annually to the corresponding constant maturity (CMT) plus a stipulated margin. ARMs generally have a cap of 2% on any increase or decrease in the interest rate at any adjustment date and include a specified cap on the maximum interest rate increases over the life of the loan. This cap is generally 6% above the initial rate. ARMs require that any payment adjustment resulting from a change in the interest rate of an adjustable-rate loan be sufficient to result in full amortization of the loan by the end of the loan term and do not permit any of the increased payment to be added to the principal amount of the loan, or so-called negative amortization. We do not have any interest-only adjustable rate one-to-four family residential loans in our portfolio. At December 31, 2009, $80.8 million, or 43.6%, of our one-to-four family residential mortgage loans were adjustable-rate loans.
 
Home Equity Products
 
     The majority of our home equity products are HELOCs which are structured as a variable-rate line of credit with terms up to 20 years including a 10 year repayment period. We also offer home equity loans with a 10 year term which have a fixed-rate through maturity. Our home equity products are secured by the underlying equity in the borrower’s residence. These products currently require LTV ratios of 80% or less after taking into consideration any first mortgage loan if the borrower’s first mortgage loan is also held with the Bank; if not, the LTV is limited to 70% or less. There is a higher level of risk associated with this type of lending since these products are typically secured by a second mortgage on the applicant’s residence. We look to the borrower’s credit score and a verification of the borrower’s debt-to-income ratio as an indication of the applicant’s ability to pay and a factor in establishing the interest rate on the loan or line of credit.
 
Retail Construction and Land Development
 
     Beginning December 31, 2007, we reclassified our construction and lot loans for one-to-four family residences out of commercial construction and land development. These loans are typically loans on single lots for the construction of the borrower’s single family residence. Due to the current economic conditions and lack of activity in the housing and land development markets, we have reduced our exposure to this type of lending since 2008.
 
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Other Loans
 
     Other retail loans consist primarily of consumer loans, loans secured by deposit accounts, and auto loans. We are not actively marketing these types of loans and offer them primarily as an accommodation to our existing relationship clients.
 
SECURITIES ACTIVITIES
 
     Our investment policy, which has been approved by our Board of Directors, prescribes authorized investments and outlines our practices for managing risks involved with investment securities. Our investments are managed to balance the following objectives:
  • protecting net interest income from the impact of changes in market interest rates;
  • providing liquidity for loan demand, deposit fluctuations, and other balance sheet changes;
  • preserving principal;
  • maximizing return on invested funds within acceptable risk guidelines; and
  • meeting pledging and liquidity requirements.
     Our investment policy permits investments in various types of securities including obligations of the U.S. Treasury, federal agencies, government sponsored enterprises (GSEs), corporate obligations (AAA rated), pooled trust preferred securities, other equity securities, commercial paper, certificates of deposit, and federal funds sold to financial institutions approved by the Board of Directors. We currently do not participate in hedging programs, interest rate swaps, or other activities involving the use of off-balance-sheet derivative instruments.
 
     We evaluate all securities on a quarterly basis, and more frequently when economic conditions warrant additional evaluations, for determining if an other-than-temporary impairment (OTTI) exists pursuant to guidelines established in ASC 320-10, Investments – Debt and Equity Securities. In evaluating the possible impairment of securities, consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial conditions and near-term prospects of the issuer, and our ability and intent to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer’s financial condition, we may consider whether the securities are issued by the federal government or its agencies or government sponsored agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition.
 
     If we determine that an investment experienced an OTTI, we must then determine the amount of the OTTI to be recognized in earnings. If we do not intend to sell the security and it is more likely than not that we will not be required to sell the security before recovery of its amortized cost basis less any current period loss, the OTTI will be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the OTTI related to other factors will be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings will become the new amortized cost basis of the investment. If we intend to sell the security or it is more likely than not we will be required to sell the security before recovery of its amortized cost basis less any current period credit loss, the OTTI will be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. Any recoveries related to the value of these securities are recorded as an unrealized gain (as other comprehensive income (loss) in shareholders’ equity) and not recognized in income until the security is ultimately sold. From time to time we may dispose of an impaired security in response to asset/liability management decisions, future market movements, business plan changes, or if the net proceeds can be reinvested at a rate of return that is expected to recover the loss within a reasonable period of time.
 
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SOURCE OF FUNDS
 
General
 
     Deposits are the primary source of funds for lending and other investment purposes. In addition to deposits, we derive funds from loan principal repayments and borrowings. Loan repayments are historically a relatively stable source of funds, while deposit inflows and outflows are significantly influenced by general interest rates and money market conditions. We have used borrowings in the past, primarily FHLB advances, to supplement our deposits as a source of funds.
 
Deposits
 
     Our deposit products include a broad selection of deposit instruments, including checking accounts, money market accounts, savings accounts, and certificates of deposit. We consider our checking, money market, and savings accounts to be our core deposits. Deposit account terms may vary with principal differences including: (i) the minimum balance required; (ii) the time period the funds must remain on deposit; and (iii) the interest rate paid on the account.
 
     We utilize traditional marketing methods to attract new clients and deposits. We do not advertise for deposits outside of our market area and do not use the services of deposit brokers. We have developed public deposit products attractive to local municipalities. Due to the relatively large size of these balances and the cyclical nature of the municipalities’ cash flows, total deposits can fluctuate as a result of changes in these balances. At times, we have implemented initiatives to attract core deposits in all of our markets by offering various limited-time promotions for new deposit accounts. As the need for funds warrant, we may continue to use deposit promotions in new and existing markets to build our client base.
 
Borrowed Money
 
     Although deposits are our primary source of funds, our policy has been to also utilize borrowings, including advances from the FHLB–IN. The advances from the FHLB–IN are secured by its capital stock, a blanket pledge of certain of our mortgage loans, and FHLB–IN time deposits. These advances are made in accordance with several different credit programs, each of which has its own interest rate and range of maturities. We also utilize short-term federal funds purchased and borrowings from the FRB as other sources of funds when necessary. We also offer sales of securities under agreements to repurchase (Repo Sweeps). These Repo Sweeps are treated as financings, and the obligations to repurchase securities sold are reflected as borrowed money in our consolidated statements of condition.
 
SUBSIDIARIES
 
     During 2009, the Bank had one active, wholly-owned subsidiary, CFS Holdings, Ltd. (CFS Holdings). This subsidiary was approved by the OTS in January 2001 and began operations in June 2001. CFS Holdings is located in Hamilton, Bermuda. It was funded with approximately $140.0 million of the Bank’s investment securities and performs a significant amount of our securities investing activities. Certain of these activities are performed by a resident agent in Hamilton in accordance with the operating procedures and investment policy established for CFS Holdings. Revenues of CFS Holdings were $5.0 million for the year ended December 31, 2009 compared to $4.5 million and $4.1 million for the years ended December 31, 2008 and 2007, respectively. Operating expenses of this subsidiary were $65,000 for the year ended December 31, 2009 and $63,000 for the years ended December 31, 2008 and 2007.
 
REGULATION AND SUPERVISION OF THE COMPANY AND THE BANK
 
General
 
     The Company and the Bank are extensively regulated under applicable federal and state laws and regulations. The Company, as a savings and loan holding company, and the Bank, as a federally-chartered savings association, are supervised, examined, and regulated by the OTS. As a company with securities registered under Section 12 of the Securities Exchange Act of 1934 (1934 Act), the Company also is subject to the regulations of the SEC and the periodic reporting, proxy solicitation, and other requirements under the 1934 Act. As an FDIC-insured institution, the Bank also is subject to regulation by the Federal Deposit Insurance Corporation (FDIC).
 
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     The Bank is a member of the FHLB system, and its deposits are insured by the Deposit Insurance Fund (DIF) of the FDIC. The Bank must file reports with the OTS concerning its activities and financial condition and obtain regulatory approval prior to entering into certain transactions such as mergers with, or acquisitions of, other savings associations. The OTS also conducts periodic examinations of the Company and the Bank. The regulatory structure applicable to the Company and the Bank gives the OTS extensive discretion in connection with its supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate allowances for loan losses for regulatory purposes. The activities, growth, earnings, and dividends of the Company and the Bank can be affected not only by management decisions and general economic conditions but also by the statutes administered by, and the regulations and policies of, various governmental regulatory authorities.
 
     Certain statutory and regulatory requirements applicable to the Company and the Bank are summarized below or elsewhere in this Annual Report on Form 10-K. These summaries do not purport to be complete explanations of all statutes and regulations applicable to, and their effects on, the Company and the Bank and are qualified in their entirety by reference to the actual laws and regulations. In addition, these statutes and regulations may change in the future, and we cannot predict what effect these changes, if implemented, will have on our operations. The supervision, examination, and regulation of the Company and the Bank by the bank regulatory agencies are intended primarily for the protection of depositors and the DIF rather than the shareholders of the Company and the Bank.
 
Holding Company Regulation
 
     The Company is a unitary savings and loan holding company. It is a legal entity separate and distinct from the Bank and any other subsidiaries of the Company, and its principal source of funds are dividends paid to it by the Bank.
 
     The Home Owners’ Loan Act, as amended (HOLA), and OTS regulations generally prohibit a savings and loan holding company from engaging in any activities that would constitute a serious risk to the safety and soundness of the Bank. Further, the HOLA and the OTS prohibit a savings and loan holding company, without prior OTS approval, from acquiring, directly or indirectly, the ownership or control, or all, or substantially all, of the assets or more than 5% of the voting shares, of any other savings association or savings and loan holding company.
 
     Depending upon the factors described below, certain holding companies may operate without significant limitations on their activities, while others are subject to significant restrictions. The restrictions which apply will depend upon whether (i) the holding company is a unitary or multiple savings and loan holding company, (ii) the holding company came into existence or filed an application to become a savings and loan holding company prior to May 4, 1999, and (iii) whether the subsidiary thrift meets the Qualified Thrift Lender (QTL) status. The Company presently operates as a unitary savings and loan holding company and has been in existence prior to May 4, 1999. The Bank currently satisfies the QTL test. Accordingly, the Company does not currently have significant limitations on its activities. If the Company ceases to be a unitary savings and loan holding company or to satisfy the QTL test, the activities of the Company and its non-savings association subsidiaries would thereafter be subject to substantial restrictions.
 
Federal Savings Association Regulation
 
     Business Activities. The Bank is a wholly-owned subsidiary of the Company. The Bank’s lending, investment, and other activities are governed by federal laws and regulations. Those laws and regulations delineate the nature and extent of the business activities in which federal savings associations may engage.
 
     Regulatory Capital Requirements and Prompt Corrective Action. OTS capital regulations require savings associations to satisfy three minimum capital standards: (i) a risk-based capital requirement, (ii) a leverage requirement, and (iii) a tangible capital requirement.
 
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     Under the risk-based capital requirements of the OTS, the Bank must have total capital (core capital plus supplementary capital) equal to at least 8% of risk-weighted assets (which includes the credit risk equivalents of certain off-balance-sheet items). In determining the amount of risk-weighted assets, all assets are multiplied by a risk-weight factor ranging from 0% to 100%, as assigned by the OTS capital regulations based on the risks inherent in the type of asset. For purposes of the risk-based capital requirement, supplementary capital may not exceed 100% of core capital. Under the leverage requirement, the Bank is required to maintain Tier 1 (core) capital equal to at least 4% of adjusted total assets (3% if the Bank has received the highest composite rating under the Uniform Financial Institutions Ratings System). Under the tangible capital requirement, the Bank is required to maintain tangible capital equal to at least 1.5% of its adjusted total assets. These capital requirements are viewed as minimum standards by the OTS, and most institutions are expected to maintain capital levels above these minimums.
 
     The prompt corrective action regulations, promulgated under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDIC Improvement Act of 1991), require certain mandatory actions and authorize certain other discretionary actions to be taken by the OTS and the FDIC against a savings association that falls within certain undercapitalized capital categories specified in the regulations. The regulations establish five categories of capital classification: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized.” Under the regulations, the ratios of total capital to risk-weighted assets and core capital to risk-weighted assets and the leverage ratio are used to determine a savings association’s capital classification.
 
     The OTS and the FDIC may order savings associations which have insufficient capital to take prompt corrective actions. For example, a savings association that is not at least “adequately capitalized” is required to submit a capital restoration plan to the regulators and may not, among other restrictions, increase its assets, engage in certain activities, make any capital distributions, establish a new branch, or acquire another financial institution. In addition, a capital restoration plan of a savings association controlled by a holding company must include a guarantee by the holding company limited to the lesser of 5% of the association’s assets when it failed to meet the “adequately capitalized” standard or the amount needed to satisfy the plan. Additional and more stringent supervisory actions may be taken depending on the financial condition of the savings association and other circumstances, such as, for example, the removal and replacement of directors and senior executive officers. Savings associations deemed to be “critically undercapitalized” are subject to the appointment of a receiver or conservator.
 
     Savings associations that have a total risk-based capital ratio of at least 10%, a leverage ratio of at least 5% and a Tier 1 risk-based capital ratio of at least 6% and that are not subject to any order or written directive to meet and maintain a specific capital level are considered “well capitalized.” At December 31, 2009, the Bank had a total-risk based capital ratio of 12.35%, a leverage ratio of 8.88% and a Tier 1 risk-based capital ratio of 11.15%. As such, the Bank was considered “well capitalized” at December 31, 2009. For further discussion related to our capital ratios see “Note 12. Stockholders’ Equity and Regulatory Capital” in the notes to consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K.
 
     Dividends and Capital Distributions. OTS regulations impose limitations upon all capital distributions by a savings association. Capital distributions include cash dividends, payments to repurchase or otherwise acquire the association’s own stock, payments to shareholders of another institution in a cash-out merger, and other distributions charged against capital. The regulations provide that an association must submit an application to the OTS to receive approval of any capital distribution if the association (i) is not eligible for expedited treatment, (ii) proposes capital distributions for the applicable calendar year that exceed in the aggregate its net income for that year to date plus its retained income for the preceding two years, (iii) would not be at least adequately capitalized following the distribution, or (iv) would violate a prohibition contained in a statute, regulation or agreement between the institution and the OTS by performing the capital distribution. Under any other circumstances, the association is required to provide a written notice (rather than an application) to the OTS prior to the capital distribution. Based on its retained income for the preceding two years, the Bank is currently restricted from making any capital distributions without prior written approval from the OTS. During 2009, the Bank did not pay dividends to the Company. The Company relies on dividends from the Bank as its primary source of funds, including the funds needed to pay dividends, if any, to shareholders of the Company.
 
     Informal Regulatory Agreements. Effective March 20, 2009, the Company and the Bank agreed to enter into informal agreements with the OTS to address certain regulatory matters. Specifically, under the agreements the Company and the Bank have submitted their capital and business plans to the OTS for its review and comment as well as its review of the Bank’s efforts in monitoring and reducing its nonperforming loans. In addition, under the agreements, both the Company and the Bank have agreed to seek the OTS’ approval prior to the declaration of any future dividends. The Company has also agreed not to repurchase or redeem any shares of its common stock or incur or renew any debt without the OTS’ approval. The Company does not currently have any debt outstanding. Compliance with the terms of the agreements is not expected to have a material effect on the financial condition or results of operations of the Company or the Bank.
 
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     Insurance of Deposit Accounts. Due to the recent difficult economic conditions in the U.S., deposit insurance per account owner has been increased from $100,000 to $250,000 through December 31, 2013. Thereafter, regular deposit accounts will be insured up to a maximum of $100,000 and self-directed retirement accounts up to a maximum of $250,000.
 
     In addition, the FDIC adopted an optional Temporary Liquidity Guarantee Program (TLGP) by which, for a fee, noninterest bearing transaction accounts receive unlimited FDIC insurance coverage through June 30, 2010 and certain senior unsecured debt issued by institutions and their holding companies would be guaranteed by the FDIC through December 31, 2012. We have elected to participate in both the unlimited noninterest bearing transaction account coverage and the unsecured debt guarantee program. For further discussion related to the TLGP see “Recent Legislative and Regulatory Initiatives to Address Financial and Economic Crises in the United States” below.
 
     The Bank’s deposits are insured up to the applicable limits under the DIF. The DIF is the successor to the Bank Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF). The FDIC maintains the DIF by assessing depository institutions an insurance premium. The FDIC annually sets the reserve level of the DIF within a statutory range between 1.15% and 1.50% of insured deposits. If the reserve level of the DIF falls below 1.15%, or is expected to do so within six months, the FDIC must adopt a restoration plan that will restore the DIF to a 1.15% ratio generally within five years. If the reserve level exceeds 1.35%, the FDIC may return some of the excess in the form of dividends to insured institutions.
 
     Under the FDIC’s risk-based assessment system, insured institutions are required to pay deposit insurance premiums based on the risk that each institution poses to the DIF. An institution’s risk to the DIF is measured by its regulatory capital levels, supervisory evaluations, and certain other factors. An institution’s assessment rate depends upon the risk category to which it is assigned. The FDIC has the authority to raise or lower assessment rates on insured deposits, subject to limits, and to impose special assessments. A significant increase in insurance premiums or the imposition of special assessments would have an adverse effect on the operating expenses and results of operations of the Bank.
 
     Currently, assessments for FDIC deposit insurance range from seven to seventy-seven basis points per $100 of assessable deposits. On May 22, 2009, the FDIC imposed a special assessment of five basis points on each institution’s assets minus Tier 1 capital as of June 30, 2009, which was payable to the FDIC on September 30, 2009. The Bank paid a total of $2.2 million in deposit insurance assessments in 2009 including $495,000 related to the special assessment. No institution may pay a dividend if it is in default on its federal deposit insurance assessment.
 
     In 2009, the FDIC adopted a rule requiring each insured institution to prepay on December 30, 2009 the estimated amount of its quarterly assessments for the fourth quarter of 2009 and all quarters through the end of 2012 (in addition to the regular quarterly assessment for the third quarter which was due on December 30, 2009). The prepaid amount is recorded as an asset with a zero risk weight and the institution will continue to record quarterly expenses for deposit insurance. Collection of the prepayment amount does not preclude the FDIC from changing assessment rates or revising the risk-based assessment system in the future. If events cause actual assessments during the prepayment period to vary from the prepaid amount, institutions will pay excess assessments or receive a rebate of prepaid amounts not fully utilized after the collection of assessments due in June 2013. The amount of the Bank’s prepayment was $6.6 million.
 
     In addition to the FDIC insurance premiums, the Bank is required to make quarterly payments on bonds issued by the Financing Corporation (FICO), an agency of the Federal government established to recapitalize a predecessor deposit insurance fund. During 2009, the Bank’s FICO assessment totaled $90,000. These assessments will continue until the FICO bonds are repaid between 2017 and 2019.
 
     Federal law also provided a one-time credit for eligible institutions based on their assessment base as of December 31, 1996. Subject to certain limitations, credits could be used beginning in 2007 to offset assessments until exhausted. The Bank’s remaining one-time credit was $1.2 million which was fully utilized at December 31, 2009.
 
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     Termination of Deposit Insurance. The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, rule, regulation, order or condition imposed by the FDIC. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, will continue to be insured for a period of six months to two years, as determined by the FDIC. There are no pending proceedings to terminate the FDIC deposit insurance of the Bank, and the management of the Bank does not know of any practice, condition, or violation that might lead to termination of deposit insurance.
 
     Qualified Thrift Lender Test. Federal law requires OTS-regulated savings associations to meet a QTL test to avoid certain restrictions on its operations. A savings association satisfies the QTL test if the savings association’s “qualified thrift investments” continue to equal or exceed 65% of the savings association’s “portfolio assets” on a monthly average basis in nine out of every twelve months. “Qualified thrift investments” generally means primarily securities, mortgage loans, and other investments related to housing, home equity loans, credit card loans, education loans, and other consumer loans up to a certain percentage of assets. “Portfolio assets” generally means total assets of a savings association less the sum of certain specified liquid assets, goodwill and other intangible assets, and the value of property used in the conduct of the savings association’s business.
 
     A savings association may also satisfy the QTL test by qualifying as a “domestic building and loan association” (DBLA) under the Internal Revenue Code of 1986. To satisfy the DBLA test, a savings association must meet a “business operations test” and a “60 percent of assets test.” The business operations test requires the business of a DBLA to consist primarily of acquiring the savings of the public and investing in loans. An institution meets the public savings requirement when it meets one of two conditions: (i) the institution acquires its savings in conformity with OTS rules and regulations, and (ii) the general public holds more than 75% of its deposits, withdrawable shares, and other obligations. An institution meets the investing in loans requirement when more than 75% of its gross income consists of interest on loans and government obligations, and various other specified types of operating income that financial institutions ordinarily earn. The 60% of assets test requires that at least 60% of a DBLA’s assets must consist of assets that savings associations normally hold, except for consumer loans that are not educational loans. The Bank met the requirements of the QTL test by maintaining 71.51% of its assets at December 31, 2009 in the foregoing asset base.
 
     A savings association which fails to meet either test must either convert to a national bank or be subject to the following: (i) it may not enter into any new activity except for those permissible for both a national bank and for a savings association, (ii) its branching activities will be limited to those of a national bank, and (iii) it will be bound by regulations applicable to national banks respecting payment of dividends. Within three years of failing the QTL test or DBLA test, the savings association must dispose of any investment or activity not permissible for both a national bank and a savings association. If such a savings association is controlled by a savings and loan holding company, then the holding company must, within a prescribed time period, become registered as a bank holding company under the Bank Holding Company Act of 1956 (BHCA) and become subject to all rules and regulations applicable to bank holding companies (including restrictions as to the scope of permissible business activities).
 
     Loans to One Borrower. Federal law provides that savings associations are generally subject to certain limits on loans to one borrower or a related group of borrowers. Generally, subject to certain exceptions, a savings association may not make a loan or extend credit on an unsecured basis to a single borrower or related group of borrowers in excess of 15% of its unimpaired capital and surplus. An additional amount may be loaned equal to 10% of unimpaired capital and surplus, if the loan is secured by specified readily-marketable collateral, which generally does not include real estate.
 
     Transactions with Affiliates. Transactions between a savings association and its “affiliates” are subject to quantitative and qualitative restrictions under Sections 23A and 23B of the Federal Reserve Act, the implementing regulations contained in Regulation W and additional regulations adopted by the OTS. Affiliates of a savings association include, among other entities, the savings association’s holding company and companies that are under common control with the savings association. In general, these restrictions limit the amount of the transactions between a savings association and its affiliates, as well as the aggregate amount of transactions between a savings association and all of its affiliates, impose collateral requirements in some cases, and require transactions with affiliates to be on the same terms comparable to those with unaffiliated entities. In addition, a savings association may not lend to any affiliate engaged in activities not permissible for a bank holding company or acquire the securities of an affiliate. The OTS has the discretion to further restrict transactions of a savings association with an affiliate on a case-by-case basis.
 
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     Change of Control. Subject to certain limited exceptions, no company can acquire control of a savings association without the prior approval of the OTS, and no individual may acquire control of a savings association if the OTS objects. Any company that acquires control of a savings association becomes a savings and loan holding company is subject to regulation, examination, and supervision by the OTS. Conclusive control exists, among other ways, when an acquiring party acquires more than 25% of any class of voting stock of a savings association or savings and loan holding company, or controls in any manner the election of a majority of the directors of the company. In addition, a rebuttable presumption of control exists if, among other things, a person acquires more than 10% of any class of a savings association’s or savings and loan holding company’s voting stock (or 25% of any class of stock) and, in either case, any of certain additional control factors exist.
 
     Companies subject to the BHCA that acquire or own savings associations are no longer defined as savings and loan holding companies under the HOLA and, therefore, are not generally subject to supervision, examination, and regulation by the OTS. OTS approval is not required for a bank holding company to acquire control of a savings association, although the OTS has a consultative role with the FRB in examination, enforcement, and acquisition matters. Holding companies that control both a bank and a savings association, however, are subject to registration, supervision, examination, and regulation under the BCHA and FRB regulations.
 
     Safety and Soundness Guidelines. The OTS and the other federal banking regulators have established guidelines for safety and soundness for insured depository institutions. These standards relate to, among other matters, internal controls, information systems, audit systems, loan documentation, credit underwriting, interest rate exposure, compensation, and other operational and managerial matters. Institutions failing to meet these standards are required to submit compliance plans to their appropriate federal banking regulator. If the deficiency persists, the OTS and the other federal banking regulators may issue an order that requires the institution to correct the deficiency and may take other statutorily-mandated or discretionary actions.
 
     Enforcement Powers. The OTS and the other federal banking regulators have the authority to assess civil and criminal penalties under certain circumstances against depository institutions and certain “institution-affiliated parties,” including controlling shareholders, directors, management, employees, and agents of a financial institution, as well as independent contractors and consultants, such as attorneys and accountants, and others who participate in the conduct of the financial institution’s affairs. In addition, the OTS and the other federal banking regulators have the authority to commence enforcement actions against institutions and institution-affiliated parties. Possible enforcement actions include, among others, issuance of capital directives, cease-and-desist orders, removal of directors and officers, termination of deposit insurance, and placing an institution into a receivership. A financial institution may also be ordered to restrict its growth, dispose of certain assets, rescind agreements or contracts, or take other actions as determined by the regulator to be appropriate.
 
     Community Reinvestment Act. Savings associations have a responsibility under the Community Reinvestment Act (CRA) and related regulations of the OTS to help meet the credit needs of their communities, including low- and moderate-income neighborhoods, consistent with safe and sound operations. The CRA requires the OTS to assess the Bank’s record of meeting the credit needs of its community, to assign the Bank one of four CRA ratings, and to take this record into account in the OTS’ evaluation of certain applications of the Bank, such as an application relating to a merger or the establishment of a branch. An unsatisfactory rating may be used as the basis for the denial of an application by the OTS. The Bank received a satisfactory rating during its latest CRA examination in 2008.
 
     Consumer Protection Laws. We are subject to many federal consumer protection statutes and regulations including the Equal Credit Opportunity Act (Regulation B), the Fair Housing Act, the Truth in Lending Act (Regulation Z), the Truth in Savings Act (Regulation DD), the Real Estate Settlement Procedures Act, the Home Mortgage Disclosure Act (Regulation C), and the Fair and Accurate Credit Transactions Act. Among other things, these statutes and regulations:
  • require lenders to disclose credit terms in meaningful and consistent ways;
  • prohibit discrimination against an applicant in any consumer or business credit transaction;
  • prohibit discrimination in housing-related lending activities;
  • require certain lenders to collect and report applicant and borrower data regarding loans for home purchases or improvement projects;
  • require lenders to provide borrowers with information regarding the nature and cost of real estate settlements;
  • prohibit certain lending practices and limit escrow account amounts with respect to real estate transactions;
  • require financial institutions to implement identity theft prevention programs and measures to protect the confidentiality of consumer financial information; and
  • prescribe possible penalties for violations of the requirements of consumer protection statutes and regulations.
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     Other Laws. The Bank is subject to a variety of other federal laws that require it to maintain certain programs or procedures and to file certain information with the U.S. Government. For example, the Bank is subject to federal laws protecting the confidentiality of consumer financial records and limiting the ability of the Bank to share non-public personal information with third parties. In addition, the Bank is subject to federal anti-money laundering requirements which provide that the Bank must maintain, among other items, client identification and anti-money laundering programs. These requirements also provide for information sharing between the Bank and the U.S. government. Further, the Bank is required to have systems in place to detect certain transactions. The Bank is generally required to report cash transactions involving more than $10,000 to the U.S. government and to file suspicious activity reports under certain circumstances involving its clients and employees or others.
 
Federal Home Loan Bank System
 
     The Bank is a member of the FHLB system, which consists of 12 regional banks. The Federal Housing Finance Board, an independent federal agency, controls the FHLB system, including the FHLB-IN. The FHLB system provides a central credit facility primarily for member institutions. As a member of the FHLB-IN, the Bank is required to acquire and hold shares of capital stock in the FHLB-IN in an amount at least equal to 1% of the aggregate principal amount of its unpaid residential mortgage loans and similar obligations at the beginning of each year, or 1/20 of its advances (borrowings) from the FHLB-IN, whichever is greater. At December 31, 2009, we had advances from the FHLB-IN with aggregate outstanding principal balances of $87.5 million, and our investment in FHLB-IN stock of $23.9 million was $19.6 million in excess of our minimum requirement. FHLB advances must be secured by specified types of assets of the Bank and are available to member institutions primarily for the purpose of providing funds for residential housing finance. The FHLB-IN has certain requirements including a five year notice period pursuant to their capital plan that must be met before they redeem their stock. We have requested redemption of $15.5 million of our investment in FHLB-IN stock. The five year notice period ends in 2011 on $12.4 million and in 2012 on $2.8 million of our requested redemption.
 
     Regulatory directives, capital requirements, and net income of the FHLBs affect their ability to pay dividends on the FHLB stock held by their members. In addition, FHLBs are required to provide funds to cover certain obligations, to fund the resolution of insolvent thrifts, and to contribute funds for affordable housing programs. These items could reduce the amount of dividends that the FHLBs pay to their members and could also result in the FHLBs imposing a higher rate of interest on advances to their members.
 
Sarbanes-Oxley Act of 2002
 
     The Company complies with the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley Act). The Sarbanes-Oxley Act’s stated goals include enhancing corporate responsibility, increasing penalties for accounting and auditing improprieties at publicly traded companies such as the Company, and protecting investors by improving the accuracy and reliability of corporate disclosures under the federal securities laws.
 
     Among other requirements, the Sarbanes-Oxley Act established: (i) new requirements for audit committees of public companies, including independence, expertise and responsibilities; (ii) new standards for independent auditors and their audits of financial statements; (iii) a requirement that the chief executive officers and chief financial officers of public companies sign certifications relating to the financial statements and other information contained in periodic reports filed with the SEC as well as the Company’s internal control over financial reporting and disclosure controls and procedures; (iv) increased and accelerated disclosure obligations for public companies; and (v) new and increased civil and criminal penalties for violation of the federal securities laws.
 
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Recent Legislative and Regulatory Initiatives to Address Financial and Economic Crises in the United States
 
     On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (EESA) was signed into law, giving the United States Department of the Treasury (Treasury Department) broad authority to address the recent deterioration of the U.S. economy, to implement certain actions to help restore confidence, stability, and liquidity to U.S. financial markets, and to encourage financial institutions to increase their lending to clients and to each other. The EESA authorized the Treasury Department to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities, and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies in a troubled asset relief program (TARP). The Treasury Department allocated $250 billion to the Voluntary Capital Purchase Program (CPP) under the TARP. The TARP also includes direct purchases or guarantees of troubled assets of financial institutions by the U.S. government.
 
     Under the CPP, the Treasury Department was authorized to purchase debt or equity securities from participating financial institutions. In connection therewith, each participating financial institution issued to the Treasury Department a warrant to purchase a certain number of shares of stock of the institution. During such time as the Treasury Department holds securities issued under the CPP, the participating financial institutions are required to comply with the Treasury Department’s standards for executive compensation and will have limited ability to increase the amounts of dividends paid on, or to repurchase, their common stock. The Company determined not to participate in the CPP.
 
     On October 14, 2008, the FDIC announced the TLGP. The TLGP includes the Transaction Account Guarantee Program (TAGP), which provided unlimited deposit insurance coverage through December 31, 2009 for non-interest bearing transaction accounts (typically business checking accounts) and certain funds swept into non-interest bearing savings accounts. Institutions that participate in the TAGP pay a 10 basis points fee (annualized) on the balance of each covered account in excess of $250,000, while the extra deposit insurance is in place. The FDIC has authorized an extension of the TAGP through June 30, 2010 for institutions participating in the original TAGP, unless an institution opts out of the extension period. During the extension period, fees increase to 15 to 25 basis points depending on an institution’s risk category for deposit insurance purposes.
 
     The TLGP also includes the Debt Guarantee Program (DGP), under which the FDIC guarantees certain senior unsecured debt issued by FDIC-insured institutions and their holding companies. Under the DGP, upon a default by an issuer of FDIC-guaranteed debt, the FDIC will continue to make scheduled principal and interest payments on the debt. The unsecured debt must have been issued on or after October 14, 2008 and not later than October 31, 2009, and the guarantee is effective through the earlier of the maturity date (or mandatory conversion date) or December 31, 2012, although the debt may have a maturity date beyond December 31, 2012. Depending on the maturity of the debt, the nonrefundable DGP guarantee fee ranges from 50 to 100 basis points (annualized) for covered debt outstanding until the earlier of maturity or December 31, 2012. The FDIC also established an emergency debt guarantee facility through April 30, 2010 through which institutions that are unable to issue non-guaranteed debt to replace maturing senior unsecured debt because of market disruptions or other circumstances beyond their control may apply on a case-by-case basis to issue FDIC-guaranteed senior unsecured debt. The FDIC guarantee of any debt issued under this emergency facility would be subject to an annualized assessment rate equal to a minimum of 300 basis points.
 
     The TAGP and DGP are in effect for all eligible entities, unless the entity opted out on or before December 5, 2008. The Company elected to participate in both the TAGP and the DGP and did not opt out of the extension period for the TAGP.
 
     On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (ARRA), more commonly known as the federal economic stimulus or economic recovery package, went into effect. The ARRA includes a wide variety of programs intended to stimulate the U. S. economy and provide for extensive infrastructure, energy, health, and education needs. The ARRA also imposes new executive compensation limits and corporate governance requirements on participants in the CPP in addition to those previously announced by the Treasury Department. Because the Company elected not to participate in the CPP, these limits and requirements do not apply to the Company.
 
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ITEM 1A. RISK FACTORS
 
     Investments in CFS Bancorp, Inc. common stock involve risk. The following discussion highlights risks management believes are material for us, but does not necessarily include all risks that we may face.
 
Failure to comply with the restrictions and conditions in the informal regulatory agreements that the Company and the Bank entered into with the Office of Thrift Supervision could result in additional enforcement action against us.
 
     Effective March 20, 2009, we entered into informal agreements with the OTS to address certain regulatory matters. Although we expect that these agreements will not have a material effect on our financial condition or results of operations, if we fail to comply with the terms and conditions of the agreements, the OTS could take additional enforcement action against us, including the imposition of further operating restrictions. Any additional action could harm our reputation and our ability to retain or attract clients or employees and impact the trading price of our common stock.
 
We operate in a highly regulated industry and may be affected adversely by negative examination results and changes in laws, regulations, and accounting industry pronouncements.
 
     The Bank, like other Federal savings banks, is subject to extensive regulation, supervision, and examination by the OTS, its chartering authority, and by the FDIC, the insurer of its deposits. CFS, like other thrift holding companies, is subject to regulation and supervision by the OTS. This regulation and supervision governs the activities in which we may engage and are intended primarily for the protection of the deposit insurance fund administered by the FDIC and our depositors. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on our operations, the classification of our assets, and determination of the level of our allowance for losses on loans.
 
     The current regulatory landscape in which insured depository financial institutions operate is expected to change – perhaps significantly – following a recent policy statement issued by the U.S. Department of the Treasury calling for stronger capital and liquidity standards for banking firms as well as the Obama Administration’s June 2009 financial regulatory reform proposal. The proposed legislation contains several provisions that would have a direct impact on us. Under the proposed legislation, the federal savings association charter would be eliminated and the OTS would be consolidated with the Comptroller of the Currency into a new regulator, the National Bank Supervisor. The proposed legislation would also require the Bank to convert to a national bank or a state-chartered institution. In addition, the proposed legislation would eliminate the status of “savings and loan holding company” and mandate that the Company register as a bank holding company. Registration as a bank holding company would represent a significant change because there are material differences between savings and loan holding company and bank holding company supervision and regulation. For example, bank holding companies above a specified asset size are subject to consolidated leverage and risk-based capital requirements whereas savings and loan holding companies are not subject to such requirements. The proposed legislation would also create the Consumer Financial Protection Agency, a new federal agency dedicated to administering and enforcing fair lending and consumer compliance laws with respect to financial products and services, which would create new regulatory requirements and increased regulatory compliance costs for us. If enacted, the proposed legislation may have a material impact on our operations. However, because any final legislation may differ significantly from the current administration’s proposal, the specific effects of the legislation cannot be evaluated at this time.
 
     In addition, like all U.S. companies who prepare their financial statements in accordance with U.S. Generally Accepted Accounting Principles (U.S. GAAP), we are subject to changes in accounting rules and interpretations. We cannot predict what effect any presently contemplated or future changes in financial market regulation or accounting rules and interpretations will have on us. Any such changes may negatively affect our financial performance, our ability to expand our products and services, and our ability to increase the value of our business and, as a result, could be materially adverse to our shareholders. In addition, like other federally insured depository institutions, CFS and the Bank prepare and publicly report additional financial information under Regulatory Accounting Principles (RAP) and are similarly subject to changes in these rules and interpretations.
 
We may be required to pay significantly higher FDIC premiums or special assessments that could adversely affect our earnings.
 
     Market developments have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits. As a result, depository institutions participating in the insurance fund, including the Bank, may be required to pay significantly higher premiums or additional special assessments that could adversely affect our earnings. It is possible that the FDIC may impose additional special assessments in the future as part of its restoration plan.
 
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Our ability to pay dividends is restricted.
 
     Although we have been paying quarterly dividends regularly since 1998, our ability to pay dividends to shareholders depends upon the prior approval of the OTS pursuant to an informal regulatory agreement with the OTS. Additionally, the Bank is subject to the same restrictions on making dividends to the Company under its informal regulatory agreement with the OTS. Accordingly, we may cease paying dividends to our shareholders.
 
If economic conditions continue to deteriorate, our results of operations and financial condition could be adversely impacted as borrowers' ability to repay loans declines and the value of the collateral securing our loans decreases.
 
     Our financial results may be adversely affected by changes in prevailing economic conditions, including decreases in real estate values, changes in interest rates that cause a decrease in interest rate spreads, adverse employment conditions, the monetary and fiscal policies of the federal government, and other significant external events. In addition, we have a significant amount of real estate loans. Accordingly, decreases in real estate values could adversely affect the value of collateral securing our loans. Adverse changes in the economy may also have a negative effect on the ability of our borrowers to make timely repayments of their loans. These factors could expose us to an increased risk of loan defaults and losses and have an adverse impact on our earnings.
 
We are subject to lending risk and could suffer losses in our loan portfolio despite our underwriting practices.
 
     There are inherent risks associated with our lending activities. There are risks inherent in making any loan, including those related to dealing with individual borrowers, nonpayment, uncertainties as to the future value of collateral, and changes in economic and industry conditions. We attempt to closely manage our credit risk through prudent loan underwriting and application approval procedures, careful monitoring of concentrations of our loans within specific industries, and periodic independent reviews of outstanding loans by third-party loan review specialists. We cannot assure that such approval and monitoring procedures will reduce these credit risks to acceptable tolerance levels.
 
     Increases in interest rates and/or weakening economic conditions could adversely impact the ability of borrowers to repay their outstanding loans. In the past, we have focused on providing ARMs to decrease the risk related to changes in the interest rate environment; however, these types of loans also involve other risks. As interest rates rise, the borrowers’ payments on an ARM also increase to the extent permitted by the loan terms thereby increasing the potential for default. Also, when interest rates decline substantially, borrowers tend to refinance into fixed-rate loans.
 
     As of December 31, 2009, approximately 67% of our loan portfolio consisted of commercial and industrial, commercial real estate (owner occupied, non-owner occupied, and multifamily), and commercial construction and land development loans. These types of loans involve increased risks because the borrower’s ability to repay the loan typically depends on the successful operation of the business or the property securing the loan. Additionally, these loans are made to small- or medium-sized business clients who may be more vulnerable to economic conditions and who may not have experienced a complete business or economic cycle. These types of loans are also typically larger than one-to-four family residential mortgage loans or consumer loans. Because our loan portfolio contains a significant number of commercial and industrial, commercial real estate (owner occupied, non-owner occupied, and multifamily), and commercial construction and land development loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in non-performing loans. An increase in non-performing loans would result in a reduction in interest income recognized on loans and also could require us to increase the provision for losses on loans and increase loan charge-offs, all of which would reduce our net income. All of these could have a material adverse effect on our financial condition and results of operations.
 
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Our allowance for losses on loans may be insufficient to cover actual losses on loans.
 
     In keeping with industry practice, regulatory guidelines, and U.S. GAAP, we maintain an allowance for losses on loans at a level we believe adequate to absorb credit losses inherent in the loan portfolio. The allowance for losses on loans is a reserve established through a provision for losses on loans charged to expense that represents our estimate of probable incurred losses within the loan portfolio at each statement of condition date and is based on the review of available and relevant information. The level of the allowance for losses on loans reflects our consideration of historical charge-offs and recoveries; levels of and trends in delinquencies, impaired loans, and other classified loans; concentrations of credit within the commercial loan portfolio; volume and type of lending; and current and anticipated economic conditions. The determination of the appropriate level of the allowance for losses on loans inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans, and other factors, both within and outside of our control, may require an increase in the allowance for losses on loans. Also, if charge-offs in future periods exceed the allowance for losses on loans, we will need additional provisions to increase our allowance for losses on loans. Any increases in the allowance for losses on loans will result in a decrease in net income and possibly capital, and may have a material adverse effect on our financial condition and results of operations.
 
Declines in asset values may result in impairment charges and adversely affect the value of our investments, financial performance, and capital.
 
     We maintain an investment portfolio that includes, but is not limited to, government sponsored entity securities, mortgage-backed securities, and pooled trust preferred securities. The market value of investments in our portfolio has become increasingly volatile. The market value of investments may be affected by factors other than the underlying performance of the issuer or composition of the bonds themselves, such as ratings downgrades, adverse changes in the business climate, and a lack of liquidity for resales of certain investment securities, as well as specific challenges which may arise in the secondary markets for such investments. We periodically, but not less than quarterly, evaluate investments and other assets for impairment indicators. We may be required to record additional impairment charges if our investments suffer a decline in value that is considered other-than-temporary. If we determine that a significant impairment has occurred, we would be required to charge against earnings the credit-related portion of the other-than-temporary impairment, which could have a material adverse effect on our results of operations in the periods in which the write-offs occur.
 
The requirement to record certain assets and liabilities at fair value may adversely affect our financial results.
 
     In accordance with U.S. GAAP, we report certain assets, including investment securities, at fair value. Generally, for assets that are reported at fair value we use quoted market prices or valuation models that utilize market data inputs to estimate fair value. Because we carry these assets on our books at their estimated fair value, we may incur losses even if the asset in question presents minimal credit risk. Given the continued disruption in the capital markets, we may be required to recognize other-than-temporary impairments in future periods with respect to investment securities in our portfolio. The amount and timing of any impairment recognized will depend on the severity and duration of the decline in fair value of our investment securities and our estimation of the anticipated recovery period.
 
Unexpected losses in future reporting periods may require us to establish a valuation allowance against our deferred tax assets.
 
     We evaluate our deferred tax assets for recoverability based on all available evidence. This process involves significant management judgment about assumptions that are subject to change from period to period based on changes in tax laws or variances between our future projected operating performance and our actual results. We are required to establish a valuation allowance for deferred tax assets if we determine, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. In determining the “more likely than not” criterion, we evaluate all positive and negative available evidence as of the end of each reporting period. Future adjustments to the deferred tax asset valuation allowance, if any, will be determined based upon changes in the expected realization of the net deferred tax assets. The realization of the deferred tax assets ultimately depends on the existence of sufficient taxable income in either the carryback or carryforward periods under applicable tax laws. Due to significant estimates utilized in establishing the valuation allowance and the potential for changes in facts and circumstances, it is reasonably possible that we will be required to record adjustments to the valuation allowance in the near term if estimates of future taxable income during the carryforward period are reduced. Such a charge could have a material adverse effect on our results of operations, financial condition, and capital position.
 
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Our operations are subject to interest rate risk and variations in interest rates may negatively affect financial performance.
 
     In addition to other factors, our earnings and cash flows are dependent upon our net interest income. Net interest income is the difference between interest income earned on interest-earning assets, such as loans and securities, and interest expense paid on interest-bearing liabilities, such as deposits and borrowed money. Changes in the general level of interest rates may have an adverse effect on our business, financial condition, and results of operations. Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the FRB. Changes in monetary policy, including changes in interest rates, influence the amount of interest income that we receive on loans and securities and the amount of interest that we pay on deposits and borrowings. Changes in monetary policy and interest rates also can adversely affect:
  • our ability to originate loans and obtain deposits;
  • the fair value of our financial assets and liabilities; and
  • the average duration of our securities portfolio.
     If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings.
 
Negative conditions in the general economy and financial services industry may limit our access to additional funding and adversely affect liquidity.
 
     An inability to raise funds through deposits, borrowings, and other sources could have a substantial negative effect on our liquidity. Our access to funding sources in amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general. General industry factors that could detrimentally affect our access to liquidity sources include severe disruption of the financial markets or negative news and expectations about the prospects for the financial services industry as a whole, as evidenced by the turmoil in the domestic and worldwide credit markets which occurred in late 2008 and early 2009. Our ability to borrow could also be impaired by factors that are specific to us, such as a decrease in the level of our business activity due to a market downturn or adverse regulatory action against us.
 
We operate in a highly competitive industry and market area with other financial institutions offering products and services similar to those we offer.
 
     In our market area, we encounter significant competition from other savings associations, commercial banks, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market mutual funds, and other financial intermediaries. Our competitors may have substantially greater resources and lending limits than we do and may offer services that we do not or cannot provide. Our profitability depends upon our continued ability to compete successfully in our market area.
 
We may experience difficulties in managing our growth, and our growth strategy involves risks that may negatively impact our net income.
 
     We may expand into additional communities or attempt to strengthen our position in our current market and in surrounding areas by opening new branches and acquiring existing branches of other financial institutions. To the extent that we undertake additional branch openings and acquisitions, we are likely to continue to experience the effects of higher operating expenses relative to operating income from the new operations, which may have an adverse effect on our levels of reported net income, return on average equity, and return on average assets. Other effects of engaging in such growth strategies may include potential diversion of management’s time and attention from other aspects of our business and the general disruption to our business.
 
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We may elect or be compelled to seek additional capital in the future, but that capital may not be available when it is needed.
 
     Like other savings and loan holding companies, we are required by our regulatory authorities to maintain adequate levels of capital to support our operations. In addition, we may elect to raise additional capital to support the growth of our business or to finance acquisitions, if any, or we may elect to raise additional capital for other reasons. In that regard, a number of financial institutions have recently raised considerable amounts of capital as a result of deterioration in their results of operations and financial condition arising from the turmoil in the mortgage loan market, deteriorating economic conditions, declines in real estate values, and other factors. Should we elect, or be required by regulatory authorities to raise additional capital, we may seek to do so through the issuance of, among other things, our common stock or securities convertible into our common stock, which could dilute your ownership interest in the Company. Although we remain “well capitalized” at December 31, 2009 for regulatory purposes and have not had a deterioration in our liquidity, the future cost and availability of capital may be adversely affected by illiquid credit markets, economic conditions, and a number of other factors, many of which lie outside of our control. Accordingly, we cannot be assured of our ability to raise additional capital if needed or on terms acceptable to us. If we cannot raise additional capital when needed or on terms acceptable to us, it may have a material adverse effect on our financial condition and results of operations.
 
We may not be able to attract and retain the skilled employees necessary for our business.
 
     Our success depends, in large part, on our ability to attract and retain key employees. Competition for the best employees in most of our business lines can be intense, and we may not be able to hire or retain the necessary employees for meeting our business goals. The unexpected loss of services of one or more of our key personnel could have a material adverse impact on our business because of their skills, knowledge of our market, years of industry experience, and the difficulty of promptly finding qualified replacement personnel.
 
Our information systems may experience an interruption or breach in security that could impact our operational capabilities.
 
     We rely heavily on communications and information systems to conduct our business. Any failure, interruption, or breach in security of these systems could result in failures or disruptions in our client relationship management, general ledger, deposit, loan, and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption, or security breach of our information systems, there can be no assurance that any such failures, interruptions, or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrences of any failures, interruptions, or security breaches of our information systems could damage our reputation, result in a loss of client business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
 
The trading volume in our common stock has been low, and the sale of a substantial number of shares of our common stock in the public market could depress the price of our common stock and make it difficult for you to sell your shares.
 
     Our common stock is listed to trade on the NASDAQ Global Market, but is thinly traded. As a result, you may not be able to sell your shares of common stock on short notice. Additionally, thinly traded stock can be more volatile than stock trading in an active public market. The sale of a substantial number of shares of our common stock at one time could temporarily depress the market price of our common stock, making it difficult for you to sell your shares and impairing our ability to raise capital.
 
We may be subject to examinations by taxing authorities which could adversely affect our results of operations.
 
     Like other for-profit enterprises, in the normal course of business, we may be subject to examinations from federal and state taxing authorities regarding the amount of taxes due in connection with investments we have made and the businesses in which we are engaged. Recently, federal and state taxing authorities have become increasingly aggressive in challenging tax positions taken by financial institutions. The challenges made by taxing authorities may result in adjustments to the timing or amount of taxable income or deductions or the allocation of income among tax jurisdictions. If any such challenges are made and are not resolved in our favor, they could have an adverse effect on our financial condition and results of operations.
 
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ITEM 1B. UNRESOLVED STAFF COMMENTS
 
     None.
 
ITEM 2. PROPERTIES
 
     We conduct our business through our main office and headquarters located at 707 Ridge Road, Munster, Indiana, 46321. In addition, we operate 23 banking centers in Cook, DuPage, and Will counties in Illinois and Lake and Porter counties in Indiana. We currently own 16 full-service banking centers and lease seven others. We intend to build future full-service banking centers and own three vacant lots in Illinois and one in Indiana. In addition, we maintain 37 automated teller machines (ATMs), 24 of which are located at our branch offices. The net book value of our property and leasehold improvements at December 31, 2009 totaled $17.2 million. See “Note 4. Office Properties and Equipment” in the notes to consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K.
 
ITEM 3. LEGAL PROCEEDINGS
 
     The Company is involved in routine legal proceedings occurring in the ordinary course of its business, which, in the aggregate, are believed to be immaterial to the financial condition of the Company.
 
ITEM 4. RESERVED
 
PART II.
 
ITEM 5.  MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES
 
(a)       
The Company’s common stock is traded on the NASDAQ Global Market under the symbol “CITZ.” As of December 31, 2009, there were 10,771,061 shares of common stock outstanding which were held by 1,926 shareholders of record. The following table sets forth the high and low closing sales price as reported by NASDAQ and cash dividends paid per share during each quarter of 2009 and 2008. See further information regarding the ability to pay dividends in “Regulation” within “Item 1. Business” and also “Note 12. Shareholders’ Equity and Regulatory Capital” in the notes to consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K.
  
      Cash
  Share Price Dividend
  High      Low      Paid
2008          
       First Quarter $   14.70 $   13.33 $   0.12
       Second Quarter 14.93 11.42   0.12
       Third Quarter 11.84   8.10     0.12
       Fourth Quarter 10.31 3.50   0.04
2009        
       First Quarter $ 4.80 $ 1.75 $ 0.01
       Second Quarter 4.33 3.50   0.01
       Third Quarter 4.68 3.75   0.01
       Fourth Quarter 4.73 3.23   0.01

     The information for equity compensation plans is incorporated by reference from “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters” of this Annual Report on Form 10-K. There were no sales of unregistered shares of common stock by the Company during the fourth quarter of 2009. Pursuant to informal regulatory agreements with the OTS, we are prohibited from paying dividends without prior approval from the OTS.
 
(b)        Not applicable.
 
(c)       
We did not repurchase any shares of common stock during the quarter ended December 31, 2009. Under our repurchase plan publicly announced on March 20, 2008 for 530,000 shares, we have 448,612 shares that may yet be purchased. We are currently prohibited from repurchasing our common stock without the prior approval of the OTS pursuant to our informal regulatory agreement with them.
 
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PERFORMANCE GRAPH
 
     The following graph compares the cumulative total returns for common stock to the total returns for the Standard and Poor’s 500 Index (S&P 500) and the NASDAQ Bank Index. The graph assumes that $100 was invested on December 31, 2004 in our common stock, the S&P 500 Index, and the NASDAQ Bank Index. The cumulative total return on each investment is as of December 31 of each of the subsequent five years and assumes dividends are reinvested.
 
 
Index      12/31/04      12/31/05      12/31/06      12/31/07      12/31/08      12/31/09
CFS Bancorp, Inc.   $   100.00    $   103.71  $   109.78    $   113.75    $   31.43  $   26.45 
S&P 500   100.00  104.91    121.48      128.16    80.74    102.11 
NASDAQ Bank Index 100.00  95.67  106.20  82.76  62.96    51.31 

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ITEM 6. SELECTED FINANCIAL DATA
 
     December 31,
2009      2008      2007      2006      2005
(Dollars in thousands except per share data)
Selected Financial Condition Data:                                      
Total assets $     1,081,515 $     1,121,855 $     1,150,278 $     1,254,390 $     1,242,888
Loans receivable   762,386       749,973       793,136       802,383       917,405  
Allowance for losses on loans 19,461 15,558 8,026 11,184 12,939
Securities, available-for-sale   188,781       251,270       224,594       298,925       218,550  
Securities, held-to-maturity 5,000 6,940 3,940
Deposits   849,758       824,097       863,272       907,095       828,635  
Borrowed money 111,808 172,937 135,459 202,275 257,326
Shareholders’ equity   110,373       111,809       130,414       131,806       142,367  
Book value per outstanding share $ 10.25 $ 10.47 $ 12.18 $ 11.84 $ 11.86
Average shareholders’ equity to average assets   10.24 %     11.14 %     10.75 %     10.54 %     11.38 %
Non-performing assets to total assets 6.31 5.16 2.67 2.22 1.74
Allowance for losses on loans to non-performing loans 32.98 28.44 27.11 40.64 61.49
Allowance for losses on loans to total loans 2.55 2.07 1.01 1.39 1.41
  
  December 31,
  2009 2008 2007 2006 2005
  (Dollars in thousands except per share data)
Selected Operations Data:
Interest income $ 51,308 $ 59,539 $ 72,241 $ 75,547 $ 69,464
Interest expense 13,715 24,656 38,134 42,644 39,603
Net interest income 37,593 34,883 34,107 32,903 29,861
Provision for losses on loans 12,588 26,296 2,328   1,309   1,580
Net interest income after provision for losses on loans 25,005 8,587 31,779 31,594   28,281
Non-interest income   11,472     5,623 11,515   10,542   11,397
Non-interest expense 39,282   34,178       33,459   36,178 33,485
Income (loss) before income taxes (2,805 ) (19,968 ) 9,835 5,958 6,193
Income tax expense (benefit) (2,262 ) (8,673 ) 2,310 618 1,176
Net income (loss) $ (543 ) $ (11,295 ) $ 7,525 $ 5,340 $ 5,017
 
Earnings (loss) per share (basic) $ (0.05 ) $ (1.10 ) $ 0.71 $ 0.48 $ 0.43
Earnings (loss) per share (diluted) (0.05 ) (1.10 ) 0.69 0.47 0.42
Cash dividends declared per common share 0.04 0.40 0.48 0.48 0.48
Dividend payout ratio NM NM 69.57 % 102.13 % 114.29 %

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Year Ended December 31,
     2009      2008      2007      2006      2005
     (Dollars in thousands except per share data)
Selected Operating Ratios:
Net interest margin 3.72 % 3.32 % 3.02 % 2.73 % 2.48 %
Average interest-earning assets to average interest-bearing liabilities 112.56 113.07 113.27 113.03 113.44
Ratio of non-interest expense to average total assets 3.58 3.01 2.76 2.83 2.62  
Return (loss) on average assets (0.05 ) (0.99 ) 0.62 0.42 0.39
Return (loss) on average equity (0.48 ) (8.93 ) 5.78 3.96 3.45
 
Efficiency Ratio Calculations (1):
Efficiency Ratio:
Non-interest expense $     39,282 $     34,178 $     33,459 $     36,178 $     33,485
Net interest income plus non-interest income $ 49,065 $ 40,506 $ 45,622 $ 43,445 $ 41,258
Efficiency ratio 80.06 % 84.38 % 73.34 % 83.27 % 81.16 %
 
Core Efficiency Ratio:
Non-interest expense $ 39,282 $ 34,178 $ 33,459 $ 36,178 $ 33,485
Adjustment for the special assessment – FDIC insurance (495 )
Adjustment for the goodwill impairment (1,185 )
Non-interest expense – as adjusted $ 38,787 $ 32,993 $ 33,459 $ 36,178 $ 33,485
Net interest income plus non-interest income $ 49,065 $ 40,506 $ 45,622 $ 43,445   $ 41,258
Adjustments:  
Net realized (gains) losses on sales of securities available-for-sale (1,092 )   (69 ) (536 )     (750 ) 238
Other-than-temporary impairment of securities available-for-sale     4,334     240
Net realized (gains) losses on sales of assets   9   (30 )   (22 ) 994 (354 )
Amortization of deferred premium on the early extinguishment of debt 175 1,452 4,540 9,624 14,381
Net interest income plus non-interest income – as adjusted $ 48,157 $ 46,193 $ 49,604 $ 53,313 $ 55,763
Core efficiency ratio 80.54 % 71.42 % 67.45 % 67.86 % 60.05 %
____________________
 
(1)    
See “Results of Operations – Non-Interest Expense” within “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussions about non-U.S. GAAP efficiency ratio and core efficiency ratio disclosures.
 
ITEM 7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW
 
     The following discussion and analysis presents the more significant factors affecting our financial condition as of December 31, 2009 and 2008 and results of operations for each of the years in the three-year period ended December 31, 2009. This discussion and analysis should be read in conjunction with our consolidated financial statements, notes thereto, and other financial information appearing elsewhere in this report.
 
     During 2009, we recorded a net loss of $543,000, or $(0.05) per share. Economic conditions locally and throughout the country continue to impact real estate values and have negatively impacted our borrowers’ ability to repay their loans in accordance with their original terms resulting in higher non-performing assets. Rapid declines in real estate values necessitated a higher than normal provision for losses on loans and increased valuation allowances on our other real estate owned properties. In addition, higher professional fees related to a shareholder derivative demand and higher FDIC insurance premiums negatively impacted earnings for the year. These factors exceeded reductions in controllable overhead costs, increases in non-interest income, and increases in net interest income attributable to higher net interest margins. Our net interest margin, driven by our extremely low cost of funds, increased for the sixth consecutive year.
 
     Despite the challenges of the past two years, our capital and liquidity positions remain strong. Our tangible common equity at December 31, 2009 was $110.4 million, or 10.31% of tangible assets. The Bank’s total capital to risk-weighted assets was 12.35%, exceeding the regulatory requirement of 10% to be considered “well capitalized” and in excess of all regulatory capital requirements set by the OTS.
 
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     We have made significant progress in diversifying our loan portfolio by growing targeted segments and reducing loans not meeting our current defined risk tolerance. Since December 31, 2008, we have increased our portfolio of commercial and industrial, owner-occupied commercial real estate, and multifamily loans by $51.1 million. These categories represent 47% of our commercial loan portfolio at December 31, 2009 compared to 39% a year ago. This growth was partially offset by decreases in commercial construction and land development, non-owner occupied commercial real estate, and one-to-four family residential loans totaling $37.3 million. Our loans receivable increased to $762.4 million at December 31, 2009 compared to $750.0 million at December 31, 2008.
 
     The deposit environment has become more favorable with consumer savings rates on the rise and overall pricing within the industry being more rational than in the recent past. We continue to focus on building new and deepening existing client relationships while remaining disciplined in our pricing, particularly our certificates of deposit. At December 31, 2009, our total core deposits increased $36.1 million, or 8.1%, from December 31, 2008. Investments in our branch network, technological infrastructure, human capital, and brand have enhanced our ability to translate existing and new client relationships into deposit growth.
 
Progress on Strategic Growth and Diversification Plan
 
     Our Strategic Growth and Diversification Plan is built around four core objectives: decreasing non-performing loans; ensuring costs are appropriate given our targeted future asset base; growing while diversifying by targeting small- and medium-sized business owners for relationship-based banking opportunities; and expanding and deepening our relationships with our clients by meeting a higher percentage of our clients’ financial service needs.
 
     Progress on the Strategic Growth and Diversification plan continues at a consistent pace, although a little slower than we would otherwise have preferred as a result of the present economic conditions. The uncertainty over future economic conditions and industry-wide concerns over capital levels necessitates prudent capital management. During the fourth quarter of 2009, the parent company elected to make a $1.75 million capital infusion into the Bank in order to maintain internal capital ratio targets.
 
     Credit quality remains a major concern and our number one priority in 2010. The decline in the real estate collateral values supporting many of our non-performing loans and other real estate owned led to increases in impairment reserves on loans, net charge-offs, and valuation allowances on other real estate owned during 2009. These non-performing assets impose negative pressure on earnings for a number of reasons, and we are committed to addressing these problem assets in a conservative, yet prudent, manner within the constraints of current and forecasted market conditions.
 
     We have continued to make progress in attracting new business banking clients and deepening relationships with current clients. Although we are doing a better job of controlling discretionary costs, higher nondiscretionary costs, including increased FDIC assessments, credit collection related costs, costs related to shareholder matters, and professional fees have negated the overall financial impact of these controls. Growth remains a strategic priority, but in the current environment, the Company is willing to accept a more linear rate of loan growth by focusing on high credit-quality borrowers and depositors.
 
     In addition, in late October 2009, our Board of Directors (Board) conducted its annual Strategic Retreat which focused on three key themes:
  • assessing our progress towards our current strategic goals and objectives;
  • evaluating the economic and regulatory environment moving forward; and
  • reviewing a wide variety of strategic alternatives for our future.
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     Our Board reiterated its vision of the Company and the Bank as a community-oriented financial institution serving the needs of its core Northwest Indiana and Southwest suburban Chicago markets. Our Board also reconfirmed its intent that the Company pursue the current Strategic Growth and Diversification Plan. Noting the current industry-wide expectations for a slow, gradual economic recovery, increased regulatory scrutiny, and anticipated higher future capital requirements for insured depository institutions, our Board articulated that the operating environment over the next few years is likely to remain unforgiving and characterized by both unforeseen threats and opportunities. In light of this, our Board has elected to further examine a number of potential strategic alternatives, such as:
  • expanding the franchise;
  • raising additional capital to further strengthen regulatory capital ratios and facilitate growth; and/or
  • exploring business combinations with desirable strategic and financial attributes.
     To assist our Board and management team in this examination, we retained David D. Olson, a highly experienced strategic and financial advisor who was formerly the co-head of Donaldson Lufkin & Jenrette’s Financial Institutions Group and head of the firm’s Chicago Investment Banking office. Mr. Olson has served as senior banker on a broad range of Midwestern bank advisory and capital raising transactions. Our Board and management team continues to work closely with Mr. Olson and these initiatives.
 
CRITICAL ACCOUNTING POLICIES
 
     The consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP), which require us to establish various accounting policies. Certain of these accounting policies require us to make estimates, judgments, or assumptions that could have a material effect on the carrying value of certain assets and liabilities. The estimates, judgments, and assumptions we used are based on historical experience, projected results, internal cash flow modeling techniques, and other factors which we believe are reasonable under the circumstances.
 
     Significant accounting policies are presented in “Note 1. Summary of Significant Accounting Policies” in the notes to consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. These policies, along with the disclosures presented in other financial statement notes and in this management’s discussion and analysis, provide information on the methodology used for the valuation of significant assets and liabilities in our financial statements. We view critical accounting policies to be those that are highly dependent on subjective or complex judgments, estimates, and assumptions, and where changes in those estimates and assumptions could have a significant impact on the financial statements. We currently view the determination of the allowance for losses on loans, valuations and impairments of securities, and the accounting for income taxes to be critical accounting policies.
 
     Allowance for Losses on Loans. We maintain our allowance for losses on loans at a level we believe is sufficient to absorb credit losses inherent in our loan portfolio. The allowance for losses on loans represents our estimate of probable incurred losses in our loan portfolio at each statement of condition date and is based on our review of available and relevant information.
 
     The first component of our allowance for losses on loans contains allocations for probable incurred losses that we have identified relating to impaired loans pursuant to ASC 310-10, Receivables. We individually evaluate for impairment all loans over $1.0 million and classified substandard. Loans are considered impaired when, based on current information and events, it is probable that the borrower will not be able to fulfill its obligation according to the contractual terms of the loan agreement. The impairment loss, if any, is generally measured based on the present value of expected cash flows discounted at the loan’s effective interest rate. As a practical expedient, impairment may be measured based on the loan’s observable market price, or the fair value of the collateral, if the loan is collateral-dependent. A loan is considered collateral-dependent when the repayment of the loan will be provided solely by the underlying collateral and there are no other available and reliable sources of repayment. If we determine a loan is collateral-dependent we will charge-off any identified collateral short fall against the allowance for losses on loans.
 
     If foreclosure is probable, we are required to measure the impairment based on the fair value of the collateral. The fair value of the collateral is generally obtained from appraisals or estimated using an appraisal-like methodology. When current appraisals are not available, management estimates the fair value of the collateral giving consideration to several factors including the price at which individual unit(s) could be sold in the current market, the period of time over which the unit(s) would be sold, the estimated cost to complete the unit(s), the risks associated with completing and selling the unit(s), the required return on the investment a potential acquirer may have, and the current market interest rates. The analysis of each loan involves a high degree of judgment in estimating the amount of the loss associated with the loan, including the estimation of the amount and timing of future cash flows and collateral values.
 
     The second component of our allowance for losses on loans contains allocations for probable incurred losses within various pools of loans with similar characteristics pursuant to ASC 450-10, Contingencies. This component is based in part on certain loss factors applied to various stratified loan pools excluding loans evaluated individually for impairment. In determining the appropriate loss factors for these loan pools, we consider historical charge-offs and recoveries; levels of and trends in delinquencies, impaired loans, and other classified loans; concentrations of credit within the commercial loan portfolios; volume and type of lending; and current and anticipated economic conditions.
 
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     Loan losses are charged off against the allowance when the loan balance or a portion of the loan balance is no longer covered by the paying capacity of the borrower based on an evaluation of available cash resources and collateral value, while recoveries of amounts previously charged off are credited to the allowance. We assess the adequacy of the allowance for losses on loans on a quarterly basis and adjust the allowance for losses on loans by recording a provision for losses on loans in an amount sufficient to maintain the allowance at a level we deem appropriate. Our evaluation of the adequacy of the allowance for losses on loans is inherently subjective as it requires estimates that are susceptible to significant revision as additional information becomes available or as future events occur. To the extent that actual outcomes differ from our estimates, an additional provision for losses on loans could be required which could adversely affect earnings or our financial position in future periods. The OTS could require us to make additional provisions for losses on loans.
 
     Securities. Under ASC 320-10, Investments – Debt and Equity Securities, investment securities must be classified as held-to-maturity, available-for-sale, or trading. We determine the appropriate classification at the time of purchase. The classification of securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Debt securities are classified as held-to-maturity and carried at amortized cost when we have the positive intent and we have the ability to hold the securities to maturity. Securities not classified as held-to-maturity are classified as available-for-sale and are carried at fair value, with the unrealized holding gains and losses, net of tax, reported in other comprehensive income and do not affect earnings until realized.
 
     The fair values of our securities are generally determined by reference to quoted prices from reliable independent sources utilizing observable inputs. Certain of the fair values of securities are determined using models whose significant value drivers or assumptions are unobservable and are significant to the fair value of the securities. These models are utilized when quoted prices are not available for certain securities or in markets where trading activity has slowed or ceased. When quoted prices are not available and are not provided by third-party pricing services, our judgment is necessary to determine fair value. As such, fair value is determined using discounted cash flow analysis models, incorporating default rates, estimation of prepayment characteristics, and implied volatilities.
 
     We evaluate all securities on a quarterly basis, and more frequently when economic conditions warrant additional evaluations, for determining if an other-than-temporary impairment (OTTI) exists pursuant to guidelines established in ASC 320-10, Investments – Debt and Equity Securities. In evaluating the possible impairment of securities, consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial conditions and near-term prospects of the issuer, and our ability and intent to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer’s financial condition, we may consider whether the securities are issued by the federal government or its agencies or government sponsored agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition.
 
     If we determine that an investment experienced an OTTI, we must then determine the amount of the OTTI to be recognized in earnings. If we do not intend to sell the security and it is more likely than not that we will not be required to sell the security before recovery of its amortized cost basis less any current period loss, the OTTI will be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the OTTI related to other factors will be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings will become the new amortized cost basis of the investment. If we intend to sell the security or it is more likely than not we will be required to sell the security before recovery of its amortized cost basis less any current period credit loss, the OTTI will be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. Any recoveries related to the value of these securities are recorded as an unrealized gain (as other comprehensive income (loss) in shareholders’ equity) and not recognized in income until the security is ultimately sold. From time to time we may dispose of an impaired security in response to asset/liability management decisions, future market movements, business plan changes, or if the net proceeds can be reinvested at a rate of return that is expected to recover the loss within a reasonable period of time.
 
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     Income Tax Accounting. We file a consolidated federal income tax return. The provision for income taxes is based upon income in our consolidated financial statements, rather than amounts reported on our income tax return. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on our deferred tax assets and liabilities is recognized as income or expense in the period that includes the enactment date.
 
     Under U.S. GAAP, a valuation allowance is required to be recognized if it is more likely than not that a deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning our evaluation of both positive and negative evidence, our forecasts of future income, applicable tax planning strategies, and assessments of current and future economic and business conditions. Positive evidence includes the existence of taxes paid in available carryback years as well as the probability that taxable income will be generated in future periods, while negative evidence includes any cumulative losses in the current year and prior two years and general business and economic trends. At December 31, 2009 and December 31, 2008, we conducted an extensive analysis to determine if a valuation allowance was required and concluded that a valuation allowance was not necessary, largely based on available tax planning strategies and our projections of future taxable income. Additional positive evidence considered in our analysis was our long-term history of generating taxable income; the industry in which we operate is cyclical in nature, as a result, recent losses are not expected to have a significant long-term impact on our profitability; the fact that recent losses were partly attributable to syndicated/participation lending which we stopped investing in during the first quarter of 2007; our history of fully realizing net operating losses most recently a federal net operating loss from a $45.0 million taxable loss in 2004; and the relatively long remaining tax loss carryforward periods (nineteen years for federal income tax purposes, ten years for the state of Indiana, and eight years for the state of Illinois). We concluded that the aforementioned positive evidence outweighs the negative evidence of cumulative losses over the past three years. Any reduction in estimated future taxable income may require us to record a valuation allowance against our deferred tax assets. Any required valuation allowance would result in additional income tax expense in the period and could have a significant impact on our future earnings.
 
     Positions taken in our tax returns may be subject to challenge by the taxing authorities upon examination. The benefit of an uncertain tax position is initially recognized in the financial statements only when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are both initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon settlement with the tax authority, assuming full knowledge of the position and all relevant facts. Differences between our position and the position of tax authorities could result in a reduction of a tax benefit or an increase to a tax liability, which could adversely affect our future income tax expense.
 
     We believe our tax policies and practices are critical accounting policies because the determination of our tax provision and current and deferred tax assets and liabilities have a material impact on our net income and the carrying value of our assets. We believe our tax liabilities and assets are adequate and are properly recorded in the consolidated financial statements at December 31, 2009.
 
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AVERAGE BALANCES, NET INTEREST INCOME, YIELDS EARNED, AND RATES PAID
 
     The following table provides information regarding: (i) interest income recognized from interest-earning assets and their related average yields; (ii) the amount of interest expense realized on interest-bearing liabilities and their related average rates; (iii) net interest income; (iv) interest rate spread; and (v) net interest margin. Information is based on average daily balances during the periods indicated.
 
Year Ended December 31,
2009 2008 2007
Average Average Average     Average Average     Average
   Balance    Interest    Yield/Cost    Balance    Interest    Yield/Cost    Balance    Interest    Yield/Cost
(Dollars in thousands)
Interest-earning assets:
      Loans receivable (1) $    752,906 $    39,277 5.22 % $    753,500 $    45,213 6.00 % $    806,626 $    56,678 7.03 %
      Securities (2) 227,999 11,334 4.90 251,785 12,673 4.95 265,116 12,684 4.72
      Other interest-earning assets (3) 28,794 697 2.42 45,330 1,653 3.65 59,215 2,879 4.86
            Total interest-earning assets 1,009,699 51,308 5.08 1,050,615 59,539 5.67 1,130,957 72,241 6.39
Non-interest earning assets 87,812 85,178 79,370
Total assets $ 1,097,511 $ 1,135,793 $ 1,210,327
Interest-bearing liabilities:
      Deposits:
            Checking accounts $ 128,037 346 0.27 $ 105,481 612 0.58 $ 100,781 955 0.95
            Money market accounts 157,518 1,133 0.72 181,852 3,768 2.07 176,538 5,947   3.37
            Savings accounts 117,539 399 0.34 121,920 589 0.48 142,018 941 0.66
            Certificates of deposit 366,506 8,569 2.34 374,834 13,130 3.50 400,607 18,379 4.59
                  Total deposits 769,600 10,447 1.36 784,087 18,099 2.31 819,944   26,222 3.20
      Borrowings:
            Other short-term borrowings (4) 14,653 101 0.69 25,743 430 1.67 19,828   811 4.09
            FHLB borrowings (5)(6)(7) 112,763 3,167 2.77 119,369 6,127 5.05 158,667 11,101 6.90
                  Total borrowed money 127,416 3,268 2.53 145,112 6,557 4.44 178,495 11,912 6.58
                        Total interest-bearing liabilities 897,016 13,715 1.53 929,199 24,656 2.65   998,439 38,134 3.82
Non-interest bearing deposits 72,968 63,276 64,315
Non-interest bearing liabilities 15,169 16,779   17,475
Total liabilities 985,153 1,009,254       1,080,229
Shareholders’ equity 112,358 126,539     130,098
Total liabilities and shareholders’ equity $ 1,097,511 $ 1,135,793   $ 1,210,327
Net interest-earning assets $ 112,683 $ 121,416 $ 132,518
Net interest income/interest rate spread     $ 37,593   3.55 %       $ 34,883 3.02 % $ 34,107 2.57 %
Net interest margin         3.72 % 3.32 % 3.02 %
Ratio of average interest-earning assets to
      average interest-bearing liabilities 112.56 % 113.07 % 113.27 %
 
____________________
 
(1)        
The average balance of loans receivable includes non-performing loans, interest on which is recognized on a cash basis.
 
(2)       
Average balances of securities are based on amortized cost.
 
(3)
Includes FHLB stock, money market accounts, federal funds sold, and interest-earning bank deposits.
 
(4)
Includes federal funds purchased, overnight borrowings from the Federal Reserve Bank discount window, and repurchase agreements (Repo Sweeps).
 
(5)
The 2009 period includes an average of $112.8 million of contractual FHLB borrowings reduced by an average of $62,000 of unamortized deferred premium on the early extinguishment of debt. Interest expense on borrowings for the 2009 period includes $175,000 of amortization of the deferred premium on the early extinguishment of debt. The amortization of the deferred premium for the 2009 period increased the average cost of borrowed money as reported to 2.53% compared to an average contractual rate of 2.39%.
 
(6)
The 2008 period includes an average of $120.1 million of contractual FHLB borrowings reduced by an average of $763,000 of unamortized deferred premium on the early extinguishment of debt. Interest expense on borrowings for the 2008 period includes $1.5 million of amortization of the deferred premium on the early extinguishment of debt. The amortization of the deferred premium for the 2008 period increased the average cost of borrowed money as reported to 4.44% compared to an average contractual rate of 2.41%.
 
(7)
The 2007 period includes an average of $162.4 million of contractual FHLB borrowings reduced by an average of $3.7 million of unamortized deferred premium on the early extinguishment of debt. Interest expense on borrowings for the 2007 period includes $4.5 million of amortization of the deferred premium on the early extinguishment of debt. The amortization of the deferred premium for the 2007 period increased the average cost of borrowed money as reported to 6.58% compared to an average contractual rate of 4.14%.
 
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RATE/VOLUME ANALYSIS
 
     The following table details the effects of changing rates and volumes on net interest income. Information is provided with respect to: (i) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume); (ii) effects on interest income attributable to changes in volume (changes in volume multiplied by prior rate); and (iii) changes in rate/volume (changes in rate multiplied by changes in volume).
 
Year Ended December 31,
2009 Compared to 2008  2008 Compared to 2007
Increase (Decrease) Due to Increase (Decrease) Due to
     Rate/ Total Net Rate/ Total Net
     Rate      Volume      Volume      Inc/(Dec)      Rate      Volume      Volume      Inc/(Dec)
(Dollars in thousands)
Interest-earning assets:
      Loans receivable $ (5,905 ) $ (36 ) $ 5 $ (5,936 ) $ (8,277 ) $ (3,733 ) $ 545 $ (11,465 )
      Securities (157 ) (1,197 ) 15 (1,339 ) 660 (638 ) (33 ) (11 )
      Other interest-earning assets (556 ) (603 ) 203 (956 ) (720 ) (675 ) 169 (1,226 )
            Total net change in income on interest-
                  earning assets (6,618 ) (1,836 ) 223 (8,231 ) (8,337 ) (5,046 ) 681 (12,702 )
Interest-bearing liabilities:
      Deposits:
            Checking accounts (327 ) 131 (70 ) (266 ) (371 ) 45 (17 ) (343 )
            Money market accounts (2,460 ) (504 ) 329 (2,635 ) (2,289 ) 179 (69 ) (2,179 )
            Savings accounts (175 ) (21 ) 6 (190 ) (255 ) (133 ) 36 (352 )
            Certificates of deposit   (4,366 ) (292 ) 97 (4,561 ) (4,347 ) (1,182 ) 280   (5,249 )
                  Total deposits (7,328 ) (686 ) 362 (7,652 ) (7,262 ) (1,091 ) 230 (8,123 )
      Borrowings:  
            Other short-term borrowings (253 ) (185 ) 109 (329 ) (480 ) 242 (143 ) (381 )
            FHLB borrowings (2,775 )   (339 )   154   (2,960 )   (2,957 ) (2,749 ) 732 (4,974 )
                  Total borrowings (3,028 )   (524 ) 263 (3,289 ) (3,437 ) (2,507 ) 589   (5,355 )
      Total net change in expense on interest-                
            bearing liabilities   (10,356 ) (1,210 ) 625   (10,941 ) (10,699 )   (3,598 ) 819 (13,478 )
Net change in net interest income $ 3,738 $ (626 ) $ (402 ) $ 2,710 $ 2,362 $ (1,448 ) $ (138 ) $ 776  
  
RESULTS OF OPERATIONS
 
Year Ended December 31, 2009 Compared to Year Ended December 31, 2008
 
Net Income
 
     We reported a net loss of $543,000, or $(0.05) per share, for 2009 compared to a net loss of $11.3 million, or $(1.10) per share, for 2008. Our 2009 results of operations were positively impacted by increases in net interest income of $2.7 million and non-interest income of $5.8 million and a decrease in the provision for losses on loans of $13.7 million from the 2008 period. Partially offsetting these favorable variances was an increase in non-interest expense of $5.1 million from 2008.
 
Net Interest Income
 
     Net interest income is the principal source of earnings and consists of interest income received on loans and investment securities less interest expense paid on deposits and borrowed money. Net interest income totaled $37.6 million for 2009 compared to $34.9 million for 2008. Net interest margin (net interest income as a percentage of average interest-earning assets) for 2009 improved 40 basis points to 3.72% from 3.32% for 2008. The increases in net interest income and net interest margin were primarily a result of a reduction in the average cost of deposits and borrowings for 2009 when compared to 2008.
 
Interest Income
 
     Interest income decreased to $51.3 million for 2009 from $59.5 million for 2008. The weighted-average yield on interest-earning assets decreased 59 basis points to 5.08% for 2009 from 5.67% for the comparable 2008 period. The decrease was primarily due to lower market rates of interest coupled with a $10.3 million increase in non-performing assets since December 31, 2008. Interest income was also impacted by a decrease in the average balance of securities available-for-sale during 2009 as we elected to utilize excess liquidity to further de-leverage the balance sheet as opposed to reinvesting proceeds from maturities, paydowns, and sales of securities.
 
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Interest Expense
 
     Total interest expense decreased to $13.7 million for 2009 from $24.7 million for the 2008 period. The average cost of interest-bearing liabilities decreased 112 basis points to 1.53% for 2009 from 2.65% for 2008. Interest expense on deposits was positively affected by disciplined pricing on deposits, including certificates of deposit. In addition, the amortization of the premium on the early extinguishment of FHLB debt decreased by $1.3 million from 2008 and was fully amortized at December 31, 2009.
 
     Interest expense on interest-bearing deposits decreased to $10.4 million for 2009 from $18.1 million for 2008. The weighted-average cost of deposits decreased 95 basis points to 1.36% from 2.31% for 2008. This decrease was primarily as a result of disciplined pricing on deposits, including certificates of deposit, as market interest rates were lower in 2009 than 2008.
 
     Interest expense on borrowed money decreased to $3.3 million for 2009 from $6.6 million for 2008 primarily as a result of lower rates on the repricing of FHLB debt. The average balances of FHLB debt also decreased during 2009 as we sought to strengthen our balance sheet and enhance our liquidity position by replacing this source of funding with core deposits and de-leveraging our balance sheet. The amortization of the deferred premium on the early extinguishment of debt (Premium Amortization) that was included in total interest expense on borrowings decreased to $175,000 for 2009 from $1.5 million for 2008, which resulted in a decrease in the cost of borrowings to 2.53% for 2009 from 4.44% for 2008. The interest expense related to the Premium Amortization was $175,000 before taxes and fully recognized as of December 31, 2009.
 
     Interest expense on borrowings is detailed in the table below for the periods indicated.
 
Year Ended
December 31,
2009      2008      $ change      % change
(Dollars in thousands)
Interest expense on short-term borrowings at contractual rates $   101 $   430 $   (329 ) (76.5 )%
Interest expense on FHLB borrowings at contractual rates   2,992   4,675     (1,683 ) (36.0 )
Amortization of deferred premium 175   1,452 (1,277 )   (87.9 )
Total interest expense on borrowings $ 3,268 $ 6,557 $ (3,289 ) (50.2 )
 
Provision for Losses on Loans
 
     The provision for losses on loans decreased to $12.6 million for 2009 from $26.3 million in 2008. For more information, see “Changes in Financial Condition – Allowance for Losses on Loans” below in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
 
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Non-Interest Income
 
     The following table identifies the changes in non-interest income for the periods presented:
 
Year Ended
December 31,
     2009      2008      $ change      % change
(Dollars in thousands)
Service charges and other fees $   5,706 $   6,051 $   (345 ) (5.7 )%
Card-based fees 1,664 1,600 64 4.0
Commission income 246 341 (95 ) (27.9 )
       Subtotal fee based revenues 7,616 7,992 (376 ) (4.7 )
Income from bank-owned life insurance 2,183 1,300 883 67.9
Other income 590   566 24 4.2
       Subtotal 10,389 9,858 531 5.4
Securities gains, net 1,092   69     1,023   NM
Impairment on securities, available-for-sale   (4,334 ) 4,334   NM
Other asset gains (losses), net (9 ) 30   (39 ) NM
       Total non-interest income   $ 11,472   $ 5,623 $ 5,849 104.0 %
 
     Non-interest income before securities and other asset gains (losses) increased 5.4% for 2009 from 2008 primarily due to a gain on our bank-owned life insurance policy as a result of the death of former employees who were insured. This increase was partially offset by lower interest crediting rates resulting from a reduction in general market interest rates. Service charges and other fees decreased during 2009 from 2008 due to reduced volume of non-sufficient funds transactions which is an industry trend that is expected to continue, if not accelerate, due to recently passed legislation. Commission income from our third-party service provider from the sale of non-deposit investment products decreased due to decreased sales activity.
 
     During 2008, we recognized an other-than-temporary impairment on our investments in Fannie Mae and Freddie Mac preferred stock totaling $4.3 million. The market for investments in these government sponsored enterprises deteriorated throughout the second half of 2008 when the Treasury Department and the Federal Housing Finance Authority placed these enterprises into conservatorship.
 
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Non-Interest Expense
 
     During 2009, significant progress has been made in managing controllable costs, which has been largely offset by increasing nondiscretionary costs. The following table identifies the changes in non-interest expense for the periods presented:
 
Year Ended  
December 31,  
     2009      2008      $ change      % change
(Dollars in thousands)
Compensation and mandatory benefits $   16,294 $   15,160 $   1,134 7.5 %
Retirement and stock related compensation 968 783 185 23.6  
Medical and life benefits 1,582 1,450 132 9.1  
Other employee benefits 54 105 (51 ) (48.6 )
       Subtotal compensation and employee benefits 18,898 17,498 1,400 8.0  
Net occupancy expense 3,022 3,175 (153 ) (4.8 )
FDIC insurance premiums 2,240 159 2,081 NM  
Professional fees 2,273 1,341 932 69.5  
Furniture and equipment expense 2,129 2,362 (233 ) (9.9
Data processing     1,670 1,749 (79 ) (4.5 )
Marketing 832 1,002   (170 ) (17.0 )
Other real estate owned expenses 2,978   263 2,715     NM  
Loan collection expense 1,077 655   422 64.4  
Goodwill impairment 1,185 (1,185 ) NM  
Other general and administrative expenses 4,163   4,789 (626 ) (13.1 )
       Total non-interest expense $ 39,282 $ 34,178 $ 5,104 14.9  
   
     Compensation and mandatory benefits expense increased during 2009 due to a full year of compensation costs associated with the mid-2008 hiring of Business Banking Relationship Managers and managers in loan operations and retail branches.
 
     Retirement and stock related compensation was impacted by changes in costs related to our deferred compensation plans, pension plan, and ESOP plan. During 2009, we amended our deferred compensation plan agreements to eliminate the ability of plan participants to diversify out of our common stock and to require distributions be made in our common stock. As a result, changes in the price of our common stock on shares held within the plan are no longer required to be recorded as compensation expense under U.S. GAAP. Prior to the amendment, changes in the price of our common stock on shares held within the plan were recorded as an adjustment to retirement and stock related compensation. As such, retirement and stock related compensation increased mainly due to the absence of a $1.4 million credit recorded in the 2008 period. This increase was partially offset by a $779,000 decrease in pension expense based on information we received from our plan administrator with respect to our annual funding requirements. Our ESOP expense also decreased $618,000 during 2009 due to the Bank paying the remaining $1.2 million on the ESOP loan during the first quarter of 2009. As such, the remaining 83,519 shares were allocated to the ESOP participants in 2009.
 
     Our FDIC insurance premiums increased $2.1 million during 2009 due to the adoption of the FDIC’s Restoration Plan. The increase in our FDIC insurance premiums included the industry-wide rate increases effective in 2009, the FDIC’s second quarter of 2009 special assessment, and the absence of the utilization of certain FDIC insurance premium credits in 2008. Our FDIC insurance premiums could increase in the near term due to industry-wide increases in assessment rates.
 
     Professional fees also increased $932,000 during 2009 compared to 2008 as a result of increased fees related to a shareholder derivative demand made late in the first quarter of 2009, additional regulatory compliance needs, supervisory examinations, and additional consulting fees. During 2009, we incurred $771,000 in expenses directly related to the shareholder derivative demand.
 
     Costs related to other real estate owned properties also increased $2.7 million during 2009 primarily due to increased valuation allowances and required expenses on our properties. Of the increase, $2.5 million was directly related to increases in the valuation reserves of three out of market commercial real estate properties caused by the decline in their net realizable value during the year.
 
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     Loan collection expense increased $422,000 during 2009 primarily due to increased non-performing assets. These types of expenses include legal fees, appraisals, real estate tax payments, title searches, and other costs to protect our interests in the loans.
 
     Our efficiency ratio was 80.1% and 84.4%, respectively, for 2009 and 2008. Our core efficiency ratio was 80.5% and 71.4%, respectively, for 2009 and 2008. These ratios were negatively affected by increased non-interest expense as discussed above. For the reconciliation of our efficiency ratio and core efficiency ratio, see “Item 6. Selected Financial Data” of this Annual Report on Form 10-K.
 
     Management has historically used an efficiency ratio that is a non-U.S. GAAP financial measure of operating expense control and operating efficiency. The efficiency ratio is typically defined as the ratio of non-interest expense to the sum of non-interest income and net interest income. Many financial institutions, in calculating the efficiency ratio, adjust non-interest income and expense (as calculated under U.S. GAAP) to exclude certain component elements, such as gains or losses on sales of securities and assets. Management follows this practice to calculate its core efficiency ratio and utilizes this non-U.S. GAAP measure in its analysis of our performance. The core efficiency ratio is different from the U.S. GAAP-based efficiency ratio. The U.S. GAAP-based measure is calculated using non-interest expense, net interest income, and non-interest income as presented in the condensed consolidated statements of operations.
 
     The core efficiency ratio is calculated as non-interest expense less the FDIC special assessment divided by the sum of net interest income, excluding the Premium Amortization, and non-interest income, adjusted for gains or losses on the sale of securities and other assets, and other-than-temporary impairments. Management believes that, when presented along with the U.S. GAAP efficiency ratio, the core efficiency ratio enhances investors’ understanding of our business and performance. The measure is also believed to be useful in understanding our performance trends and to facilitate comparisons with the performance of others in the financial services industry. Management further believes the presentation of the core efficiency ratio provides useful supplemental information, a clearer understanding of our financial performance, and better reflects our core operating activities.
 
     The risks associated with utilizing operating measures (such as the efficiency ratio) are that various persons might disagree as to the appropriateness of items included or excluded in these measures and that other companies might calculate these measures differently. Management compensates for these limitations by providing detailed reconciliations between U.S. GAAP information and our core efficiency ratio as noted above; however, these disclosures should not be considered an alternative to U.S. GAAP.
 
Income Tax Expense
 
     The income tax benefit totaled $2.3 million for 2009 compared to $8.7 million for 2008. Our effective income tax rate benefit was 80.6% for 2009 compared to 43.4% for 2008. The increase in our income tax benefit rate was mainly the result of an increase in the percentage of permanent tax items to pre-tax loss during 2009. The overall effective tax rates continue to benefit from our investments in bank-owned life insurance and the application of available tax credits.
 
Year Ended December 31, 2008 Compared to Year Ended December 31, 2007
 
Net Income
 
     We reported a net loss of $11.3 million, or $(1.10) per share, for 2008 compared to net income of $7.5 million, or $0.69 diluted earnings per share, for 2007. Our 2008 earnings were impacted by provisions for losses on loans totaling $26.3 million, other-than-temporary impairments on our investments in Fannie Mae and Freddie Mac preferred stock totaling $4.3 million, and a goodwill impairment of $1.2 million. Combined, these charges reduced net income by $19.9 million and reduced diluted earnings per share by $1.90.
 
Net Interest Income
 
     Net interest income totaled $34.9 million for 2008 compared to $34.1 million for 2007. The net interest margin for 2008 improved 30 basis points to 3.32% from 3.02% for 2007. The increases in net interest income and net interest margin were primarily a result of a reduction in the average cost of deposits and a decrease in the average balance of borrowings for 2008 when compared to 2007.
 
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Interest Income
 
     Interest income was $59.5 million for 2008 compared to $72.2 million for 2007. The weighted-average yield on interest-earning assets decreased 72 basis points to 5.67% for 2008 from 6.39% for the comparable 2007 period.
 
     The decrease in interest income was primarily caused by a decrease in interest rates earned on loans receivable and a $53.1 million decrease in the average balance of loans receivable. Variable rate loans totaled $449.8 million at December 31, 2008 and were negatively affected by the decrease in current market rates throughout 2008. In addition, a $25.1 million increase in non-performing loans negatively affected the interest income and weighted-average yield recognized on loans receivable during 2008.
 
Interest Expense
 
     Total interest expense decreased to $24.7 million for 2008 from $38.1 million for the 2007 period. The average cost of interest-bearing liabilities decreased to 2.65% for 2008 when compared to 3.82% for 2007 as a result of decreases in the average balance of deposits and borrowings coupled with the positive affect of lower market interest rates during 2008.
 
     Interest expense on interest-bearing deposits decreased to $18.1 million for 2008 from $26.2 million for 2007. The weighted-average cost of deposits decreased 89 basis points due to disciplined pricing on these products as market interest rates decreased throughout 2008. In addition, the average balance on interest-bearing deposits decreased 4.4% from 2007 primarily due to a decrease in the balance of certificate of deposit accounts. Tightening liquidity in the financial services sector has resulted in increased interest rates paid by other institutions on certificates of deposit. These balances are more vulnerable to above market rates paid by institutions facing liquidity issues while we continue to be disciplined in pricing these deposits.
 
     Interest expense on borrowed money for 2008 decreased 45.0% to $6.6 million for 2008 from $11.9 million for 2007 primarily as a result of lower rates on the repricing of FHLB debt. The average balances of FHLB debt also decreased during 2008 as we were able to utilize our excess liquidity to repay maturing advances. The Premium Amortization that was included in total interest expense on borrowings decreased to $1.5 million for 2008 from $4.5 million for 2007 which resulted in a decrease in cost of borrowings to 4.44% for 2008 from 6.58% for 2007. The Premium Amortization adversely affected the net interest margin by 14 basis points in 2008 and 40 basis points in 2007. Interest expense on borrowings is detailed in the table below for the periods indicated.
 
Year Ended
December 31,
     2008      2007      $ change      % change
(Dollars in thousands)
Interest expense on short-term borrowings at contractual rates $   430 $   811 $   (381 ) (47.0 )%
Interest expense on FHLB borrowings at contractual rates 4,675 6,561   (1,886 )   (28.7 )
Amortization of deferred premium 1,452   4,540   (3,088 ) (68.0 )
Total interest expense on borrowings   $ 6,557   $ 11,912 $ (5,355 ) (45.0 )
 
Provision for Losses on Loans
 
     The provision for losses on loans was $26.3 million for 2008 compared to $2.3 million in 2007 reflecting reduced collateral valuations on impaired loans as well as an increase of $2.8 million in general reserves in the allowance for losses on loans as determined by our quarterly analysis of the adequacy of the allowance for losses on loans. For more information, see “Changes in Financial Condition – Allowance for Losses on Loans” below in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
 
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Non-Interest Income
 
     The following table identifies the changes in non-interest income for the periods presented:
 
Year Ended
December 31,
     2008      2007      $ change      % change
(Dollars in thousands)
Service charges and other fees $   6,051 $   6,795 $   (744 ) (10.9 )%
Card-based fees 1,600 1,489 111 7.5
Commission income 341 147 194 132.0
       Subtotal fee based revenues 7,992 8,431 (439 ) (5.2 )
Income from bank-owned life insurance 1,300 1,634 (334 ) (20.4 )
Other income 566 892 (326 ) (36.5 )
       Subtotal 9,858 10,957 (1,099 ) (10.0 )
Securities gains, net 69   536   (467 )   (87.1 )
Impairment on securities, available-for-sale     (4,334 )     (4,334 ) NM
Other asset gains, net 30   22 8 36.4
       Total non-interest income $ 5,623 $ 11,515 $ (5,892 ) (51.2 )%
 
     Non-interest income before securities gains, impairments, and other asset gains decreased 10.0% for 2008 from 2007 due to decreases in the following:
  • service charges and other fees from lower volume of non-sufficient funds items and lower fee income from letters of credit and credit enhancements;
  • income from bank-owned life insurance due to other-than-temporary impairments on certain investments recognized by the underwriters and decreases in overall market rates on investments underlying the policy; and
  • other income from a decrease in the profit earned on the sale of loans and the related loan servicing rights when we began retaining in 2008 the one-to-four family mortgage loans we originate.
     We recognized an other-than-temporary impairment on our investments in Fannie Mae and Freddie Mac preferred stock totaling $4.3 million. The market for investments in these government sponsored enterprises deteriorated throughout the second half of 2008 when the Treasury Department and the Federal Housing Finance Authority placed these enterprises into conservatorship.
 
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Non-Interest Expense
 
     The following table identifies the changes in non-interest expense for the periods presented:
 
Year Ended
December 31,
     2008      2007      $ change      % change
(Dollars in thousands)
Compensation and mandatory benefits $   15,160 $   16,236 $   (1,076 ) (6.6 )%
Retirement and stock related compensation 783 1,054 (271 ) (25.7 )
Medical and life benefits 1,450 1,025 425 41.5
Other employee benefits 105 91 14 15.4
       Subtotal compensation and employee benefits 17,498 18,406 (908 ) (4.9 )
Net occupancy expense 3,175 2,847 328 11.5
FDIC insurance premiums 159 106 53 50.0
Professional fees 1,341 1,540 (199 ) (12.9 )
Furniture and equipment expense 2,362 2,241 121 5.4
Data processing 1,749 2,169 (420 ) (19.4 )
Marketing 1,002 842 160 19.0
Other real estate owned expense 263 343   (80 ) (23.3 )
Loan collection expense 655 164   491 299.4
Goodwill impairment 1,185   1,185   NM
Other general and administrative expenses   4,789   4,801 (12 ) (0.2 )
       Total non-interest expense   $ 34,178 $ 33,459 $ 719 2.1 %
 
     Non-interest expense for 2008 increased when compared to 2007 due to increases in the following:
  • medical and life benefits as the number of and the amount paid for medical claims increased;
  • net occupancy expense as a result of vacating certain leased space and additional expenses relating to higher utility and snow removal costs; and
  • other general and administrative expenses relating to loan collection expense for the workout of problem loans and an increase in recruiting expense related to the above mentioned new employees.
      In addition, the $1.2 million of goodwill we had acquired through our 2003 acquisition of a bank branch in Illinois was determined to be fully impaired based on management’s goodwill impairment analysis at December 31, 2008. The analysis was conducted pursuant to Accounting Standards Codification 350, Intangibles - Goodwill and Other, as a result of the disruption in the public capital markets and our market capitalization falling below its book value.
 
     During 2008, compensation and mandatory benefits decreased due to the absence of separation expenses from 2007 totaling $625,000 which were related to the separation of two senior officers and the consolidation of our retail lending operations during the fourth quarter of 2007 and the reduction in force of other employees during the first quarter of 2007. We also incurred lower incentive costs as a result of not meeting our 2008 performance goals for key officers and employees.
 
     Retirement and stock related benefits decreased during 2008 due to a $1.4 million decrease in compensation for the Rabbi Trust deferred compensation plans. The value of our common stock held in these plans declined as a result of the change in the stock price of $3.90 at December 31, 2008 compared to $14.69 at December 31, 2007. This decrease was partially offset by a $417,000 increase in pension expense during 2008 based on information received from our plan administrator with respect to our annual funding requirements. During the fourth quarter of 2008, we also made a principal prepayment of $2.8 million on our ESOP loan. The additional principal payment was made to satisfy the 4.1% minimum funding requirement we agreed to upon the modification of the ESOP loan in March 2007 and to minimize the impact of this funding requirement in 2009. As a result of the principal payment, ESOP expense in 2008 increased to $1.1 million from $288,000 in 2007.
 
     The efficiency ratio was 84.4% and 73.3%, respectively, for 2008 and 2007. The core efficiency ratio was 71.4% and 67.5%, respectively, for 2008 and 2007. During 2008, the efficiency and core efficiency ratios were impacted by the decreases in net interest income and non-interest income and the increase in non-interest expense as discussed above. The core efficiency ratio was negatively affected by the increased non-interest expense coupled with lower revenues when compared to the prior period. For the reconciliation of our efficiency ratio and core efficiency ratio, see “Item 6. Selected Financial Data” of this Annual Report on Form 10-K.
 
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Income Tax Expense
 
     The income tax benefit was $8.7 million for 2008 compared to income tax expense of $2.3 million for 2007. The effective income tax rate was (43.4)% and 23.5%, respectively, for 2008 and 2007. The significant change from income tax expense to an income tax benefit during 2008 was mainly a result of the pre-tax losses recognized during 2008. The overall effective tax rates continue to benefit from our investment in bank-owned life insurance and the application of available tax credits.
 
CHANGES IN FINANCIAL CONDITION FOR 2009
 
General
 
     During 2009, total assets decreased by $40.3 million to $1.08 billion from $1.12 billion at December 31, 2008. Securities available-for-sale decreased $62.5 million due to maturities, paydowns, and sales activity during 2009. With market conditions demanding strong capital positions through the year, we elected to utilize excess liquidity to further de-leverage the balance sheet as opposed to reinvesting in our securities portfolio.
 
Securities
 
     We manage our securities portfolio to adjust balance sheet interest rate sensitivity to insulate net interest income against the impact of changes in market interest rates, to maximize the return on invested funds within acceptable risk guidelines, and to meet pledging and liquidity requirements.
 
     We adjust the size and composition of our securities portfolio according to a number of factors including expected loan and deposit growth, the interest rate environment, and projected liquidity. The amortized cost of available-for-sale securities and their fair values were as follows for the dates indicated:
 
December 31,
2009 2008 2007
Par Amortized Fair Par Amortized Fair Par Amortized Fair
     Value      Cost      Value      Value      Cost      Value      Value      Cost      Value
(Dollars in thousands)
Available-for-sale securities:
       Government sponsored entity
              securities (GSE) $   40,450 $   40,374 $   41,457 $   98,400 $   97,987 $   102,345 $   141,300 $   140,301 $   143,146
       Mortgage-backed securities 9,527 9,426 9,835 10,881 10,774 10,856 12,545 12,587 12,563
       Collateralized mortgage
              obligations 67,307 66,413 66,768 78,276 76,506 75,543 57,635 56,672 57,180
       Commercial mortgage-backed
              securities 49,722 49,210 50,522 40,511 39,669 38,393
       Pooled trust preferred securities 30,223 27,093 20,012 30,966 27,668 24,133 10,000 8,900 8,900
       Equity securities 5,837 187 5,837   3,176 3,344 2,805
  $ 203,066   $ 192,516   $ 188,781   $ 264,871   $ 252,604   $ 251,270   $ 224,656   $ 221,804   $ 224,594
 
     Our held-to-maturity securities had an amortized cost of $5.0 million and $6.9 million, respectively, at December 31, 2009 and 2008 with $179,000 and $161,000, respectively, of gross unrealized holding gains.
 
     At December 31, 2009, our collateralized mortgage obligation portfolio totals $66.4 million with 90% of the portfolio comprised of AAA-rated securities mainly backed by conventional residential mortgages with 15-year, fixed-rate, prime loans originated prior to 2005; low historical delinquencies; weighted-average credit scores in excess of 725; and loan-to-values under 50%. The composition of this portfolio includes $20.4 million backed by Ginnie Mae, Fannie Mae, or Freddie Mac. The portfolio of non-agency collateralized mortgage obligations has underlying collateral with a weighted-average 90-day delinquency ratio of 0.8% and a weighted-average loan-to-value of 39.0% when using valuations from the original appraisal. One $2.5 million bond was downgraded in 2009 and now has two non-investment grade ratings. This bond was AAA-rated when we purchased it at a 7.9% discount. One $79,000 bond was downgraded in 2009 and now has two non-investment grade ratings. This bond was originally issued in 1998, was AAA-rated when we purchased it, and is currently insured by MBIA.
 
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     Our commercial mortgage-backed securities portfolio consists mainly of short-term, senior tranches of seasoned issues with extensive subordination and limited balloon risk. All bonds are AAA-rated. We stress test all bonds in this sector on a monthly basis. Of this portfolio, 94.2% of the bonds can withstand a minimum annual default rate of 50% with recoveries of 50 cents on the dollar and not experience any losses. One $2.8 million bond projects a 1.3% loss under this stress scenario. Bonds totaling $2.4 million of the commercial mortgage-backed securities portfolio have collateral that has been completely replaced with U.S. Treasury obligations.
 
     Our investments in pooled trust preferred securities are all “Super Senior” and backed by senior securities issued mainly by bank and thrift holding companies. All of our holdings were AAA-rated when we purchased them at large discounts. In 2009, the market for pooled trust preferred securities was severely impacted by the credit crisis leading to increased deferral and defaults. Ratings were negatively affected in 2009 and $20.6 million of these securities in our portfolio have at least one rating below investment grade. One tranche totaling $7.8 million holds a rating of both AAA and BB. We utilize extensive external and internal analysis on our pooled trust preferred holdings. Stress tests are performed on all underlying issuers in the pools to project probabilities of deferral or default. Both external and internal analysis suggests default levels must increase by 275% to 775% immediately before any par value of principal is at risk. Our internal stress testing utilizes immediate defaults for all deferring collateral. Any collateral that we believe may be at risk for deferring is defaulted immediately. Internal stress testing also assumes no recoveries on defaulted collateral. All external and internal stress testing currently project no losses of principal or interest on any of our holdings. Due to the structure of the securities, as deferrals and defaults on the underlying collateral increase, cash flows are increasingly diverted from mezzanine and subordinate tranches to pay down principal on the Super Senior tranches. Past defaults on underlying collateral ensure cash flows will continue to be diverted to our Super Senior tranches to pay down principal for several years.
 
     We measure fair value according to ASC 820-10, Fair Value Measurements and Disclosures, which establishes a fair value hierarchy that prioritizes the inputs used in valuation techniques, but not the valuation techniques themselves. The fair value hierarchy is designed to indicate the relative reliability of the fair value measure. The highest priority is given to quoted prices in active markets and the lowest to unobservable data such as our internal information. ASC 820-10 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” There are three levels of inputs into the fair value hierarchy (Level 1 being the highest priority and Level 3 being the lowest priority):
 
Level 1 – Unadjusted quoted prices for identical instruments in active markets;
 
Level 2 – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable; and
 
Level 3 – Instruments whose significant value drivers or assumptions are unobservable and that are significant to the fair value of the assets or liabilities.
 
     A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.
 
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     The following table sets forth our financial assets by level within the fair value hierarchy that were measured at fair value on a recurring basis during the dates indicated.
 
Fair Value Measurements at December 31, 2009
Quoted Prices in
Active Markets for Significant Other Significant
Identical Assets Observable Inputs Unobservable Inputs
     Fair Value      (Level 1)      (Level 2)      (Level 3)
(Dollars in thousands)
Securities available-for-sale:
       Government sponsored entity (GSE) securities $   41,457 $   $   41,457 $  
       Mortgage-backed securities 9,835 9,835
       Collateralized mortgage obligations 66,767 66,767
       Commercial mortgage-backed securities 50,522   50,522    
       Pooled trust preferred securities   20,013 20,013
       Equity securities 187     187

     Securities available-for-sale are measured at fair value on a recurring basis. Level 2 securities are valued by a third-party pricing service commonly used in the banking industry utilizing observable inputs. The pricing provider utilizes evaluated pricing models that vary based on asset class. These models incorporate available market information including quoted prices of securities with similar characteristics and, because many fixed-income securities do not trade on a daily basis, apply available information through processes such as benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing. In addition, model processes, such as an option adjusted spread model, are used to develop prepayment and interest rate scenarios for securities with prepayment features.
 
     Level 3 models are utilized when quoted prices are not available for certain securities or in markets where trading activity has slowed or ceased. When quoted prices are not available and are not provided by third-party pricing services, management judgment is necessary to determine fair value. As such, fair value is determined using discounted cash flow analysis models, incorporating default rates, estimation of prepayment characteristics, and implied volatilities.
 
     We determined that Level 3 pricing models should be utilized for valuing our investments in pooled trust preferred securities. The market for these securities at December 31, 2009 was not active and markets for similar securities were also not active. There are very few market participants who are willing and/or able to transact for these securities. Given the limited number of observable transactions in the secondary market and the absence of a new issue market, management determined an income valuation approach (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than the market approach valuation technique.
 
     For our Level 3 pricing model, we used externally provided fair value rates that were no longer available in the third quarter of 2009. As such, we discontinued our use of the internal model and utilized the external fair values provided by the same third-party. The external model uses deferral and default probabilities for underlying issuers, estimated deferral periods, and recovery rates on defaults. In prior periods, the internal model’s fair values were similar to the external model’s fair values. The internal model we previously used assumed (i) any defaulted underlying issues would not have any recovery and (ii) underlying issues that are currently deferring or in receivership or conservatorship would eventually default and not have any recovery. In addition, our internal model estimated cash flows to maturity and assumed no early redemptions of principal due to call options or successful auctions.
 
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     The following is a reconciliation of the beginning and ending balances of recurring fair value measurements recognized in the accompanying consolidated statement of condition using Level 3 inputs for the years indicated:
 
Available-for-sale Securities
     2009      2008
(Dollars in thousands)
Beginning balance January 1 $   24,133 $  
       Total realized and unrealized gains and losses:
              Included in accumulated other comprehensive income (3,546 ) (578 )
       Purchases, sales, issuances, and settlements, net (575 ) (139 )
Transfers in and/or out of Level 3     24,850
Ending balance December 31   $ 20,012   $ 24,133
                 
     On a quarterly basis, we evaluate securities available-for-sale with significant declines in fair value to determine whether they should be considered other-than-temporarily impaired. Current accounting guidance generally provides that if a marketable security is in an unrealized loss position, whether due to general market conditions or industry or issuer-specific factors, the holder of the securities must assess whether the impairment is other-than-temporary. At December 31, 2009, all of our securities available-for-sale with an unrealized loss position were, in our belief, primarily due to changes in market interest rates combined with an illiquid fixed-income market and not due to credit quality or other issuer specific factors. In addition, we do not have the intent to sell these securities, and it is more likely than not these securities will not be sold prior to recovery of amortized cost; however, we may from time to time dispose of an impaired security in response to asset/liability management decisions, future market movements, business plan changes, or if the net proceeds could be reinvested at a rate of return that is expected to recover the loss within a reasonable period of time. We concluded that the unrealized losses that existed at December 31, 2009, did not constitute other-than-temporary impairments.
 
     The following table sets forth certain information regarding the maturities and weighted-average yield of securities as of December 31, 2009. The amounts and yields listed in the table are based on amortized cost.
 
Mortgage- Collateralized Commercial Trust State
Backed Mortgage Mortgage-Backed Preferred and
GSE Securities Securities (1) Obligations (1) Securities (2) Securities (3) Municipal Total
   Amount    Yield    Amount    Yield    Amount    Yield    Amount    Yield    Amount    Yield    Amount    Yield    Amount    Yield
(Dollars in thousands)
Maturities:
       Less than 1 year 33,582 5.05 % % 10,693 6.02 % 21,466 6.63 % % 2,000 3.18 % 67,741 5.65 %
       1 to less than 5 years 6,792 5.18 9,426 4.23 53,190 5.13 27,744 6.24 3,000 3.44 100,152 5.30
       5 to less than 10 years 2,530 8.21 2,530 8.21
       10 years and over 27,093 1.54 27,093 1.54
Total securities $ 40,374 5.07 % $ 9,426 4.23 % $ 66,413 5.39 % $ 49,210 6.41 % $ 27,093 1.54 % $ 5,000 3.34 % $ 197,516 4.94 %
Average months to maturity     7.4           33.6           29.6           16.6           245.9           18.6           51.4  
____________________
 
(1)         Our mortgage-backed securities and collateralized mortgage obligations are amortizing in nature. As such, the maturities presented in the table for these securities are based on historical and estimated prepayment rates for the underlying mortgage collateral and were calculated using prepayment speeds based on the trailing three-month CPR (Constant Prepayment Rate). The estimated average lives may differ from actual principal cash flows since cash flows include prepayments and scheduled principal amortization.
 
(2) Our commercial mortgage-backed securities are amortizing in nature. As such, the maturities presented in the table for these securities are based on contractual payment assumptions for the underlying collateral and were calculated using a prepayment speed of 0 CPY (Constant Prepayment Yield).
 
(3) Our pooled trust preferred securities have floating rates. The projected yields are calculated to the contractual maturity and are based on the coupon rates at December 31, 2009 and fourth quarter of 2009 prepayment rates.
 
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LOANS
 
     The following table sets forth the composition of loans receivable and the percentage of loans by category as of the dates indicated.
 
2009 2008 2007 2006 2005
Percent Percent Percent Percent Percent
   Amount    of Total    Amount    of Total    Amount    of Total    Amount    of Total    Percent    of Total
(Dollars in thousands)
Commercial loans:
       Commercial and industrial $   78,600 10.3 % $   64,021 8.5 % $   60,398 7.6 % $   35,743 4.5 % $   61,956 6.8 %
       Commercial real estate – owner occupied 99,559 13.1 85,565 11.4 82,382 10.4
       Commercial real estate – non-owner occupied 218,329 28.6 222,048 29.6 207,270 26.1 339,110 42.2 381,956 41.6
       Commercial real estate – multifamily 63,008 8.3 40,503 5.4 38,775 4.9
       Commercial construction and land development 55,733 7.3 70,848 9.5 117,453 14.8 128,529 16.0 136,558 14.9
              Total commercial loans 515,229 67.6 482,985 64.4 506,278 63.8 503,382 62.7 580,470 63.3
Retail loans:
       One-to-four family residential 185,293 24.3 203,797 27.2 212,598 26.8 225,007 28.1 235,359 25.7
       Home equity lines of credit 56,911 7.5 58,918 7.8 60,326 7.6 70,527 8.8 96,403 10.5
       Retail construction and land development 3,401 0.4 2,650 0.4 11,131 1.4
       Other 1,552 0.2 1,623 0.2 2,803 0.4 3,467 0.4 5,173 0.5
              Total retail loans 247,157 32.4 266,988 35.6 286,858 36.2 299,001 37.3 336,935 36.7
 
       Total loans receivable, net of unearned fees   $ 762,386   100.0 %   $ 749,973   100.0 %   $ 793,136   100.0 %   $ 802,383   100.0 %   $ 917,405   100.0 %
 
     Loans receivable totaled $762.4 million at December 31, 2009 compared to $750.0 million at December 31, 2008. Through the execution of our Strategic Growth and Development Plan and our focus on lending to small- to medium-sized businesses, we have made significant progress in diversifying our loan portfolio and reducing loans not meeting our current defined risk tolerance. In 2009, we increased commercial and industrial, owner occupied commercial real estate, and multifamily loans by $52.0 million. This growth was partially offset by decreases in commercial construction and land development and non-owner occupied commercial real estate loans.
 
     During the fourth quarter of 2008, we revised our classification of commercial real estate loans to provide a better understanding of the types of commercial real estate loans within our loan portfolio. The method of presentation identifies commercial real estate loans that are owner occupied, non-owner occupied, and multifamily loans. Loans to owner occupied businesses are generally engaged in manufacturing, sales, and/or services. We believe that these loans have a lower risk profile than non-owner occupied commercial real estate loans since they are primarily dependent on the borrower’s business-generated cash flows for repayment, not on the conversion of real estate that may be pledged as collateral. Loans related to rental income-producing properties, properties intended to be sold, and properties collateralizing hospitality loans will continue to be classified as commercial real estate – non-owner occupied loans. Loans related to residential rental properties such as apartment complexes are now classified as commercial real estate loans – multifamily. Completing these changes in presentation involved a loan-by-loan review of our commercial real estate loans. The presentation methodology was implemented as of December 31, 2007 and prospectively, as it was impractical to apply it to data from 2006 and 2005. The classification of construction and land development and one-to-four family residential loans was also reviewed resulting in a reclassification of all one-to-four family construction and lot loans as retail construction loans within the retail loan category since these loans are typically loans on single lots for the construction of the borrower’s primary residence. These loans were previously identified in commercial construction and land development.
 
     Historically we have invested, on a participating basis, in loans originated by other lenders and loan syndications to supplement the direct origination of our commercial and construction loan portfolio. We stopped investing in these types of credits in the second quarter of 2007 due to marginal pricing, increased credit risk, and decreasing collateral values in this segment. We continue to reduce our exposure on these types of loans. Participations and syndication loans outstanding at December 31, 2009 totaled $24.6 million in construction and land development loans, $27.5 million in loans secured by commercial real estate, and $273,000 in commercial and industrial loans. Total participations and syndications by state are presented in the following table for the dates indicated.
 
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December 31, 2009 December 31, 2008
     Amount      % of Total      Amount      % of Total      % Change
(Dollars in thousands)
Illinois $   21,964 41.9 % $   25,012 41.3 % (12.2 )%
Indiana 13,149 25.1 13,215 21.8 (0.5 )
Ohio 9,284 17.7 9,734 16.1 (4.6 )
Florida 3,303 6.4 6,590 10.9 (49.9 )
Colorado 2,514 4.8 3,103 5.1 (19.0 )
Texas   1,660   3.2   1,732   2.9 (4.2 )
New York   491 0.9     1,150 1.9 (57.3 )
       Total participations and syndications $ 52,365 100.0 % $ 60,536 100.0 %   (13.5 )%
 
Loan Concentrations
 
     Loan concentrations are considered to exist when there are amounts loaned to a multiple number of borrowers engaged in similar activities which would cause them to be similarly impacted by economic or other conditions. At December 31, 2009, we had a concentration of loans secured by office and/or warehouse buildings totaling $218.2 million or 28.6% of our total loan portfolio. Loans secured by these types of collateral involve higher principal amounts. The repayment of these loans generally is dependent, in large part, on the successful operation of the property securing the loan or the business conducted on the property securing the loan. These loans may be more adversely affected by general conditions in the real estate market or in the economy. At December 31, 2009, we had no other concentrations of loans to any industry exceeding 10% of our total loan portfolio.
 
Contractual Principal Repayments and Interest Rates
 
     The following table sets forth scheduled contractual amortization of our commercial loans at December 31, 2009, as well as the dollar amount of loans scheduled to mature after one year. Demand loans and loans having no scheduled repayments and no stated maturity are reported as due in one year or less.
 
Total at Principal Repayments Contractually Due
December 31, in Year(s) Ended December 31,
     2009 (1)      2010      2011-2013 (2)      Thereafter (2)
(Dollars in thousands)
Commercial loans:
       Commercial and industrial $   78,393 $   30,724 $ 27,031 $   20,638
       Commercial real estate – owner occupied 99,552 8,907 31,435 59,210
       Commercial real estate – non-owner occupied 218,471 53,020 96,054 69,397
       Commercial real estate – multifamily 62,995 13,089 22,688 27,218
       Commercial construction and land development 55,728 48,706 5,288 1,734
       Total commercial loans   $ 515,139   $ 154,446   $ 182,496   $ 178,197
 
____________________
 
(1)         Gross loans receivable does not include deferred fees and costs of $90,000 as of December 31, 2009.
 
(2) Of the $360.7 million of loan principal repayments contractually due after December 31, 2010, $165.1 million have fixed interest rates and $195.6 million have variable interest rates which reprice from one month up to five years.
 
     Scheduled contractual loan amortization does not reflect the expected term of the loan portfolio. The average life of loans is substantially less than their contractual terms because of prepayments. The average life of mortgage loans tends to increase when current market rates of interest for mortgage loans are higher than rates on existing mortgage loans and, conversely, decrease when rates on existing mortgage loans are higher than current market rates as borrowers refinance adjustable-rate and fixed-rate loans at lower rates. Under the latter circumstance, the yield on loans decreases as higher yielding loans are repaid or refinanced at lower rates.
 
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ALLOWANCE FOR LOSSES ON LOANS
 
     We maintain our allowance for losses on loans at a level that we believe is sufficient to absorb credit losses inherent in the loan portfolio. Our allowance for losses on loans represents our estimate of probable incurred losses existing in our loan portfolio that are both probable and reasonable to estimate at each statement of condition date and is based on our review of available and relevant information. Our quarterly evaluation of the adequacy of the allowance is based in part on historical charge-offs and recoveries; levels of and trends in delinquencies; impaired loans and other classified loans; concentrations of credit within the commercial loan portfolio; volume and type of lending; and current and anticipated economic conditions. In addition, we consider expected losses resulting in specific credit allocations for individual loans not considered above. Our analysis of each loan involves a high degree of judgment in estimating the amount of the loss associated with the loan, including the estimation of the amount and timing of future cash flows and collateral values.
 
     Loan losses are charged off against the allowance for losses on loans when we believe that the loan balance or a portion of the loan balance is no longer covered by the paying capacity of the borrower based on an evaluation of available cash resources and collateral value. Recoveries of amounts previously charged off are credited to the allowance. We assess the adequacy of the allowance on a quarterly basis with adjustments made by recording a provision for losses on loans in an amount sufficient to maintain the allowance at a level we deem appropriate. While we believe the allowance was adequate at December 31, 2009, it is possible that further deterioration in the economy, devaluations of collateral held, or requirements from regulatory agencies may require us to make future provisions to the allowance. See further analysis in the “Critical Accounting Policies” previously discussed in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as well as “Note 1. Summary of Significant Accounting Policies” in the notes to consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K.
 
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     The following table sets forth the activity in allowance for losses on loans during the periods indicated:
 
Year Ended December 31,
     2009      2008 (1)      2007 (1)      2006      2005
(Dollars in thousands)
Allowance at beginning of period $   15,558 $   8,026 $   11,184 $   12,939 $   13,353
Provision 12,588 26,296 2,328 1,309 1,580
       Charge-offs:
              Commercial loans:
                     Commercial and industrial (1,313 ) (74 ) (231 ) (241 ) (505 )
                     Commercial real estate – owner occupied
(53 ) (1,699 )
                     Commercial real estate – non-owner occupied
(1,699 ) (3,054 ) (4,260 ) (2,987 ) (877 )
                     Commercial real estate – multifamily
(61 )
                     Commercial construction and land development
(3,309 ) (13,255 ) (776 )
                     Total commercial loans
(6,435 ) (18,082 ) (5,267 ) (3,228 ) (1,382 )
              Retail loans: