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Capitol Federal Financial 10-Q 2009

Documents found in this filing:

  1. 10-Q
  2. Ex-10.9
  3. Ex-31.1
  4. Ex-31.2
  5. Ex-32
  6. 10-Q
  7. 10-Q
cffn10q123108.htm
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
_________________

Form 10-Q
(Mark One)
 
þ          QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2008

                                                                                                 or

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

Commission file number:  000-25391
_________________

Capitol Federal Financial
(Exact name of registrant as specified in its charter) 
United States                                                                                          48-1212142
  (State or other jurisdiction of incorporation                                                           (I.R.S. Employer
           or organization)                                                                                         Identification No.)
 
                                                                                                           700 Kansas Avenue, Topeka, Kansas                                                                               66603
                       (Address of principal executive offices)                                                                        (Zip Code)

Registrant’s telephone number, including area code:
(785) 235-1341


         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 requirements for the past 90 days.   Yes þ    No ¨       
 
         Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “accelerated filer, large accelerated filer, and smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer    þ         Accelerated filer    ¨        Non-accelerated filer   ¨      Smaller Reporting Company   ¨
                                                                                              (do not check if a smaller
                                                                                                   reporting company)
        
 Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes  ¨    No  þ      
                                                                                                                                   
          As of January 26, 2009, there were 74,074,380 shares of Capitol Federal Financial Common Stock outstanding.




 
1

 


 
Page
Number
Item 1.  Financial Statements (Unaudited):
 
             Consolidated Balance Sheets at December 31, 2008 and September 30, 2008
3
             Consolidated Statements of Income for the three months ended
 
                  December 31, 2008 and December 31, 2007
4
             Consolidated Statement of Stockholders’ Equity for the three months ended
 
                  December 31, 2008
5
             Consolidated Statements of Cash Flows for the three months ended
 
                  December 31, 2008 and December 31, 2007
6
8
Item 2.  Management’s Discussion and Analysis of Financial Condition and
 
                  Results of Operations
11
41
48
   
PART II -- OTHER INFORMATION
 
Item 1.    Legal Proceedings
48
Item 1A. Risk Factors
48
Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds
49
49
50
Item 5.    Other Information
50
Item 6.    Exhibits
50
   
51
   
INDEX TO EXHIBITS
52
   


 
2

 

PART I -- FINANCIAL INFORMATION
Item 1. Financial Statements
CAPITOL FEDERAL FINANCIAL AND SUBSIDIARY
(Dollars in thousands except per share data and amounts)
   
December 31,
   
September 30,
 
   
2008
   
2008
 
ASSETS:
 
(Unaudited)
       
Cash and cash equivalents
  $ 143,134     $ 87,138  
Investment securities:
               
       Available-for-sale ("AFS") at market (amortized cost of $51,560 and $51,700)
    49,841       49,586  
       Held-to-maturity ("HTM") at cost (market value of $57,273 and $92,211)
    56,124       92,773  
Mortgage-related securities:
               
       AFS, at market (amortized cost of $1,442,111 and $1,491,536)
    1,466,761       1,484,055  
       HTM, at cost (market value of $720,442 and $743,764)
    709,541       750,284  
Loans receivable held-for-sale, net
    244       997  
Loans receivable, net
    5,456,569       5,320,780  
Capital stock of Federal Home Loan Bank ("FHLB"), at cost
    131,230       124,406  
Accrued interest receivable
    32,424       33,704  
Premises and equipment, net
    31,769       29,874  
Real estate owned ("REO"), net
    4,477       5,146  
Other assets
    75,210       76,506  
        TOTAL ASSETS
  $ 8,157,324     $ 8,055,249  
                 
LIABILITIES:
               
Deposits
  $ 3,867,304     $ 3,923,883  
Advances from FHLB
    2,596,964       2,447,129  
Other borrowings, net
    713,595       713,581  
Advance payments by borrowers for taxes and insurance
    19,330       53,213  
Income taxes payable
    10,985       6,554  
Deferred income tax liabilities, net
    16,588       3,223  
Accounts payable and accrued expenses
    35,123       36,450  
        Total liabilities
    7,259,889       7,184,033  
                 
STOCKHOLDERS' EQUITY:
               
Preferred stock ($0.01 par value) 50,000,000 shares authorized; none issued
    --       --  
Common stock ($0.01 par value) 450,000,000 shares authorized, 91,512,287
               
        shares issued; 74,109,081 and 74,079,868 shares outstanding
               
        as of December 31, 2008 and September 30, 2008, respectively
    915       915  
Additional paid-in capital
    448,066       445,391  
Unearned compensation, Employee Stock Ownership Plan ("ESOP")
    (9,578 )     (10,082 )
Unearned compensation, Recognition and Retention Plan ("RRP")
    (468 )     (553 )
Retained earnings
    762,490       759,375  
Accumulated other comprehensive gain (loss)
    14,263       (5,968 )
Less shares held in treasury (17,403,206 and 17,432,419 shares as of
               
       December 31, 2008 and September 30, 2008, respectively, at cost)
    (318,253 )     (317,862 )
           Total stockholders' equity
    897,435       871,216  
                 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
  $ 8,157,324     $ 8,055,249  
See accompanying notes to consolidated interim financial statements.

 
3

 

CONSOLIDATED STATEMENTS OF INCOME  (Unaudited)
(Dollars and share counts in thousands except per share data and amounts)

   
For the Three Months Ended
 
   
December 31,
 
   
2008
   
2007
 
INTEREST AND DIVIDEND INCOME:
           
Loans receivable
  $ 76,716     $ 76,263  
Mortgage-related securities
    26,402       17,127  
Investment securities
    1,326       4,130  
Capital stock of FHLB
    780       2,080  
Cash and cash equivalents
    49       1,428  
     Total interest and dividend income
    105,273       101,028  
                 
INTEREST EXPENSE:
               
Deposits
    26,785       38,033  
FHLB advances
    29,545       34,161  
Other borrowings
    7,725       2,207  
     Total interest expense
    64,055       74,401  
                 
NET INTEREST AND DIVIDEND INCOME
    41,218       26,627  
PROVISION FOR LOAN LOSSES
    549       --  
    NET INTEREST AND DIVIDEND INCOME
               
       AFTER PROVISION FOR LOAN LOSSES
    40,669       26,627  
                 
OTHER INCOME:
               
Retail fees and charges
    4,530       4,489  
Loan fees
    569       598  
Insurance commissions
    491       478  
Income from BOLI
    384       621  
Gains on securities and loans receivable, net
    24       77  
Other, net
    644       848  
     Total other income
    6,642       7,111  
                 
OTHER EXPENSES:
               
Salaries and employee benefits
    11,164       10,435  
Occupancy of premises
    3,722       3,157  
Advertising
    1,742       831  
Deposit and loan transaction fees
    1,303       1,355  
Regulatory and other services
    1,149       1,619  
Other, net
    3,107       2,054  
     Total other expenses
    22,187       19,451  
INCOME BEFORE INCOME TAX EXPENSE
    25,124       14,287  
INCOME TAX EXPENSE
    9,272       5,174  
NET INCOME
  $ 15,852     $ 9,113  
                 
Basic earnings per common share
  $ 0.22     $ 0.12  
Diluted earnings per common share
  $ 0.22     $ 0.12  
Dividends declared per public share
  $ 0.61     $ 0.50  
                 
Basic weighted average common shares
    73,063       72,956  
Diluted weighted average common shares
    73,162       73,018  
 
                 See accompanying notes to consolidated interim financial statements.

 
4

 

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(Unaudited)
(Dollars in thousands except per share data and amounts)


           
Accumulated
   
   
Additional
Unearned
Unearned
 
Other
   
 
Common
Paid-In
Compensation
Compensation
Retained
Comprehensive
Treasury
 
 
Stock
Capital
(ESOP)
(RRP)
Earnings
Gain (Loss)
Stock
Total
                 
Balance at October 1, 2008
 $       915 
 $ 445,391 
 $         (10,082)
 $           (553)
 $   759,375 
 $           (5,968)
 $ (317,862)
 $     871,216 
Comprehensive income:
               
   Net income
       
        15,852 
   
15,852 
   Changes in unrealized gains(losses) on
               
   securities available-for-sale,
             
   
   net of deferred income taxes
               
   of $12,295
         
20,231 
 
20,231 
Total comprehensive income
             
36,083 
                 
                 
ESOP activity, net
 
1,666 
504 
       
2,170 
RRP activity, net
 
         
Stock based compensation - stock options and RRP
 
92 
 
85 
     
177 
Acquisition of treasury stock
           
(859)
(859)
Stock options exercised
 
909 
       
468 
1,377 
Dividends on common stock to public
               
  stockholders ($.61 per public share)
       
(12,737)
   
(12,737)
Balance at December 31, 2008
 $       915 
 $ 448,066 
 $           (9,578)
 $           (468)
 $   762,490 
 $          14,263 
 $ (318,253)
 $       897,435 


See accompanying notes to consolidated interim financial statements.




 
5

 

CAPITOL FEDERAL FINANCIAL AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(Dollars in thousands)
   
For the Three Months Ended
 
   
December 31,
 
   
2008
   
2007
 
CASH FLOWS FROM OPERATING ACTIVITIES:
           
Net income
  $ 15,852     $ 9,113  
Adjustments to reconcile net income to net cash provided by
               
  operating activities:
               
    FHLB stock dividends
    (780 )     (2,080 )
    Provision for loan losses
    549       --  
    Originations of loans receivable held-for-sale
    (738 )     (7,631 )
    Proceeds from sales of loans receivable held-for-sale
    1,508       7,224  
    Amortization and accretion of premiums and discounts on mortgage-
               
      related securities and investment securities
    220       164  
    Depreciation and amortization of premises and equipment
    1,156       1,272  
    Common stock committed to be released for allocation - ESOP
    2,170       1,656  
    Stock based compensation - stock options and RRP
    177       216  
    Other, net
    (99     1,669  
  Changes in:
               
      Accrued interest receivable
    1,280       4,662  
      Other assets
    1,303       375  
      Income taxes payable/receivable
    5,855       6,767  
      Accounts payable and accrued expenses
    (1,327 )     (4,383 )
             Net cash provided by operating activities
    27,126       19,024  
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Proceeds from maturities or calls of investment securities AFS
    28       64,782  
Proceeds from maturities or calls of investment securities HTM
    37,400       125,108  
Purchases of investment securities HTM
    (886 )     (165,590 )
Principal collected on mortgage-related securities AFS
    49,459       44,882  
Purchases of mortgage-related securities AFS
    --       (286,168 )
Principal collected on mortgage-related securities HTM
    40,735       50,361  
Purchases of mortgage-related securities HTM
    --       (1,033 )
Proceeds from the redemption of capital stock of FHLB
    2,958       12,361  
Purchases of capital stock of FHLB
    (9,002 )     (10,000 )
Loan originations, net of principal collected
    (25,289 )     (22,892 )
Loan purchases, net of principal collected
    (112,860 )     3,232  
Net deferred fee activity
    (35 )     (111 )
Purchases of premises and equipment
    (3,088 )     (974 )
Proceeds from sales of real estate owned, net
    2,131       976  
             Net cash used in investing activities
    (18,449 )     (185,066 )

(Continued)

 
6

 


   
For the Three Months Ended
 
   
December 31,
 
   
2008
   
2007
 
CASH FLOWS FROM FINANCING ACTIVITIES:
           
Dividends paid
    (12,737 )     (10,430 )
Deposits, net of withdrawals
    (56,579 )     58,667  
Proceeds from advances/line of credit from FHLB
    312,682       200,000  
Repayments on advances/line of credit from FHLB
    (162,682 )     (200,000 )
Proceeds from repurchase agreements
    --       250,000  
Change in advance payments by borrowers for taxes and insurance
    (33,883 )     (34,112 )
Acquisitions of treasury stock
    (859 )     (7,245 )
Stock options exercised
    1,032       96  
Excess tax benefits from stock options
    345       --  
             Net cash provided by financing activities
    47,319       256,976  
                 
NET INCREASE IN CASH AND CASH EQUIVALENTS
    55,996       90,934  
CASH AND CASH EQUIVALENTS:
               
Beginning of period
    87,138       162,791  
End of period
  $ 143,134     $ 253,725  
                 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
               
      Income tax payments, net of refund
  $ 3,417     $ (1,594 )
      Interest payments, net of interest credited to deposits
  $ 36,542     $ 35,031  
                 
SUPPLEMENTAL DISCLOSURE OF NON-CASH
               
      INVESTING AND FINANCING ACTIVITIES:
               
      Loans transferred to real estate owned
  $ 1,846     $ 901  
                 
      Market value change related to fair value hedge:
               
            Interest rate swaps hedging FHLB advances
  $ --     $ (12,729 )


(Concluded)
                 See accompanying notes to consolidated interim financial statements.

 
7

 


1.   Basis of Financial Statement Presentation
The accompanying consolidated financial statements of Capitol Federal Financial (“CFFN”) and subsidiary (the “Company”) have been prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included.  These statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s 2008 Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”).  Interim results are not necessarily indicative of results for a full year.

In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting periods.  Significant estimates include the allowance for loan losses, other-than-temporary declines in the fair value of securities and other financial instruments. Actual results could differ from those estimates.  See “Item 2- Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies.”

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiary, Capitol Federal Savings Bank (the “Bank”). The Bank has a wholly owned subsidiary, Capitol Funds, Inc.  Capitol Funds, Inc. has a wholly owned subsidiary, Capitol Federal Mortgage Reinsurance Company.  All intercompany accounts and transactions have been eliminated.

2.   Earnings Per Share

   
For the Three Months Ended
 
   
December 31,
 
   
2008(1)
   
2007(2)
 
(Dollars in thousands, except per share amounts)
 
Net income
  $ 15,852     $ 9,113  
                 
Average common shares outstanding
    73,062,337       72,955,067  
Average committed ESOP shares outstanding
    548       548  
Total basic average common shares outstanding
    73,062,885       72,955,615  
                 
                 
Effect of dilutive RRP shares
    8,716       6,789  
Effect of dilutive stock options
    90,443       55,183  
                 
Total diluted average common shares outstanding
    73,162,044       73,017,587  
                 
Net earnings per share:
               
     Basic
  $ 0.22     $ 0.12  
     Diluted
  $ 0.22     $ 0.12  
 
(1) Options to purchase 25,500 shares of common stock at $43.46 per share were outstanding as of December 31, 2008, but were not included in the computation of diluted earnings per share because they were anti-dilutive for the three months ended December 31, 2008.

(2) Options to purchase 185,300 shares of common stock at prices between $33.69 per share and $38.77 per share were outstanding as of December 31, 2007, but were not included in the computation of diluted earnings per share because they were anti-dilutive for the three months ended December 31, 2007.
 


 
8

 

 

3. Fair Value Measurements
Effective October 1, 2008, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 157 “Fair Value Measurements” which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. The statement applies whenever other standards require or permit assets or liabilities to be measured at fair value.  The statement does not require new fair value measurements, but rather provides a definition and framework for measuring fair value which will result in greater consistency and comparability among financial statements prepared under GAAP. The Company’s adoption of SFAS No. 157 did not have a material impact on its financial condition or results of operations.  The following disclosures, which include certain disclosures which are generally not required in interim period financial statements, are included herein as a result of the Company’s adoption of SFAS No. 157.

The Company uses fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures. The Company did not have any liabilities that were measured at fair value at December 31, 2008.  The Company’s securities that are AFS are recorded at fair value on a recurring basis.  Additionally, from time to time, the Company may be required to record at fair value other assets or liabilities on a non-recurring basis, such as real estate owned, loans held for sale, and impaired loans. These non-recurring fair value adjustments involve the application of lower-of-cost-or-fair value accounting or write-downs of individual assets.

In accordance with SFAS No. 157, the Company groups its assets at fair value in three levels, based on the markets in which the assets are traded and the reliability of the assumptions used to determine fair value. These levels are:

 
Level 1 — Valuation is based upon quoted prices for identical instruments traded in active markets.
     
 
Level 2 — Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
     
 
Level 3 — Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect the Company’s own estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include the use of option pricing models, discounted cash flow models, and similar techniques. The results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability.
 


 
9

 

The Company bases its fair values on the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date.  SFAS No. 157 requires the Company to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

The following is a description of valuation methodologies used for assets measured at fair value on a recurring basis.

AFS Securities
The Company’s AFS securities portfolio is carried at estimated fair value on a recurring basis, with any unrealized gains and losses, net of taxes, reported as accumulated other comprehensive income/loss in stockholders' equity.  Substantially all of the securities within the AFS portfolio consist of mortgage-related securities and investment securities issued by U.S. Government sponsored enterprises or agencies.  The fair values for all of the AFS securities are obtained from independent nationally recognized pricing services. Various modeling techniques are used to determine pricing for the Company’s  mortgage-related securities and investment securities, including option pricing and discounted cash flow models. The inputs to these models may include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, benchmark securities, bids, offers and reference data.  There are some AFS securities in the AFS portfolio that have significant unobservable input requiring the independent pricing services to use some judgment in pricing the related securities.  These AFS securities are classified as Level 3.  All other AFS securities are classified as Level 2.

The following table provides the level of valuation assumption used to determine the carrying value of the Company’s assets measured at fair value on a recurring basis at December 31, 2008:

         
Quoted Prices in Active
   
Significant Other
   
Significant
 
   
Carrying
   
Markets for Identical
   
Observable Inputs
   
Unobservable Inputs
 
   
Value
   
Assets (Level 1)
   
(Level 2)
   
(Level 3)(1)
 
   
(Dollars in thousands)
 
AFS securities:
                       
 Investment securities
  $ 49,841     $ --     $ 47,922     $ 1,919  
 Mortgage-related securities
    1,466,761       --       1,466,761       --  
  
  $ 1,516,602     $ --     $ 1,514,683     $ 1,919  

(1) The Company’s Level 3 AFS securities were immaterial as of December 31, 2008 and had no material activity during the period ended December 31, 2008.

The following is a description of valuation methodologies used for significant assets measured at fair value on a non-recurring basis.

Loans Receivable
Loans which meet certain criteria are evaluated individually for impairment. A loan is considered impaired when, based upon current information and events, it is probable the Bank will be unable to collect all amounts due, including principal and interest, according to the contractual terms of the loan agreement.  Substantially all of the Bank’s impaired loans at December 31, 2008 are secured by real estate.  These impaired loans are individually assessed to determine that the carrying value of the loan is not in excess of the fair value of the collateral, less estimated selling costs. Fair value is estimated through current appraisals, real estate brokers or listing prices.  Fair values may be adjusted by management to reflect current market conditions and, as such, are classified as Level 3.  Impaired loans at December 31, 2008 were $19.5 million. Based on this evaluation, the Company established an allowance for loan losses of $842 thousand at December 31, 2008 for such impaired loans.

REO, net
REO represents real estate acquired as a result of foreclosure or by deed in lieu of foreclosure and is carried at the lower of cost or fair value less estimated selling costs.  Fair value is estimated through current appraisals, real estate brokers or listing prices.  As these properties are actively marketed, estimated fair values may be adjusted by management to reflect current market conditions and, as such, are classified as Level 3.  REO at December 31, 2008 was $4.5 million. During the quarter ending December 31, 2008, charge-offs to the allowance for loan losses related to loans that were transferred to REO were $90 thousand. Write downs related to REO that were charged to non-interest expense were $244 thousand for that same period.

 
10

 

The following table provides the level of valuation assumption used to determine the carrying value of the Company’s assets measured at fair value on a non-recurring basis at December 31, 2008:

   
Quoted Prices in Active
   
Significant Other
   
Significant
   
Markets for Identical
   
Observable Inputs
   
Unobservable Inputs
   
Assets (Level 1)
   
(Level 2)
   
(Level 3)
         
(Dollars in thousands)
     
Impaired loans
  $ --     $ --     $ 19,513  
REO, net
    --       --       4,477  
    $ --     $ --     $ 23,990  

4.  Recent Accounting Pronouncements
In January 2009, the Financial Accounting Standards Board (“FASB”) issued FASB issued Staff Position (“FSP”) Emerging Issues Task Force (“EITF”) 99-20-1, “Amendments to the Impairment Guidance of EITF Issue No. 99-20.”  FSP EITF 99-20-1 eliminates the requirement that a security holder’s best estimate of cash flows be based upon those that “a market participant” would use.  Instead, an other–than-temporary impairment (“OTTI”) should be recognized as a realized loss through earnings when it is probable there has been an adverse change in the security holder’s estimated cash flows from previous projections.  This treatment is consistent with the impairment model in SFAS No. 115 “Accounting for Certain Investments in Debt and Equity Securities.”  FSP EITF 99-20-1 is effective for the Company for the period ending December 31, 2008, and did not have a material impact on its financial condition or results of operations.


The Company and its wholly-owned subsidiary, the Bank, may from time to time make written or oral “forward-looking statements,” including statements contained in the Company’s filings with the SEC.  These forward-looking statements may be included in this Quarterly Report on Form 10-Q and the exhibits attached to it, in the Company’s reports to stockholders and in other communications by the Company, which are made in good faith by us pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements include statements about our beliefs, plans, objectives, goals, expectations, anticipations, estimates and intentions, that are subject to significant risks and uncertainties, and are subject to change based on various factors, some of which are beyond our control.  The words “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan” and similar expressions are intended to identify forward-looking statements. The following factors, among others, could cause our future results to differ materially from the plans, objectives, goals, expectations, anticipations, estimates and intentions expressed in the forward-looking statements:

·  
our ability to continue to maintain overhead costs at reasonable levels;
·  
our ability to continue to originate a significant volume of one- to four-family mortgage loans in our market area;
·  
our ability to acquire funds from or invest funds in wholesale or secondary markets;
·  
the future earnings and capital levels of the Bank, which could affect the ability of the Company to pay dividends in accordance with its dividend policies;
·  
fluctuations in deposit flows, loan demand, and/or real estate values, which may adversely affect our business;
·  
the credit risks of lending and investing activities, including changes in the level and direction of loan delinquencies and write-offs and changes in estimates of the adequacy of the allowance for loan losses;
·  
the strength of the U.S. economy in general and the strength of the local economies in which we conduct operations;
·  
the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System;
·  
the effects of, and changes in, foreign and military policies of the United States Government;
·  
inflation, interest rate, market and monetary fluctuations;
·  
our ability to access cost-effective funding;

 
11

 

·  
the timely development of and acceptance of our new products and services and the perceived overall value of these products and services by users, including the features, pricing and quality compared to competitors’ products and services;
·  
the willingness of users to substitute competitors’ products and services for our products and services;
·  
our success in gaining regulatory approval of our products and services and branching locations, when required;
·  
the impact of changes in financial services laws and regulations, including laws concerning taxes, banking securities and insurance and the impact of other governmental initiatives affecting the financial services industry;
·  
implementing business initiatives may be more difficult or expensive than anticipated;
·  
technological changes;
·  
acquisitions and dispositions;
·  
changes in consumer spending and saving habits; and
·  
our success at managing the risks involved in our business

This list of important factors is not all inclusive.  We do not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of the Company or the Bank.

As used in this Form 10-Q, unless we specify otherwise, “the Company,” “we,” “us,” and “our” refer to Capitol Federal Financial, a United States corporation. “Capitol Federal Savings,” and “the Bank,” refer to Capitol Federal Savings Bank, a federal savings bank and the wholly-owned subsidiary of Capitol Federal Financial. “MHC” refers to Capitol Federal Savings Bank MHC, a mutual holding company and majority-owner of Capitol Federal Financial.

The following discussion and analysis is intended to assist in understanding the financial condition and results of operations of the Company.  It should be read in conjunction with the consolidated financial statements and notes presented in this report.  The discussion includes comments relating to the Bank, since the Bank is wholly owned by the Company and comprises the majority of its assets and is the principal source of income for the Company.  This discussion and analysis should be read in conjunction with the management discussion and analysis included in the Company’s 2008 Annual Report on Form 10-K filed with the SEC.


Executive Summary

The following summary should be read in conjunction with our Management’s Discussion and Analysis of Financial Condition and Results of Operations in its entirety.

Our principal business consists of attracting deposits from the general public and investing those funds primarily in permanent loans secured by first mortgages on owner-occupied, one- to four-family residences.  We also originate consumer loans, loans secured by first mortgages on non-owner-occupied one- to four-family residences, permanent and construction loans secured by one- to four-family residences, commercial real estate loans, and multi-family real estate loans.  While our primary business is the origination of one- to four-family mortgage loans funded through retail deposits, we also purchase whole loans and invest in certain investment and mortgage-related securities using FHLB advances and repurchase agreements as additional funding sources.

The Company is significantly affected by prevailing economic conditions including federal monetary and fiscal policies and federal regulation of financial institutions.  Deposit balances are influenced by a number of factors including interest rates paid on competing personal investment products, the level of personal income, and the personal rate of savings within our market areas.  Lending activities are influenced by the demand for housing and other loans, changing loan underwriting guidelines, as well as interest rate pricing competition from other lending institutions.  The primary sources of funds for lending activities include deposits, loan repayments, investment income, borrowings, and funds provided from operations.

The Company’s results of operations are primarily dependent on net interest income, which is the difference between the interest earned on loans, mortgage-related securities, investment securities, and cash, and the interest paid on deposits and borrowings.  On a weekly basis, management reviews deposit flows, loan demand, cash levels, and changes in several market rates to assess all pricing strategies.  We generally price our loan and deposit products based upon an analysis of our competition and changes in market rates.  The Bank generally prices its first mortgage loan products based upon prices available in the secondary market.  Generally, deposit pricing is based upon a survey of peers in the Bank’s market areas, and the need to attract funding and retain maturing deposits.  The

 
12

 

majority of our loans are fixed-rate products with maturities up to 30 years, while the majority of our deposits have maturity or reprice dates of less than two years.

During the first quarter of fiscal year 2009, the financial services industry and the economy as a whole continued to experience turmoil in the wake of steep declines in credit and asset quality due largely to subprime lending, real estate devaluations, and an increase in unemployment.  As a result of a relatively stable economy and real estate market valuations in the Bank’s market areas, along with the Bank’s traditional lending practices, the Bank has not experienced the adverse operational impacts felt by many financial institutions.  However, we are not immune to negative consequences arising from the overall economic weakness and sharp downturn in the housing industry nationally.  We have experienced a moderate increase in the balance of our non-performing loans, but the balance of our non-performing loans continue to remain at low levels relative to the size of our loan portfolio.  We continue to closely monitor the local and national real estate markets and other factors related to risks inherent in our loan portfolio.  Based on our evaluation of our loan quality, real estate markets, the overall economic environment, and the increase in and composition of our delinquencies and non-performing loans, management determined a $549 thousand provision for loan losses was appropriate for the quarter ended December 31, 2008.

During late December 2008 and continuing into the second quarter of fiscal year 2009, mortgage rates declined to record lows in response to the Federal Reserve’s purchases of U.S. agency debt and mortgage-backed securities.  The decline in mortgage rates has spurred an increased demand for our loan modification program.  Our loan modification program allows existing loan customers, whose loans have not been sold to third parties and who have been current on their contractual loan payments for the previous 12 months, the opportunity to modify their original loan terms to current loan terms being offered.  Since the Federal Reserve lowered rates in December, approximately $520.0 million of loan modification requests have been received, through January 2009.  The weighted average interest rate reduction for these loans is approximately 95 basis points.  During the same time period, the Bank received approximately $90.0 million of refinancing requests.  The volume and magnitude of these loan modifications and refinances will likely have a negative impact on our net interest margin in future quarters as a result of loans repricing to lower market interest rates.

The Bank continues to maintain access to liquidity in excess of forecasted needs by diversifying its funding sources and maintaining a strong retail oriented deposit portfolio.  We believe the turmoil in the credit and equity markets has made deposit products in strong financial institutions desirable for many customers.  In addition, the investments of the Bank are government-agency backed securities which are highly liquid and have not been credit impaired and are therefore available as collateral for additional borrowings or for sale if the need or unforeseen conditions warrant.  See additional discussion regarding liquidity in the section entitled “Liquidity and Capital Resources.”

The Bank opened one new branch in our Wichita market area in October 2008.  The Bank has plans to open two additional branches in fiscal year 2009 located in our market area in south Johnson County, Kansas.  The Bank has preliminary plans to open three additional branches in our market areas in Kansas City and Wichita by September 30, 2010.

Available Information

Company and financial information, including press releases, Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports can be obtained free of charge from our investor relations website, http://ir.capfed.com.  SEC filings are available on our website immediately after they are electronically filed with or furnished to the SEC, and are also available on the SEC’s website at www.sec.gov.


Critical Accounting Policies

Our most critical accounting policies are the methodologies used to determine the allowance for loan losses and other-than-temporary declines in the value of securities.  These policies are important to the presentation of our financial condition and results of operations, involve a high degree of complexity, and require management to make difficult and subjective judgments that may require assumptions or estimates about highly uncertain matters.  The use of different judgments, assumptions, and estimates could cause reported results to differ materially.  These critical accounting policies and their application are reviewed at least annually by our audit committee.  The following is a description of our critical accounting policies and an explanation of the methods and assumptions underlying their application.

 
13

 

 
All loans that are not impaired, as defined in SFAS No. 114, “Accounting by Creditors for Impairment of a Loan, an Amendment of FASB Statements No. 5 and 15” and No. 118 “Accounting by Creditors for Impairment of a Loan – Income Recognition and Disclosures, an Amendment of FASB Statement No. 114”, are included in a formula analysis, as permitted by SFAS No. 5, “Accounting for Contingencies.”   Management uses the formula analysis to evaluate the adequacy of the general valuation allowance.  Each quarter, the loan portfolio is segregated into categories in the formula analysis based upon certain risk characteristics such as loan type (one- to four-family, multi-family, etc.), interest payments (fixed-rate, adjustable-rate), loan source (originated or purchased), and payment status (i.e. current or number of days delinquent).  Impaired loans and loans with known potential losses are excluded from the analysis and evaluated for specific valuation allowances.  Potential loss factors are assigned to each category in the analysis based on management’s assessment of the potential risk inherent in each category.  The greater the risks associated with a particular category, the higher the loss factor.  Loss factors increase as individual loans become classified, delinquent, the foreclosure process begins or as economic conditions warrant.  The loss factors are periodically reviewed by management for appropriateness giving consideration to historical loss experience, delinquency and non-performing loan trends, the results of foreclosed property transactions and the status of the local and national economies and housing markets, in order to ascertain that the loss factors cover probable and estimable losses inherent in the loan portfolio.  Management’s evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with a specific problem loan or portfolio segments.
 
The amounts actually observed with respect to these losses can vary significantly from the estimated amounts. Our methodology permits adjustments to any loss factor used in the computation of the formula analysis in the event that, in management’s judgment, significant factors which affect the collectibility of the portfolio or any category of the loan portfolio, as of the evaluation date, are not reflected in the current loss factors.  By assessing the estimated losses inherent in our loan portfolio on a quarterly basis, we can adjust specific and inherent loss estimates based upon more current information.
 
Specific valuation allowances are established in connection with individual loan reviews of specifically identified problem loans and the asset classification process, including the procedures for impairment recognition under SFAS No. 114 and SFAS No. 118.  Such evaluations include a review of loans on which full collectibility is not reasonably assured, evaluation of the estimated fair value of the underlying collateral, and other factors that determine risk exposure to arrive at an adequate specific valuation allowance amount.  Loans with an outstanding balance of $1.5 million or more are reviewed annually if secured by property in one of the following categories:  multi-family (five or more units) property, unimproved land, other improved commercial property, acquisition and development of land projects, developed building lots, office building, single-use building, or retail building.  Specific valuation allowances are established if the review determines a quantifiable impairment.  If a loan is not impaired, it is included in the formula analysis.
 
Management reviews the appropriateness of the allowance for loan losses based upon its evaluation of then-existing economic and business conditions affecting our key lending areas.  Other conditions management considers in determining the appropriateness of the allowance for loan losses include, but are not limited to, changes in our underwriting standards, credit quality trends (including changes in the balance and characteristics of non-performing loans expected to result from existing economic conditions), trends in collateral values, loan volumes and concentrations, and recent loss experience in particular segments of the portfolio as of the balance sheet date.  Management also measures the impact these conditions were believed to have had on the collectibility of impaired loans.
 
Assessing the adequacy of the allowance for loan losses is inherently subjective.  Actual results could differ from our estimates as a result of changes in economic or market conditions.  Changes in estimates could result in a material change in the allowance for loan losses.  In the opinion of management, the allowance for loan losses, when taken as a whole, is adequate to absorb reasonable estimated losses inherent in our loan portfolio.  However, future adjustments may be necessary if portfolio performance or economic or market conditions differ substantially from the conditions that existed at the time of the initial determinations.
 
 

 
14

 

the security has had a market value less than the cost basis, the cause(s), severity of the loss, the intent and ability of the Bank to hold the security for a period of time sufficient for a substantial recovery of its investment, expectation of an anticipated recovery period, recent events specific to the issuer or industry including the issuer’s financial condition and current ability to make future payments in a timely manner, external credit ratings and recent downgrades in such ratings.  If management deems the decline to be other-than-temporary, the carrying value of the security is adjusted and an impairment amount is recorded in the consolidated statements of income.  At December 31, 2008, all securities were rated investment grade, and there was a market for the securities.  At December 31, 2008, no securities had been identified as other-than-temporarily impaired.
 


Financial Condition

Total assets increased from $8.06 billion at September 30, 2008 to $8.16 billion at December 31, 2008.  The $102.1 million increase in assets was primarily attributed to a $135.8 million increase in the loan portfolio as a result of loan purchases during the quarter.  Total liabilities increased from $7.18 billion at September 30, 2008 to $7.26 billion at December 31, 2008.  The $75.9 million increase in liabilities was primarily a result of an increase in FHLB advances of $149.8 million, partially offset by a decrease in deposits of $56.6 million.  The additional FHLB advance in the current quarter was taken in anticipation of maturing advances in January 2009.  The new advance was taken prior to the maturity of the other advances due to favorable rate and term offerings available at the time of the new advance.  Stockholders’ equity increased $26.2 million to $897.4 million at December 31, 2008, from $871.2 million at September 30, 2008.  A large component of this increase was related to an increase in Accumulated other comprehensive gain (loss) due to an increase in the market value of AFS securities at December 31, 2008.

The following table presents selected balance sheet data for the Company at the dates indicated.

   
Balance at
 
   
December 31,
   
September 30,
   
June 30,
   
March 31,
   
December 31,
 
   
2008
   
2008
   
2008
   
2008
   
2007
 
   
(Dollars in thousands, except per share amounts)
 
Selected Balance Sheet Data:
                             
Total assets
  $ 8,157,324     $ 8,055,249     $ 7,892,137     $ 8,034,662     $ 7,945,586  
Cash and cash equivalents
    143,134       87,138       86,437       264,501       253,725  
Investment securities
    105,965       142,359       144,346       88,597       500,045  
Mortgage-related securities
    2,176,302       2,234,339       2,066,685       2,076,766       1,608,897  
Loans receivable, net
    5,456,569       5,320,780       5,326,061       5,292,866       5,310,296  
Capital stock of FHLB
    131,230       124,406       129,172       129,170       139,380  
Deposits
    3,867,304       3,923,883       3,961,543       4,020,966       3,981,449  
Advances from FHLB
    2,596,964       2,447,129       2,547,294       2,547,588       2,746,532  
Other borrowings
    713,595       713,581       453,566       453,552       303,538  
Stockholders' equity
    897,435       871,216       863,906       869,106       862,579  
Accumulated other comprehensive gain (loss)
    14,263       (5,968 )     (5,202 )     6,215       3,165  
Equity to total assets at end of  period
    11.00 %     10.82 %     10.95 %     10.82 %     10.86 %
Book value per share
  $ 12.27     $ 11.93     $ 11.84     $ 11.92     $ 11.84  

 
Loans Receivable. The loan portfolio increased $135.8 million from $5.32 billion at September 30, 2008 to $5.46 billion at December 31, 2008.  The increase was primarily a result of $146.1 million of loan purchases during the quarter.  Loans purchased from nationwide lenders represented 15% of the loan portfolio at December 31, 2008 compared to 14% at September 30, 2008.  As of December 31, 2008, the average balance of a purchased mortgage loan was approximately $350 thousand while the average balance of an originated mortgage loan was approximately $120 thousand.
 
Included in the loan portfolio at December 31, 2008 were $325.6 million of interest-only loans, which were primarily purchased from nationwide lenders during fiscal year 2005.  These loans do not typically require principal payments during their initial term, and have initial interest-only terms of either five or ten years.  At December 31, 2008, $317.0 million, or 97%, of these loans were still in their interest-only payment term.  As of December 31,
 

 
15

 

2008, $144.7 million will begin to amortize principal within two years, $22.4 million will begin amortizing principal within two-to-five years, and the remaining $149.9 million will begin to amortize principal within five-to-ten years.  Loans of this type generally are considered to be of greater risk to the lender because of the possibility that the borrower may default once principal payments are required.  The loans had an average credit score of 737 and an average LTV ratio of 80% or less at the time of purchase.  The Bank has not purchased any interest-only loans since 2006.
 
The following table presents loan origination, refinance and purchase activity for the periods indicated.  Loan originations, purchases and refinances are reported together.  The fixed-rate one- to four-family loans less than or equal to 15 years have an original maturity at origination of less than or equal to 15 years, while fixed-rate one- to four-family loans greater than 15 years have an original maturity at origination of greater than 15 years.  The adjustable-rate one- to four-family loans less than or equal to 36 months have a term to first reset of less than or equal to 36 months at origination and adjustable-rate one- to four-family loans greater than 36 months have a term to first reset of greater than 36 months at origination.

   
For the Three Months Ended
   
For the Three Months Ended
 
   
December 31, 2008
   
December 31, 2007
 
   
Amount
   
Rate
   
% of Total
   
Amount
   
Rate
   
% of Total
 
Fixed-Rate:
 
(Dollars in thousands)
 
   One- to four-family
                                   
      <= 15 years
  $ 28,017       5.47 %     8.98 %   $ 26,614       5.77 %     12.89 %
      > 15 years
    107,145       5.79       34.35       110,121       6.09       53.34  
   Other real estate
    5,965       5.88       1.91       --       --       --  
   Consumer
    3,284       7.59       1.05       6,696       8.42       3.24  
    Total fixed-rate
    144,411       5.77       46.29       143,431       6.14       69.47  
                                                 
Adjustable-Rate:
                                               
   One- to four-family
                                               
      <= 36 months
    88,076       5.00       28.24       9,740       5.54       4.72  
      > 36 months
    55,922       5.32       17.93       32,639       5.85       15.81  
   Consumer
    23,503       5.09       7.54       20,655       8.31       10.00  
    Total adjustable-rate
    167,501       5.12       53.71       63,034       6.61       30.53  
                                                 
Total originations, refinances and purchases
  $ 311,912       5.42 %     100.00 %   $ 206,465       6.29 %     100.00 %
                                                 
Purchased loans included above:
                                               
  Fixed-rate
  $ 14,005       5.76 %           $ 12,086       6.20 %        
  Adjustable-rate
  $ 132,064       5.09 %           $ 19,780       5.85 %        

During the three months ended December 31, 2008, the rate on the Bank’s 30-year fixed-rate one- to four-family loans, with no points paid by the borrower, were approximately 260 basis points above the average 10-year Treasury rate, while the rate on the Bank’s 15-year fixed-rate one- to four-family loans were approximately 230 basis points above the average 10-year Treasury rate.  The Bank generally prices its first mortgage loan products based upon prices available in the secondary market.
 


 
16

 


The following table summarizes the activity in the loan portfolio for the periods indicated, excluding changes in loans in process, deferred fees and allowance for loan losses.

   
For the Three Months Ended
 
   
December 31, 2008
   
September 30, 2008
   
June 30, 2008
   
March 31, 2008
 
   
Amount
   
Rate
   
Amount
   
Rate
   
Amount
   
Rate
   
Amount
   
Rate
 
   
(Dollars in thousands)
 
Beginning balance
  $ 5,379,845       5.66 %   $ 5,389,901       5.63 %   $ 5,352,278       5.66 %   $ 5,366,186       5.71 %
Originations and refinances:
                                                               
  Fixed
    130,406       5.77       140,565       6.08       213,098       5.72       167,003       5.67  
  Adjustable
    35,437       5.23       45,333       5.69       47,641       5.82       32,596       6.24  
Purchases:
                                                               
  Fixed
    14,005       5.76       7,309       6.12       18,209       5.51       10,191       5.71  
  Adjustable
    132,064       5.09       17,225       5.76       14,509       5.51       20,322       5.51  
Repayments
    (183,532 )             (216,090 )             (254,784 )             (242,391 )        
Other (1)
    (1,873 )             (4,398 )             (1,050 )             (1,629 )        
Ending balance
  $ 5,506,352       5.63 %   $ 5,379,845       5.66 %   $ 5,389,901       5.63 %   $ 5,352,278       5.66 %


(1) “Other” consists of transfers to REO and net fees advanced.
 

 


 
17

 


 
The following table presents the Company’s loan portfolio at the dates indicated.
 
   
December 31, 2008
   
September 30, 2008
 
   
Amount
   
Average Rate
   
% of Total
   
Amount
   
Average Rate
   
% of Total
 
   
(Dollars in thousands)
 
Real Estate Loans
                                   
     One- to four-family
  $ 5,154,113       5.60 %     93.60 %   $ 5,026,358       5.61 %     93.43 %
     Multi-family and commercial
    61,353       6.38       1.12       56,081       6.44       1.04  
     Construction and development
    76,601       5.59       1.39       85,178       5.66       1.58  
          Total real estate loans
    5,292,067       5.61       96.11       5,167,617       5.62       96.05  
                                                 
Consumer Loans
                                               
     Savings loans
    4,497       5.79       0.08       4,634       5.95       0.09  
     Automobile
    3,307       6.97       0.06       3,484       7.00       0.07  
     Home equity
    205,409       5.97       3.73       202,956       6.53       3.77  
     Other
    1,072       7.74       0.02       1,154       7.13       0.02  
          Total consumer loans
    214,285       5.99       3.89       212,228       6.52       3.95  
Total loans receivable
    5,506,352       5.63 %     100.00 %     5,379,845       5.66 %     100.00 %
                                                 
Less:
                                               
     Loans in process
    33,593                       43,186                  
     Deferred fees and discounts
    10,053                       10,088                  
     Allowance for loan losses
    6,137                       5,791                  
          Total loans receivable, net
  $ 5,456,569                     $ 5,320,780                  

 
Lending Practices and Underwriting Standards

The Bank’s primary lending activity is the origination of loans and the purchase of loans from a select group of correspondent lenders.  These loans are generally secured by first mortgages on owner-occupied, one- to four-family residences in the Bank’s primary market areas and select market areas in Missouri.  The Bank also makes consumer loans, construction loans secured by residential properties, commercial properties and multi-family real estate loans secured by multi-family dwellings or commercial properties.  Additional lending volume has been generated by purchasing whole one- to four-family mortgage loans from nationwide lenders.  By purchasing loans from nationwide lenders, the Bank is able to attain some geographic diversification and mitigate credit concentration risks in its loan portfolio, and to help mitigate the Bank’s interest rate risk exposure because the purchased loans are predominately adjustable-rate or 15-year fixed-rate loans.

The Bank’s one- to four-family loans are primarily fully amortizing fixed- or adjustable-rate loans with contractual maturities of up to 30 years, except for interest-only loans which require the payment of interest during the interest-only period, all with payments due monthly.  Our one- to four- family loans are generally not assumable and do not contain prepayment penalties.  A “due on sale” clause, allowing the Bank to declare the unpaid principal balance due and payable upon the sale of the secured property, is generally included in the security instrument.

Current adjustable-rate one- to four-family loans originated by the Bank generally provide for a specified rate limit or cap on the periodic adjustment to the interest rate, as well as a specified maximum lifetime cap and minimum rate, or floor.  As a consequence of using caps, the interest rates on these loans may not be as rate sensitive as our cost of funds. Negative amortization of principal is not allowed.  Borrowers are qualified based on the principal, interest, taxes and insurance payments at the initial rate for three, five and seven year adjustable-rate mortgage (“ARM”) loans.  After the initial three, five or seven year period, the interest rate is repriced annually and the new principal and interest payment is based on the new interest rate, remaining unpaid principal balance and term of the

 
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ARM loan.  Our ARM loans are not automatically convertible into fixed-rate loans; however, we do allow borrowers to pay a modification fee to convert an ARM loan to a fixed-rate loan.  ARM loans can pose different credit risks than fixed-rate loans, primarily because as interest rates rise, the borrower’s payment also rises, increasing the potential for default.  This specific risk type is known as repricing risk.

During 2008, the Bank discontinued offering an interest-only ARM product, but holds in its portfolio originated and purchased interest-only ARM loans.  The product was discontinued to reduce future credit risk exposure.  At the time of origination, these loans did not require principal payments for a period of up to ten years.  Borrowers were qualified based on a fully amortizing payment at the initial loan rate.  The Bank was more restrictive on debt-to-income ratios and credit scores on interest-only ARM loans than on other ARM loans to offset the potential risk of payment shock at the time the loan rate adjusts and/or the principal and interest payments begin.   At December 31, 2008, 6% of our loan portfolio consisted of non-amortizing interest-only ARM loans.  The majority of these loans were purchased from nationwide lenders during fiscal year 2005.  These loans had an initial interest-only term of either five or ten years, with approximately equal distribution between the two terms.

One- to four-family loans are generally underwritten using an automated underwriting system developed by a third party.  The system’s components closely resemble the Bank’s manual underwriting standards which are generally in accordance with Federal Home Loan Mortgage Corporation (“FHLMC”) and Federal National Mortgage Association (“FNMA”) underwriting guidelines.  The automated underwriting system analyzes the applicant’s data, with emphasis on credit history, employment and income history, qualifying ratios reflecting the applicant’s ability to repay, asset reserves, and loan-to-value ratio.  Loans that do not meet the automated underwriting standards are referred to a staff underwriter for manual underwriting.  Full documentation to support the applicant’s credit, income, and sufficient funds to cover all applicable fees and reserves at closing are required on all loans.  Properties securing one- to four-family loans are appraised by either staff appraisers or fee appraisers, both of which are independent of the loan origination function and have been approved by the board of directors.

For loans with an LTV ratio in excess of 80% at the time of origination, private mortgage insurance is required in order to reduce the Bank’s loss exposure to less than 80% of the appraised value or the purchase price of the property.  The Bank will lend up to 97% of the lesser of the appraised value or purchase price for one- to four-family loans provided the Bank is able to obtain private mortgage insurance.

The underwriting standards of the lenders from whom the Bank purchases loans are generally similar to the Bank’s internal underwriting standards.  “No Doc” or “Stated Income, Stated Assets” loans are not permitted.  Lenders are required to fully document all data sources for each application.  Management believes these requirements reduce the credit risk associated with these loans.  Before committing to purchase a pool of loans from a nationwide lender, the Bank’s Chief Lending Officer or Secondary Marketing Manager reviews specific criteria such as loan amount, credit scores, LTV ratios, geographic location, and debt ratios of each loan in the pool.  If the specific criteria do not meet the Bank’s underwriting standards and compensating factors are not sufficient, then a loan will be removed from the pool.  Once the review of the specific criteria is complete and loans not meeting the Bank’s standards are removed from the pool, changes are sent back to the lender for acceptance and pricing.  Before the pool is funded, an approved Bank underwriter reviews at least 25% of the loan files and the supporting documentation in the pool.  Our standard contractual agreement with the seller includes recourse options for any breach of representation or warranty with the respect to the loans purchased.

The underwriting of loans purchased through correspondent lenders is generally performed by a third party underwriter who is under contract to use a product description supplied by the Bank that is specific to each correspondent.  The products offered by the correspondents are at least as restrictive as the Bank’s own internal underwriting standards.  Correspondent lenders are located within the metropolitan Kansas City market area and select market areas in Missouri.  The Bank purchases approved loans and the related servicing rights, on a loan-by-loan basis.

In an effort to offset the impact of repayments and to retain our customers, the Bank offers existing loan customers whose loans have not been sold to third parties the opportunity to modify their original loan terms to new loan terms generally consistent with those currently being offered.  This is a convenient tool for customers who may have considered refinancing from an ARM loan to a fixed-rate loan, would like to reduce their term, or take advantage of

 
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lower rates associated with current market rates.  The program helps ensure the Bank maintains the relationship with the customer and significantly reduces the amount of effort required for customers to obtain current market pricing and terms without having to refinance their loans.  The Bank charges a fee for this service generally comparable to fees charged on new loans.  The Bank does not solicit customers for this program, but considers it a valuable opportunity to retain customers who, due to our strict initial underwriting, could likely obtain similar financing elsewhere.

The Bank also originates construction-to-permanent loans primarily secured by one- to four-family residential real estate.  Presently, all of the one- to four-family construction loans are secured by property located within the Bank’s market areas.  Construction loans are obtained primarily by homeowners who will occupy the property when construction is complete.  The Bank is also a participant with five other banking institutions on a construction loan secured by a retail shopping center in Kansas with two major retailers.  Construction loans to builders for speculative purposes are not permitted.  The application process includes submission of complete plans, specifications, and costs of the project to be constructed.  These items are used as a basis to determine the appraised value of the subject property.  All construction loans are manually underwritten using the Bank’s internal underwriting standards.  The construction and permanent loans are closed at the same time allowing the borrower to secure the interest rate at the beginning of the construction period and throughout the permanent loan.  Construction draw requests and the supporting documentation are reviewed and approved by management.  The Bank also performs regular documented inspections of the construction project to ensure the funds are being used for the intended purpose and the project is being completed according to the plans and specifications provided.

The Bank offers a variety of secured consumer loans, including home equity loans and lines of credit, home improvement loans, auto loans, and loans secured by savings deposits.  The Bank also originates a very limited amount of unsecured loans.  The Bank does not originate any consumer loans on an indirect basis, such as contracts purchased from retailers of goods or services which have extended credit to their customers.  All consumer loans are originated in the Bank’s market areas.  Home equity loans may be originated in amounts, together with the amount of the existing first mortgage, of up to 95% of the value of the property securing the loan.  In order to minimize risk of loss, home equity loans that are greater than 80% of the value of the property, when combined with the first mortgage, require private mortgage insurance.  The term-to-maturity of home equity and home improvement loans may be up to 20 years.  Other home equity lines of credit have no stated term-to-maturity and require a payment of 1.5% of the outstanding loan balance per month. Interest-only home equity lines of credit have a maximum term of 12 months, monthly payments of accrued interest, and a balloon payment at maturity.  Repaid principal may be re-advanced at any time, not to exceed the original credit limit of the loan.  Other consumer loan terms vary according to the type of collateral and the length of the contract.  The majority of the consumer loan portfolio is comprised of home equity lines of credit, which have interest rates that can adjust monthly based upon changes in the prime rate, to a maximum of 18%.

The underwriting standards for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of their ability to meet existing obligations and payments on the proposed loan. Although creditworthiness of the applicant is a primary consideration, the underwriting process also includes a comparison of the value of the security in relation to the proposed loan amount.

Consumer loans generally have shorter terms to maturity or reprice more frequently, which reduces our exposure to changes in interest rates, and usually carry higher rates of interest than do one- to four-family mortgage loans.  However, consumer loans may entail greater risk than do one- to four-family mortgage loans, particularly in the case of consumer loans that are secured by rapidly depreciable assets, such as automobiles.  Management believes that offering consumer loan products helps to expand and create stronger ties to our existing customer base by increasing the number of customer relationships and providing cross-marketing opportunities.

The Bank’s multi-family and commercial real estate loans are secured primarily by multi-family dwellings and small commercial buildings generally located in the Bank’s market areas.  These loans are granted based on the income producing potential of the property and the financial strength of the borrower.  LTV ratios on multi-family and commercial real estate loans usually do not exceed 80% of the appraised value of the property securing the loans.  The net operating income, which is the income derived from the operation of the property less all operating expenses, must be sufficient to cover the payments related to the outstanding debt at the time of origination.  The Bank generally requires personal guarantees of the borrowers covering a portion of the debt in addition to the

 
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security property as collateral for these loans.  The Bank also generally requires an assignment of rents or leases in order to be assured that the cash flow from the project will be used to repay the debt.  Appraisals on properties securing these loans are performed by independent state certified fee appraisers approved by the board of directors.  Our multi-family and commercial real estate loans are originated with either a fixed or adjustable interest rate.  The interest rate on adjustable-rate loans is based on a variety of indices, generally determined through negotiation with the borrower.  While maximum maturities may extend to 30 years, these loans frequently have shorter maturities and may not be fully amortizing, requiring balloon payments of unamortized principal at maturity.

Our multi-family and commercial real estate loans are generally large dollar loans and involve a greater degree of credit risk than one- to four-family mortgage loans.  Such loans typically involve large balances to single borrowers or groups of related borrowers.  Because payments on multi-family and commercial real estate loans are often dependent on the successful operation or management of the properties, repayment of such loans may be subject to adverse conditions in the real estate market or the economy.  If the cash flow from the project is reduced, or if leases are not obtained or renewed, the borrower’s ability to repay the loan may be impaired.  See “Asset Quality - Non-performing Loans.”

All originated loans are generated by our own employees.  Loans over $500 thousand must be underwritten by two Class V underwriters, which is the highest class of underwriter.  Any loan greater than $750 thousand must be approved by the Asset and Liability Management Committee (“ALCO”) and loans over $1.5 million must be approved by the board of directors.  For loans requiring ALCO and/or board of directors’ approval, lending management is responsible for presenting to the ALCO and/or board of directors information about the creditworthiness of the borrower and the estimated value of the subject property.  Information pertaining to the creditworthiness of the borrower generally consists of a summary of the borrower’s credit history, employment stability, sources of income, assets, net worth, and debt ratios.  The estimated value of the property must be supported by an independent appraisal report prepared in accordance with our appraisal policy.

Asset Quality
 
Historically, the Bank’s underwriting guidelines have provided the Bank with loans of high quality and generally low delinquencies and low levels of non-performing assets compared to national levels.  Of particular importance is the complete documentation required for each loan the Bank originates and purchases.  This allows the Bank to make an informed credit decision based upon a thorough assessment of the borrower’s ability to repay the loan compared to underwriting methodologies that do not require full documentation.

The following matrix shows the balance of one-to-four family mortgage loans cross-referenced by LTV ratio and credit score.  The LTV ratios used in the matrix were based on the current loan balance and the lesser of the purchase price or the most recent bank appraisal available.  Credit scores were updated in January 2008 for loans originated by the Bank and purchased loans.  Credit scores were updated again for the majority of our purchased loans as of August 2008.  Management will continue to update credit scores as deemed necessary based upon economic conditions.  Per the matrix, the greatest concentration of loans fall into the “751 and above” credit score category and have a LTV ratio of less than 70%.  The loans falling into the “less than 660” credit score category and having LTV ratios of more than 80% comprise the lowest concentration.
 

 
Credit Score
 
 
Less than 660
 
661 to 700
 
701 to 750
 
751 and above
 
Total
LTV ratio
Amount
% of total
   
Amount
% of total
   
Amount
% of total
   
Amount
% of total
   
Amount
% of total
 
 
(Dollars in thousands)
 
Less than 70%
 $              135,886
2.6
%
 
 $        155,796
3.0
%
 
 $           450,170
8.7
%
 
 $          1,824,343
35.4
%
 
 $        2,566,195
49.8
%
70% to 80%
                 109,886
2.1
   
           134,025
2.6
   
              397,071
7.7
   
             1,162,127
22.6
   
           1,803,109
35.0
 
More than 80%
                   75,304
1.5
   
             90,077
1.8
   
              225,615
4.4
   
                393,813
7.6
   
              784,809
15.2
 
Total
 $              321,076
6.2
%