HF Financial (HFFC)

Interest Rate Risk Management

The Company’s net income is largely dependent on its net interest income.  Net interest income is susceptible to interest rate risk to the degree that interest-bearing liabilities with short- and medium-term maturities mature or reprice more rapidly than its interest-earning assets.  When interest-bearing liabilities mature or reprice more quickly than interest-earning assets in a given period, a significant increase in market rates of interest could adversely affect net interest income.  Similarly, when interest-earning assets mature or reprice more quickly than interest-bearing liabilities, falling interest rates could result in a decrease in net income.

In an attempt to manage its exposure to change in interest rates, management monitors the Company’s interest rate risk.  The Asset-Liability Committee meets periodically to review the Company’s interest rate risk position and profitability, and to recommend adjustments for consideration by executive management. Management also reviews the Bank’s securities portfolio, formulates investment strategies, and oversees the timing and implementation of transactions to assure attainment of the Board’s objectives in the most effective manner.  In managing market risk and the asset/liability mix, the Bank has placed its emphasis on developing a portfolio in which, to the extent practicable, assets and liabilities reprice within similar periods.  Notwithstanding the Company’s interest rate risk management activities, the potential for changing interest rates is an uncertainty that can have an adverse effect on net income.  The Company does not currently engage in trading activities or use derivative instruments to control interest rate risk although it may in the future, if necessary, to manage interest rate risk.

In adjusting the Company’s asset/liability position, management attempts to manage the Company’s interest rate risk while enhancing net interest margins.  At times, depending on the level of general interest rates, the relationship between long and short-term interest rates, market conditions and competitive factors, management may determine to increase the Company’s interest rate risk position somewhat in order to increase its net interest margin.  The Company’s results of operations and net portfolio values remain vulnerable to increases in interest rates and to fluctuations in the difference between long- and short-term interest rates.

Consistent with the asset/liability management philosophy described above, the Company has taken several steps to manage its interest rate risk.  The Company has structured its security portfolio to shorten the repricing of its interest-earning assets.  The Company’s mortgage-backed securities and securities available for sale typically have either short or medium terms to maturity or adjustable interest rates.  At June 30, 2006, the Company had investment securities available for sale of $16.5 million with contractual maturities of five years or less.  Variable-rate mortgage-backed securities totaled $69.6 million at June 30, 2006.  Mortgage-backed securities amortize and experience prepayments of principal.  The Company has received average cash flows from principal paydowns, maturities, sales and calls of all securities available for sale of $48.4 million annually over the past three fiscal years.  The Company also manages interest rate risk reduction by utilizing non-certificate depositor accounts for certain liquidity purposes.  The Board and management believe that such accounts carry a lower cost than certificate accounts, and that a material portion of such accounts may be more resistant to changes in interest rates than are certificate accounts.  At June 30, 2006, the Company had $76.7 million of savings accounts, $232.5 million of money market accounts and $139.6 million of checking accounts, representing 58.4% of total depositor accounts.

One approach used to quantify interest rate risk is the NPV analysis.  In essence, this analysis calculates the difference between the present value of liabilities and the present value of expected cash flows from assets and off-balance sheet contracts.  See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Asset/Liability and Risk Management” of this Form 10-K for further discussion regarding the NPV analysis and an analysis of the Company’s interest rate risk as measured by the estimated changes in NPV resulting from instantaneous and sustained parallel shifts in the yield curve.

62