HF Financial 10-K 2008
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Commission file number 0-19972
HF FINANCIAL CORP.
Registrant's telephone number, including area code: (605) 333-7556
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.01 per share
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 ý
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes o No ý
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or Section 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 ý No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) 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. ý
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No ý
The aggregate market value of the common stock held by non-affiliates of the Registrant, computed by reference to the closing price as of the last business day of the Registrant's most recently completed second fiscal quarter, December 31, 2007, was approximately $60.1 million.
As of September 16, 2008, there were 3,982,068 shares of the Registrant's common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive proxy statement to be delivered to stockholders in connection with the 2008 annual meeting of stockholders to be held on November 19, 2008, are incorporated by reference in response to Part III of this report.
Table of Contents
This Annual Report on Form 10-K ("Form 10-K") and other reports issued by HF Financial Corp. (the
"Company"), including reports filed with the Securities and Exchange Commission (the "SEC"), contain "forward-looking statements" that deal with future results, expectations, plans and performance. In
addition, the Company's management may make forward-looking statements orally to the media, securities analysts, investors or others. These forward-looking statements might include one or more of the
Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include words such as "optimism," "look-forward," "bright," "believe," "expect," "anticipate," "intend," "plan," "estimate" or words of similar meaning, or future or conditional verbs such as "will," "would," "should," "could" or "may."
Forward-looking statements about the Company's expected financial results and other plans are subject to certain risks, uncertainties and assumptions. These include, but are not limited to, the risks discussed in Part I, Item 1A "Risk Factors" in this Form 10-K and the following: possible legislative changes and adverse economic, business and competitive conditions and developments (such as shrinking interest margins and continued short-term rate environments); deposit outflows; reduced demand for financial services and loan products; changes in accounting policies or guidelines, or in monetary and fiscal policies of the federal government; changes in credit and other risks posed by the Company's loan and lease portfolios; the ability or inability of the Company to manage interest rate and other risks; unexpected or continuing claims against the Company's self-insured health plan; the Company's use of trust preferred securities; the ability or inability of the Company to successfully enter into a definitive agreement for and close anticipated transactions; technological, computer-related or operational difficulties; adverse changes in securities markets; results of litigation; or other significant uncertainties.
Forward-looking statements speak only as of the date they are made. The Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made. Although the Company believes that its expectations are reasonable, it can give no assurance that such expectations will prove to be correct. Based upon changing conditions, should any one or more of these risks or uncertainties materialize, or should any underlying assumptions prove incorrect, actual results may vary materially from those described in any forward-looking statements.
References in this Form 10-K to "we," "our," "us" and other similar references are to the Company, unless otherwise expressly stated or the context requires otherwise.
This section should be read in conjunction with the following parts of this Form 10-K: Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," Part II, Item 7A, "Quantitative and Qualitative Disclosures About Market Risk" and Part II, Item 8, "Financial Statements and Supplementary Data."
HF Financial Corp., a unitary thrift holding company, was formed in November 1991 for the purpose of owning all of the outstanding stock of Home Federal Bank (the "Bank") issued in the mutual to stock conversion of the Bank. The Company acquired all of the outstanding stock of the Bank on April 8, 1992. The Company is incorporated under the laws of the State of Delaware and generally is authorized to engage in any activity that is permitted by the Delaware General Corporation Law. Unless otherwise indicated, all matters discussed in this Form 10-K relate to the Company, and its direct and indirect subsidiaries, including without limitation, the Bank. See "Subsidiary Activities" below for further information regarding the subsidiary operations of the Company and the Bank.
The executive offices of the Company and its direct and indirect subsidiaries are located at 225 South Main Avenue, Sioux Falls, South Dakota, 57104. The Company's telephone number is (605) 333-7556.
Website and Available Information
The website for the Company and the Bank is located at www.homefederal.com. Information on this website does not constitute part of this Form 10-K.
The Company makes available, free of charge, its Form 10-K, its quarterly reports on Form 10-Q, its current reports on Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), as soon as reasonably practicable after such forms are filed with or furnished to the SEC. Copies of these documents are available to stockholders upon request addressed to the Secretary of the Company at 225 South Main Avenue, Sioux Falls, South Dakota, 57104.
The Bank was founded in 1929 and is a federally chartered stock savings bank headquartered in Sioux Falls, South Dakota. The Bank provides full-service consumer and commercial business banking, including an array of financial products, to meet the needs of its market place. The Bank attracts deposits from the general public and uses such deposits, together with borrowings and other funds, to originate one- to four-family residential, commercial business, consumer, multi-family, commercial real estate, construction and agricultural loans. The Bank's consumer loan portfolio includes, among other things, automobile loans, home equity loans, loans secured by deposit accounts and student loans. The Bank also purchases mortgage-backed securities and invests in U.S. Government and agency obligations and other permissible investments. The Bank does not hold any non-investment grade bonds (i.e., "junk bonds"). The Bank receives loan servicing income on loans serviced for others and commission income from credit life insurance on consumer loans. The Bank, through its wholly-owned subsidiaries, offers annuities, mutual funds, life insurance and other financial products and equipment leasing services.
The Bank's deposits are insured up to applicable limits by the Deposit Insurance Fund ("DIF"), which is administered by the Federal Deposit Insurance Corporation ("FDIC"), and the Bank is subject to primary regulation and examination by the Office of Thrift Supervision ("OTS").
Operating segments are defined as components of an enterprise for which separate financial information is available that is evaluated regularly by the chief operating decision makers in deciding how to allocate resources and in assessing performance. The Company's reportable segments are "banking" (including leasing activities) and "other." The "banking" segment is conducted through the Bank and Mid America Capital Services, Inc. ("Mid America Capital") and the "other" segment is composed of smaller non-reportable segments, the Company and inter-segment eliminations. For
financial information by segment see Note 1 of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Form 10-K.
In addition to the Bank, the Company had six other wholly-owned subsidiaries as of June 30, 2008: HF Financial Group, Inc. ("HF Group"), HF Financial Capital Trust III ("Trust III"), HF Financial Capital Trust IV ("Trust IV"), HF Financial Capital Trust V ("Trust V"), HF Financial Capital Trust VI ("Trust VI") and HomeFirst Mortgage Corp. (the "Mortgage Corp.").
In August 2002, the Company formed HF Group, a South Dakota corporation, to market software to facilitate employee benefits administration, payroll processing and management and governmental reporting. HF Group has an approved line of credit with the Company of $100,000, with no funds advanced as of June 30, 2008. Intercompany interest income and interest expense are eliminated in the preparation of consolidated financial statements.
In December 2002, the Company formed Trust III, a Delaware corporation, for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company. These subordinated debentures constitute the sole asset of Trust III.
In September 2003, the Company formed Trust IV, a Delaware corporation, for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company. These subordinated debentures constitute the sole asset of Trust IV.
In December 2006, the Company formed Trust V, a Delaware corporation, for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company. These subordinated debentures constitute the sole asset of Trust V.
In July 2007, the Company formed Trust VI, a Delaware corporation, for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company. These subordinated debentures constitute the sole asset of Trust VI.
The Mortgage Corp., a South Dakota corporation, was previously engaged in the business of originating one- to four-family residential mortgage loans, which were sold into the secondary market. The Mortgage Corp. had no activity during fiscal 2008.
As a federally chartered thrift institution, the Bank is permitted by OTS regulations to invest up to 2.00% of its assets in the stock of, or loans to, service corporation subsidiaries. The Bank may invest an additional 1.00% of its assets in service corporations where such additional funds are used for inner-city or community development purposes. The Bank currently has less than 1.00% of its assets in investments in its subsidiary service corporations as defined by the OTS. In addition to investments in service corporations, the Bank is permitted to invest an unlimited amount in operating subsidiaries engaged solely in activities in which the Bank may engage directly.
The Bank has five wholly-owned subsidiaries, Hometown Insurors, Inc. ("Hometown"), Mid America Capital, Home Federal Securitization Corp. ("HFSC"), Mid-America Service Corporation ("Mid-America") and PMD, Inc. ("PMD").
Hometown, a South Dakota corporation, provides financial and insurance products to customers of the Bank and members of the general public in the Bank's market area. Insurance products offered by Hometown primarily include annuities and life insurance products. Hometown obtains its funding via a line of credit from the Bank. Banking regulations do not limit the amount of funding provided to an operating subsidiary. As of June 30, 2008, the Bank had advanced no funds on an approved line of credit of $100,000. Intercompany interest income and interest expense are eliminated in the preparation of consolidated financial statements.
Mid America Capital, a South Dakota corporation, specializes in equipment finance leasing. Mid America Capital obtains its funding through a line of credit from the Bank. Banking regulations do not limit the amount of funding provided to an operating subsidiary. As of June 30, 2008, Mid America Capital had advanced $16.2 million on an approved line of credit of $35.0 million with the Bank. Intercompany interest income and interest expense are eliminated in the preparation of consolidated financial statements.
HFSC, a Delaware corporation, existed for the sole purpose of buying motor vehicle installment loans from the Bank to be securitized. HFSC had no activity during fiscal 2008. See "Off-Balance Sheet Financing Arrangements" of this Form 10-K for more information on the automobile securitization.
Mid-America, a South Dakota corporation, in the past provided residential appraisal services to the Bank and other lenders in the Bank's market. Mid-America had no activity during fiscal 2008.
PMD, a South Dakota corporation, in the past was engaged in the business of buying, selling and managing repossessed real estate properties. PMD had no activity during fiscal 2008.
Based on total assets at June 30, 2008, the Bank is the largest savings association headquartered in South Dakota. The Bank has a total of 33 banking centers in its market area and one internet branch located at www.homefederal.com. The Bank's primary market area includes communities located in eastern and central South Dakota, including the Sioux Falls metropolitan statistical area (MSA), Pierre, Mitchell, Aberdeen, Brookings, Dakota Dunes, Watertown, and Yankton. The Bank also has a branch in Marshall, Minnesota, which serves customers located in southwestern Minnesota, and its banking center located in Dakota Dunes, South Dakota serves customers located in northwestern Iowa. The Bank's primary market area features a variety of agri-business, banking, financial services, health care and light manufacturing firms. The internet branch allows access to customers beyond traditional geographical areas.
Mid America Capital provides services to customers primarily in a five-state area in the upper Midwest, but originations can and have expanded nationwide based on relationships developed with existing Bank customers and other vendor relationships.
HF Group provided services to customers in the three-state region of South Dakota, Minnesota and Iowa.
The Bank originates a variety of loans including business banking loans, commercial and agricultural loans; mortgage lending, including one- to four-family residential mortgages; and consumer loans, including loans for automobile purchases, home equity and home improvement loans and student loans.
Commercial Business Lending. In order to serve the needs of the local business community and improve the interest rate sensitivity and yield of its assets, the Bank originates adjustable- and fixed-rate commercial loans. Interest rates on commercial business loans generally adjust or float with a designated national index plus a specified margin. The Bank's commercial business lending activities encompass loans with a variety of purposes and security, including loans to finance accounts receivable, inventory and equipment and business expansion within the Bank's market area. The Bank originates commercial business loans directly and through programs sponsored by the Small Business Administration ("SBA") of which a portion of such loans are also guaranteed in part by the SBA. The Bank generally originates commercial business loans for its portfolio and retains the servicing with
respect to such loans. The Bank anticipates continued expansion and emphasis of its commercial business lending, subject to market conditions and the Home Owners' Loan Act ("HOLA") restrictions. See "RegulationBusiness Activities" below for HOLA restrictions.
Commercial business loans typically are made on the basis of the borrower's ability to make repayment from the cash flow of the borrower's business. As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself (which, in turn, may be dependent upon the general economic environment). The Bank's commercial business loans are occasionally secured by the assets of the business, such as accounts receivable, equipment and inventory. However, the collateral securing the loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. Whenever possible, the Bank's commercial business loans include personal guarantees of the borrowers. In addition, the loan officer may perform on-site visits, obtain financial statements and perform a financial review of the loan.
Multi-Family and Commercial Real Estate Lending. The Bank engages in multi-family and commercial real estate lending primarily in South Dakota and the adjoining Midwestern states. These lending activities may include existing property or new construction development or purchased loans.
Loans secured by multi-family and commercial real estate properties are generally larger and involve a greater degree of credit risk than one- to four-family residential mortgage loans. Because payments on loans secured by multi-family and commercial real estate properties 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 (for example, if leases are not obtained or renewed), the borrower's ability to repay the loan may be impaired. In addition, loans secured by property outside of the Bank's primary market area may contain a higher degree of risk due to the fact that the Bank may not be as familiar with market conditions where such property is located. The Bank does not have a material concentration of multi-family or commercial real estate loans outside of South Dakota and the adjoining Midwestern states.
The Bank presently originates adjustable-rate, short-term balloon payment, fixed-rate multi-family and commercial real estate loans. The Bank's multi- family and commercial real estate loan portfolio is secured primarily by apartment buildings and owner occupied and non-owner occupied commercial real estate. The terms of such loans are negotiated on a case-by-case basis. Commercial real estate loans generally have terms that do not exceed 25 years. The Bank has a variety of rate adjustment features, call provisions and other terms in its multi-family and commercial real estate loan portfolio. Generally, the loans are made in amounts up to 80.00% of the appraised value of the collateral property and with debt service coverage ratios of 115.00% or higher. The debt service coverage is the ratio of net cash from operations before payment of debt service. However, these percentages may vary depending on the type of security and the guarantor. Such loans provide for a negotiated margin over a designated national index. The Bank analyzes the financial condition of the borrower, the borrower's credit history, the borrower's prior record for producing sufficient income from similar loans, references and the reliability and predictability of the net income generated by the property securing the loan. The Bank generally requires personal guarantees of borrowers.
Depending on the circumstances of the security of the loan or the relationship with the borrower, the Bank may decide to sell participations in the loan. The sale of participation interests in a loan are necessitated by the amount of the loan or the limitation of loans-to-one borrower. See "RegulationLoans-to-One Borrower" for a discussion of the loans-to-one borrower regulations. In return for servicing these loans for the participants, the Bank generally receives a fee of 0.25% to 0.38%. Also, income is received at loan closing from loan fees and discount points. Appraisals on properties securing multi-family and commercial real estate loans originated by the Bank are performed by appraisers approved pursuant to the Bank's appraisal policy.
The HOLA includes a provision that limits the Bank's non-residential real estate lending to no more than four times its total capital. This maximum limitation, which at June 30, 2008 was $350.6 million, has not materially limited the Bank's lending practices.
Under HOLA, the maximum amount which the Bank may lend to any one borrower is 15.00% of the Bank's unimpaired capital and surplus, or $13.3 million at June 30, 2008. Loans in an amount equal to an additional 10.00% of unimpaired capital and surplus may be made to the same borrower if such loans are fully secured by readily marketable collateral. The Bank may request a waiver from the OTS to exceed the 15.00% loans-to-one borrower limitation on a case-by-case basis. See "RegulationLoans-to-One Borrower" for more information and a discussion of the loans-to-one borrower regulations.
Construction and Development Lending. The Bank makes construction loans to individuals for the construction of their residences as well as to builders and, to a lesser extent, developers, for the construction of one- to four-family residences and condominiums and the development of one- to four-family lots in the Bank's primary market area.
Construction loans to individuals for their residences are structured to be converted to mortgage loans at the end of the construction phase, which typically runs six to 12 months. These construction loans have rates and terms which match the one- to four-family residential mortgage loans offered by the Bank. Residential construction loans are generally underwritten pursuant to the same guidelines used for originating residential mortgage loans.
The Bank also makes loans to developers for the purpose of developing one- to four-family lots. These loans typically have terms of one year and carry floating interest rates based on a national designated index. Loan commitment and partial release fees are charged. These loans generally provide for the payment of interest and loan fees from loan proceeds. The principal balance of these loans is typically paid down as lots are sold. Builder construction and development loans are obtained principally through continued business from developers and builders who have previously borrowed from the Bank, as well as broker referrals and direct solicitations of developers and builders. The application process includes a submission to the Bank of plans, specifications and costs of the project to be constructed or developed. These items are used as a basis to determine the appraised value of the subject property. Loans are based on the lesser of current appraised value and/or the cost of construction (land plus building).
The Bank makes loans for the construction of multi-family residential properties. Such loans are generally made at adjustable rates, which adjust periodically based on the appropriate Treasury Note maturity.
Construction loans are generally originated with a maximum loan-to-value ratio of 80.00% and land development loans are generally originated with a maximum loan-to-value ratio of 60.00%, based upon an independent appraisal. Because of the uncertainties inherent in estimating development and construction costs and the market for the project upon completion, it is relatively difficult to evaluate accurately the total loan funds required to complete a project, the related loan-to-value ratios and the likelihood of ultimate success of the project. Construction and development loans to borrowers other than owner occupants also involve many of the same risks discussed above regarding multi-family and commercial real estate loans and tend to be more sensitive to general economic conditions than many other types of loans.
Prior to making a commitment to fund a construction loan, the Bank requires an appraisal of the property, or, for larger projects, both an appraisal and a study of the feasibility of the proposed project. The Bank's construction loan policy provides for the inspection of properties by independent in-house and outside inspectors at the commencement of construction and prior to disbursement of funds during the term of the construction loan.
Agricultural Loans. In order to serve the needs of the local agricultural community and improve the interest rate sensitivity and yield of its assets, the Bank originates agricultural loans through its agricultural division. The agricultural division offers loans to its customers such as: (1) operating loans which are used to fund operating expenses, which typically have a one year term and are indexed to the national prime rate; (2) term loans on machinery, equipment and breeding stock that may have a term up to seven years and require annual payments; (3) agricultural farmland term loans which are used to fund land purchases or refinances; (4) specialized livestock loans to fund facilities and equipment for confinement enterprises; and (5) loans to fund ethanol plant development. Agriculture real estate loans typically will have personal guarantees of the borrowers, a first lien on the real estate, interest rates adjustable to the national prime rate or Treasury Note rates, and annual, quarterly or monthly payments. Operating and term loans are secured by farm chattels (crops, livestock, machinery, etc.), which are the operating assets of the borrower. The Bank also originates agricultural loans directly and through programs sponsored by the Farmers Service Agency ("FSA") of which a portion of such loans are also guaranteed in part by the FSA.
Loan customers are required to supply current financial statements, tax returns and cash flow projections which are updated on an annual basis. In addition, on major loans, the loan officer will perform an annual farm visit, obtain financial statements and perform a financial review of the loan.
One- to Four-Family Residential Mortgage Lending. One- to four-family residential mortgage loan originations are primarily generated by the Bank's marketing efforts, its present customers, walk-in customers and referrals from real estate agents and builders. The Bank has focused its lending efforts primarily on the origination of loans secured by first mortgages on owner-occupied, one- to four-family residences.
The Bank currently makes 10-, 15-, 20- and 30-year fixed- and adjustable-rate ("ARM") one- to four-family residential mortgage loans in amounts up to 95.00% of the appraised value of the collateral property provided that private mortgage insurance is obtained in an amount sufficient to reduce the Bank's exposure at or below the 80.00% level. The Bank generally offers an ARM loan having a fixed rate for the initial three to five years, which then converts to a one-year ARM loan for the remainder of the life of the loan. These loans provide for an annual cap and a lifetime cap at a set percent over the fully-indexed rate.
The Bank also offers balloon loans, which are sold on the secondary market and have a fixed-rate for the first five or seven years of the loan. At the end of the five- or seven-year period, the loan converts to a 23- or 25-year fixed-rate loan at the then current market rate provided that the borrower qualifies at the new rate. If the borrower fails to qualify at the new rate, the loan becomes payable in full. The Bank also offers a portfolio loan product that is a five- or seven-year balloon loan that is underwritten to secondary market standards but if fully payable at the end of the balloon term.
To meet the needs of the Bank's borrowers and financial needs of the communities it serves, the Bank has developed two distinct types of loan programs. The Integrity Mortgage Program is a limited documentation program that is generally available to the upper credit profile customer. The Olympic Plus Program is a program for individuals that do not meet secondary market standards but are eligible for private mortgage insurance. The program underwriting guidelines match those as established by the private mortgage insurance company. Borrowers may choose from either an ARM or balloon product as a financing option.
The Bank also offers fixed-rate 10- to 30-year mortgage loans that conform to secondary market standards. Interest rates charged on these fixed-rate loans are competitively priced on a daily basis according to market conditions. Residential loans generally do not include prepayment penalties.
The Bank also originates fixed-rate one- to four-family residential mortgage loans through the South Dakota Housing Development Authority ("SDHDA") program. These loans generally have terms not to exceed 30 years and are insured by the Federal Housing Administration ("FHA"), Veterans Administration ("VA"), Rural Development or private mortgage insurance. The Bank receives an origination fee of 1.00% of the loan amount from the borrower and a servicing fee of generally 0.38% from the SDHDA for these services. The Bank is the largest servicer of loans for the SDHDA. At June 30, 2008, the Bank serviced $932.9 million of mortgage loans for the SDHDA. See Note 4 of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8, "Financial Statements and Supplementary Data" in this Form 10-K for information on loan servicing.
In underwriting one- to four-family residential mortgage loans, the Bank evaluates both the borrower's ability to make monthly payments and the value of the property securing the loan. The property that secures the real estate loans made by the Bank is appraised by an appraiser approved under the Bank's appraisal policy. The Bank requires borrowers to obtain title, fire and casualty insurance in an amount not less than the amount of the loan. Real estate loans originated by the Bank contain a "due-on-sale" clause allowing the Bank to declare the unpaid principal balance due and payable upon the sale of the collateral property.
The Bank offers on-line mortgage capabilities through QuickClick Online Mortgage Solutions, a service that allows customers to check rates, research loan options and complete mortgage applications via the Bank's website. This service is currently available to branch locations in South Dakota and Minnesota.
Other Consumer Lending. The Bank's management considers its consumer loan products to be an important component of its lending strategy. Specifically, consumer loans generally have shorter terms to maturity and carry higher rates of interest than one- to four-family residential mortgage loans. In addition, the Bank's management believes that the offering of consumer loan products helps to expand and create stronger ties to its existing customer base by increasing the number of customer relationships and providing cross-marketing opportunities.
Loans secured by second mortgages, together with loans secured by all prior liens, are generally limited to 100.00% or less of the appraised or assessed value of the property securing the loan and generally have maximum terms that do not exceed 10 to 15 years.
The student loans originated by the Bank are guaranteed as to principal and interest by the South Dakota Education Assistance Corporation. The Bank typically sells such student loans with servicing rights released approximately 120 days after funds have been disbursed to the student.
Consumer loan terms vary according to the type of collateral, length of contract and creditworthiness of the borrower. The Bank offers both open- and closed-end credit. Overdraft lending is extended through lines of credit that are tied to a checking account. The credit lines generally bear interest at 18.00% and are generally limited to no more than $2,000. Loans secured by deposit accounts at the Bank are currently originated for up to 90.00% of the account balance (although historically the Bank has loaned up to 100.00% of the account balance), with a hold placed on the account restricting the withdrawal of the account balance. The interest rate on such loans is typically equal to 2.00% above the contract rate.
The underwriting standards employed by the Bank for consumer loans include an application, a determination of the applicant's payment history on other debts, and an assessment of the 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, if any, in relation to the proposed loan amount.
Consumer loans may entail greater credit risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured or are secured by rapidly depreciable assets, such as automobiles or boats. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, thus are more likely to be affected by adverse personal circumstances. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.
General. Through its wholly-owned subsidiary, Mid America Capital, the Bank originates commercial and municipal leases. These products have a fixed interest rate for the duration of the lease with terms typically ranging from 24 - 60 months. The leases generally are 100.00% financed with only the first or first and last months' payments due at lease inception. As a result of the 100.00% financing and fixed interest rate, the yield on leases is higher than similar type lending products.
Leases are originated generally in a five-state area in the upper Midwest. All leases are secured by the equipment leased, with personal guarantees of the borrowers normally obtained on commercial leases.
Commercial Leases. In order to support the Bank and its customers and to improve the yield of its assets, Mid America Capital originates commercial leases to customers primarily in the upper Midwest. Mid America Capital offers three types of commercial leases: capital, tax and Terminal Rental Adjustment Clause ("TRAC") leases. TRAC leases are generally for medium- to heavy-duty titled equipment, such as semi-tractors and trailers and medium- to heavy-duty trucks. Leases may be structured with a contracted residual of as little as $1.00 up to 20.00-25.00% of the equipment cost. Leases encompass a wide variety of equipment for a variety of commercial uses. The customer base tends to be small- to medium-sized businesses that view leasing as another financing option that augments their overall operation. Repayment terms tend to be monthly in nature.
As with commercial loans, commercial leases typically are made on the basis of the borrower's ability to make repayment from the cash flow of their business. As a result, the availability of funds for the repayment of commercial leases may be substantially dependent on the success of the business itself. The collateral securing the leases will generally depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business.
Municipal Leases. The Bank and Mid America Capital also originate leases to municipal entities such as cities, counties, and public schools. The lessee must be a political subdivision of the state in order to qualify as a municipal lease. Because the interest income earned on this type of lease is exempt from federal income taxes, the rate offered to the municipality is usually substantially lower than a comparable commercial lease. Repayment terms generally are on a monthly, semi-annual or annual basis. Residuals are $1.00 for municipal leases.
Repayment is based on the municipality's ability to levy and collect taxes. Assuming the municipality has a bond rating, that bond rating, together with audited financial statements, are the basis for the lease. On larger leases, bond ratings and financial statements will be reviewed annually.
Loan and Lease Portfolio Composition. The following table sets forth information concerning the composition of the Company's loan and lease portfolio from continuing operations in dollar amounts and in percentages (before deductions for the undisbursed portion of loans in process, deferred fees and discounts and allowance for losses) as of the dates indicated.
The following table sets forth the composition of the Company's loan and lease portfolio from continuing operations by fixed- and adjustable-rate in dollar amounts and in percentages (before deductions for the undisbursed portion of loans in process, deferred fees and discounts and allowance for losses) as of the dates indicated. Variable loans are tied to various indices including prime rate and the treasury yield curve and have reset dates ranging from daily to several years.
The following schedule illustrates the scheduled principal contractual repayments of the Company's loan and lease portfolio at June 30, 2008. Mortgages which have adjustable or renegotiable interest rates are shown as maturing at the contractual maturity date. The schedule does not reflect the effects of possible prepayments or enforcement of due-on-sale clauses.
Scheduled contractual principal repayments of loans do not reflect the actual life of such assets. The average life of loans is substantially less than their average contractual terms because of prepayments. In addition, due-on-sale clauses on loans generally give the Bank the right to declare a conventional loan immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase when current mortgage loan rates are substantially higher than rates on existing mortgage loans and decrease when rates on existing mortgages are substantially higher than current mortgage loan rates.
The following table sets forth the composition of the Company's deferred fees and discounts on loans as of the dates indicated.
Deferred fees and discounts on loans and leases have trended to a net deferred cost position. In fiscal 2008, the net deferred fees and discounts on loans and leases decreased by $775,000. This decrease was primarily due to a $832,000 decrease in dealer reserve, as a result of lower dollar volume of originated indirect automobile loans as the Company ceased originations in the first quarter of fiscal 2008.
Potential Problem Loans
Nonperforming Assets. See "Asset Quality" under Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Form 10-K for discussion.
Classified Assets. Federal regulations provide for the classification of loans, leases and other assets, such as debt and equity securities considered by the OTS to be of lesser quality, as "substandard," "doubtful" or "loss." An asset is considered "substandard" if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. "Substandard" assets include those characterized by the "distinct possibility" that the Company will sustain "some loss" if the deficiencies are not corrected. Assets classified as "doubtful" have all of the weaknesses inherent in those classified "substandard," with the added characteristic that the weaknesses present make "collection or liquidation in full," on the basis of currently existing facts, conditions, and values, "highly questionable and improbable." Assets classified as "loss" are those considered "uncollectible" and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. Assets which do not currently expose the Company to sufficient risk to warrant classification in one of the aforementioned categories, but possess weaknesses, are required to be designated "criticized" or "special mention" by management.
When the Company classifies problem assets as "loss," it is required either to establish a specific allowance for losses equal to 100.00% of that portion of the asset so classified or to charge-off such amount. The Company's determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the Bank's Regional Director at the regional OTS office, who may order the establishment of additional general or specific loss allowances.
In connection with the filing of its periodic reports with the OTS and in accordance with its classification of assets policy, the Company regularly reviews problem loans and leases in its portfolio to determine whether any loans or leases require classification in accordance with applicable regulations. On the basis of management's monthly review of its assets, at June 30, 2008, the Company had designated $22.2 million of its assets as special mention and $11.5 million of its assets as classified. Other potential problem loans are included in criticized and classified assets. See "Asset Quality" under Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Form 10-K for further discussion.
Allowance for Loan and Lease Losses. See "Application of Critical Accounting Policies" and "Asset Quality" under Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Form 10-K for discussion.
The Bank is required under OTS regulation to maintain a sufficient amount of liquid assets. Liquidity may increase or decrease depending upon the availability of funds and comparative yields on investments in relation to the return on loans.
Federally chartered savings institutions have the authority to invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies, certain certificates of deposit of insured banks and savings institutions, certain bankers' acceptances, repurchase agreements and federal funds. Subject to various restrictions, federally chartered savings institutions may also invest their assets in commercial paper, investment grade corporate debt securities and mutual funds whose assets conform to the investments that a federally chartered savings institution is otherwise authorized to make directly.
Generally, the investment policy of the Bank is to invest funds among various categories of investments and maturities based upon the Bank's asset/liability management policies, investment quality and marketability, liquidity needs and performance objectives.
At June 30, 2008, the Company's investments in mortgage-backed securities totaled $189.6 million, or 17.2% of its total assets. As of such date, the Bank also had a $11.2 million investment in the stock
of the Federal Home Loan Bank of Des Moines ("FHLB" or "FHLB of Des Moines") in order to satisfy the FHLB of Des Moines' requirement for membership.
The composition and maturities of the investment securities portfolio, excluding equity securities, are indicated in the following table.
The effective maturities for the Bank's mortgage-backed securities are much shorter due to the combination of prepayments and the variable nature of $63.1 million of mortgage-backed securities. The variable or hybrid (fixed for a period of time and then variable thereafter) structure gives the Bank flexibility in risk management of the balance sheet.
The Company's investment securities portfolio did not contain non-investment grade bonds (i.e., "junk bonds") or other corporate debt securities.
No other-than-temporary impairments were recorded against earnings during fiscal years 2008, 2007 or 2006. See Note 1, "Summary of Significant Accounting Policies," and Note 2, "Investment Securities," of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8 of this Form 10-K for additional information.
The Bank's investment security portfolio is managed in accordance with a written investment policy adopted by the Board of Directors. Investments may be made by the Bank's officers within specified limits and approved in advance by the Board of Directors for transactions over these limits. At the present time, the Bank does not have any investments that are held for trading purposes. At June 30, 2008, the Company had $225.0 million of securities available for sale, including mortgage-backed securities of $189.6 million. See Note 2 of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K for further information on the Company's investment portfolio.
Sources of Funds
General. The Company's primary sources of funds are earnings, in-market deposits, FHLB advances and other borrowings, amortization and repayments of loan principal, mortgage-backed securities and callable agency securities. Secondary sources include sales of mortgage loans, sales and/or maturities of securities, out-of-market deposits and short-term investments.
Borrowings of the Bank are primarily from the FHLB of Des Moines, and may be used on a short-term basis to compensate for seasonal reductions in deposits or deposit inflows at less than projected levels, and may be used on a longer-term basis to support expanded lending activities. The Bank has established collateral at the Federal Reserve Bank ("FRB") as a contingent source of funding. See Note 7 of the "Notes to Consolidated Financial Statements," which is included in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K for further detail of the Company's borrowings.
Deposits. The Bank offers a variety of deposit accounts having a wide range of interest rates and terms. The Bank's deposits consist of statement savings accounts, checking accounts, money market and certificate of deposit accounts ranging in terms from 30 days to five years. The Bank primarily solicits deposits from its market area. The Bank relies primarily on customer service, competitive pricing policies and advertising to attract and retain these deposits. Based on liquidity needs, the Bank may, from time to time, acquire out-of-market deposits.
The flow of deposits is influenced by general economic conditions, changes in money market and prevailing interest rates and competition.
The variety of deposit accounts offered by the Bank has allowed it to be competitive in obtaining funds and to respond with flexibility to changes in consumer demand. In recent years, the Bank has become more susceptible to short-term fluctuations in deposit flows as customers have become more interest rate conscious. The Bank manages the pricing of its deposits in keeping with its asset/liability management and profitability objectives. Based on its experience, the Bank believes that its savings, money market, and checking accounts are stable sources of deposits. However, the ability of the Bank to attract and maintain certificates of deposit, and the rates paid on these deposits, has been and will continue to be significantly affected by market conditions.
The following table sets forth the dollar amount of deposits in the various types of deposit accounts offered by the Bank as of the dates indicated.
The Bank solicits certificates of deposit of $100,000 or greater from various state, county and local government units which carry rates which are negotiated at the time of deposit. See Note 6 of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K. Deposits at June 30, 2008, and 2007 included $76.5 million and $73.3 million, respectively, of deposits from one local governmental entity, the majority of which are savings account balances.
Borrowings. Although deposits are the Bank's primary source of funds, the Bank's policy has been to utilize borrowings when they are a less costly source of funds or can be invested at a positive rate of return.
The Bank's borrowings consist primarily of advances from the FHLB of Des Moines upon the security of its capital stock of the FHLB of Des Moines and certain pledgeable loans, including but not limited to, its mortgage related loans, mortgage-backed securities and U.S. Government and other agency securities. Such advances can be made pursuant to several different credit programs, each of which has its own interest rate and range of maturities. At June 30, 2008, the Bank's FHLB advances totaled $198.3 million, representing 19.1% of total Company liabilities. See Note 7 of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K for further detail of the Company's borrowings.
The following table sets forth the maximum month-end balances and average balances of FHLB and FRB advances and other borrowings at the dates indicated.
The following table sets forth certain information as to the Bank's FHLB and FRB advances and other borrowings of the Company at the dates indicated.
The banking business is highly competitive and the Bank experiences competition in each of its markets from many other financial institutions, many of which are larger and may have significantly greater financial and other resources. Specifically, the Bank competes with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as super-regional, national and international financial institutions, that operate offices in our primary market areas and elsewhere. Many of these competitors are also well-established financial institutions.
Competitors that are not depository institutions are generally not subject to the extensive regulations that apply to the Bank. The Bank competes with these institutions both in attracting deposits and in making loans. The Bank competes for deposits by offering a variety of deposit accounts at competitive rates, convenient business hours and convenient branch locations with inter-branch deposit and withdrawal privileges at each. The Bank competes for loans on the basis of quality of service, interest rates, loan fees and loan type. In addition, the Bank must attract its customer base from other existing financial institutions and from new residents. In new markets that the Bank may enter, the Bank will also compete against well-established community banks that have developed relationships within the community.
At June 30, 2008, the Bank had a total of 307 full-time equivalent employees ("FTEs") including 5 FTEs of the Bank's subsidiary corporations. The Bank's employees are not represented by any collective bargaining group. Management considers its relations with its employees to be good.
General. The Bank is a federally chartered thrift institution, the deposits of which are federally insured by the DIF. Accordingly, the Bank is subject to broad federal regulation and oversight extending to all its operations, by its primary federal regulator, the OTS, and by its deposit insurer, the FDIC. The Bank is a member of the FHLB of Des Moines and is subject to certain limited regulation by the Federal Reserve Board. As the unitary thrift holding company of the Bank, the Company is also subject to federal regulation and oversight by the OTS. The purpose of the regulation of the Company, like other depository institution holding companies, is to protect subsidiary institutions where deposits are federally insured.
Certain of these regulatory requirements and restrictions are discussed below or elsewhere in this Form 10-K. The following discussion is intended to be a summary of the material statutes, regulations and policies applicable to savings associations and their holding companies, and it does not purport to be a complete discussion of all such statutes, regulations and policies.
Regulation of Federal Savings Associations. The OTS has extensive authority over the operations of federal savings associations, such as the Bank. This regulation and supervision establishes a comprehensive framework of activities in which a federal savings association can engage and is intended primarily for the protection of the DIF and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such laws and regulations or interpretations thereof, whether by the OTS, the FDIC or through legislation, could have a material adverse impact on the Company and the Bank and their operations and stockholders.
The Bank is required to file periodic reports with the OTS and is subject to periodic examinations primarily by the OTS and to a lesser extent by the FDIC. The last examination of the Bank by the OTS concluded on June 28, 2008.
Assessments. The OTS has established a schedule for the assessment of fees upon all savings associations to fund the operations of the OTS. The general assessment, paid on a semiannual basis, is computed by totaling three components: the Bank's total assets, supervisory condition, and complexity of operations. The Bank's OTS assessment (standard assessment) for the fiscal year ended June 30, 2008, was approximately $219,206.
Enforcement. The OTS has primary enforcement responsibility over savings associations, including the Bank. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease and desist orders and to remove directors and officers. In general, these enforcement actions may be initiated in response to violations of laws and regulations and to unsafe or unsound practices. Under the Federal Deposit Insurance Act, the FDIC has the authority to recommend to the Director of the OTS that enforcement action be taken with respect to a particular savings association. If action is not taken by the OTS, the FDIC may take action under certain circumstances.
Safety and Soundness Standards. Under federal law, the OTS has adopted a set of guidelines prescribing safety and soundness standards. The guidelines establish general standards relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, asset quality, earnings and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal stockholder.
In addition, the OTS adopted regulations that authorize, but do not require, the OTS to order an institution that has been given notice by the OTS that it is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan or fails in any material respect to implement an accepted compliance plan, the OTS must issue an order directing action to correct the deficiency and may issue an order directing corrective actions and other actions of the types to which an undercapitalized association is subject under the "prompt corrective action" provisions of federal law. If an institution fails to comply with such an order, the OTS may seek to enforce such order in judicial proceedings and to impose civil money penalties.
Prompt Corrective Regulatory Action. Under the OTS prompt corrective action regulations, the OTS is
required to take certain, and is authorized to take other, supervisory actions against undercapitalized savings banks. For this purpose, a savings bank is placed in one of the following five
categories based on the association's capital:
The severity of the action authorized or required to be taken under the prompt corrective action regulations increases as a bank's capital decreases within the three undercapitalized categories. All banks are prohibited from paying dividends or other capital distributions or paying management fees to any controlling person if, following such distribution, the bank would be undercapitalized. The OTS is required to monitor closely the condition of an undercapitalized bank and to restrict the growth of its assets.
undercapitalized bank is required to file a capital restoration plan within 45 days of the date the bank receives notices that it is within any of the three
undercapitalized categories, and the plan must be guaranteed by any parent holding company. The aggregate liability of a parent holding company is limited to the lesser
If a bank fails to submit an acceptable plan, it is treated as if it were "significantly undercapitalized." Banks that are "significantly" or "critically undercapitalized" are subject to a wider range of regulatory requirements and restrictions. Under the OTS regulations, generally, a federally chartered savings bank is treated as "well-capitalized" if its total risk-based capital ratio is 10% or greater, its Tier 1 risk-based capital ratio is 6% or greater, its leverage ratio is 5% or greater, and it is not subject to any order or directive by the OTS to meet a specific capital level.
At June 30, 2008, the Bank met the criteria for being considered "well-capitalized."
Business Activities. The activities of federal savings banks are governed by federal laws and regulations. These laws and regulations delineate the nature and extent of the activities in which federal savings associations may engage. In particular, many types of lending authority for federal savings associations are limited to a specified percentage of the institution's capital or assets.
Loan and Investment Powers. The Bank derives its lending and investment powers from the HOLA, and the regulations of the OTS thereunder. Under these laws and regulations, the Bank may invest in mortgage loans secured by residential and commercial real estate, commercial and consumer loans, certain types of debt securities and certain other assets. The Bank may also establish service corporations that may engage in activities not otherwise permissible for the Bank, including certain real estate equity investments and securities and insurance brokerage activities. These investment powers are subject to various limitations, including (a) a prohibition against the acquisition of any corporate debt security that is not rated in one of the four highest rating categories; (b) a limit of 400.00% of an association's capital on the aggregate amount of loans secured by non-residential real estate property; (c) a limit of 20.00% of an association's assets on the aggregate amount of commercial and agricultural loans and leases with the amount of commercial loans in excess of 10.00% of assets being limited to small business loans; (d) a limit of 35.00% of an association's assets on the aggregate amount of secured consumer loans and acquisitions of certain debt securities, with amounts in excess of 30.00% of assets being limited to loans made directly to the original obligor and where no third-party finder or referral fees were paid; (e) a limit of 5.00% of assets on non-conforming loans (loans in excess of the specific limitations of the HOLA); and (f) a limit of the greater of 5.00% of assets or an association's capital on certain construction loans made for the purpose of financing what is or is expected to become residential property. In addition, the HOLA and the OTS regulations provide that a federal savings association may invest up to 10.00% of its assets in tangible personal property for leasing purposes. At June 30, 2008, the Bank met the 10.00% leasing limitation with 1.74% of total Bank assets. Such general leases, however, do not have to be aggregated with the institution's loans for purposes of the HOLA's investment and lending limitations. At June 30, 2008, the Bank met the 20.00% limitation with 18.85% of total Bank assets.
Loans-To-One Borrower. Under the HOLA, the Bank is generally subject to the same limits on loans-to-one borrower as are imposed on national banks. With specified exceptions, the Bank may not make a loan or extend credit to a single or related group of borrowers in excess of 15.00% of the association's unimpaired capital and surplus. Additional amounts may be loaned, not in excess of 10.00% of unimpaired capital and surplus, if such loans or extensions of credit are fully secured by readily-marketable collateral. At June 30, 2008, the Bank's lending limit under this restriction was $13.3 million.
Insurance of Accounts and Regulation by the FDIC. The Bank is a member of, and pays deposit insurance assessments to, the DIF, which is administered by the FDIC. Savings deposits are generally insured up to $100,000 per insured member (as defined by law and regulation) by the FDIC and such insurance is backed by the full faith and credit of the United States Government. Effective April 1, 2006, through the Federal Deposit Insurance Reform Act of 2005, the maximum insurance coverage for self-directed retirement plan deposits only, increased from $100,000 to $250,000. All other deposit coverage remains at $100,000. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the DIF. The FDIC also has the authority to initiate enforcement actions against savings associations, after giving the OTS an opportunity to take such action, and may terminate the deposit insurance if it determines that the institution has engaged or is engaging in unsafe or unsound practices, or is in an unsafe or unsound condition.
The DIF was formed on March 31, 2006, following the merger of the Bank Insurance Fund and the Savings Association Insurance Fund in accordance with the Federal Deposit Insurance Reform Act of 2005 (the "Deposit Insurance Fund Act"). In addition to merging the insurance funds, the Deposit Insurance Fund Act established a statutory minimum and maximum designated reserve ratio for the DIF and granted the FDIC greater flexibility in establishing the required reserve ratio. In its
regulations implementing the Deposit Insurance Fund Act, the FDIC has set the current annual designated reserve ratio for the DIF at 1.25%.
In order to maintain the DIF, member institutions are assessed an insurance premium. The amount of each institution's premium is currently based on the balance of insured deposits and the degree of risk the institution poses to the DIF. Under the assessment system, the FDIC assigns an institution to one of nine risk categories using a two-step process based first on capital ratios (the capital group assignment) and then on other relevant information (the supervisory subgroup assignment). Each risk category is assigned an assessment rate. Assessment rates currently range from 0.00% of deposits for an institution in the highest category (i.e., well-capitalized and financially sound, with no more than a few minor weaknesses) to 0.43% of deposits for an institution in the lowest category (i.e., undercapitalized and substantial supervisory concerns). The FDIC is authorized to raise the assessment rates as necessary to maintain the DIF. The Bank's assessment rate at June 30, 2008 was 0.056%. Any increase in insurance assessments could have an adverse effect on the earnings of insured institutions, including the Bank.
The Federal Deposit Insurance Reform Act of 2005 allows "eligible insured depository institutions" to share a one-time assessment credit pool of approximately $4.7 billion. To be eligible, an institution must have been in existence on December 31, 1996 and have paid a deposit insurance assessment prior to that date, or be a "successor" to such an institution. The Bank's remaining assessment credit is $111,219, which will be applied to reduce future deposit insurance assessments.
In addition, all FDIC-insured institutions are required to pay assessments to the FDIC at an annual rate of approximately 0.0124% of insured deposits to fund interest payments on bonds issued by the Financing Corporation ("FICO"), an agency of the federal government established in 1987 to recapitalize the predecessor to the DIF. These assessments, which are adjusted quarterly, will continue until the FICO bonds mature in 2017 through 2019.
The Bank's assessment rate for the fiscal year ending June 30, 2008, was 0.056% and the premium paid for this period was $91,872. The FDIC has authority to increase insurance assessments. A significant increase in DIF insurance premiums would have an adverse effect on the operating expenses and results of operations of the Bank. Management cannot predict what the insurance assessment rate will be in the future.
Under federal law, insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the OTS. The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.
Regulatory Capital Requirements. OTS regulations require the Bank to meet three minimum capital standards:
In assessing an institution's capital adequacy, the OTS takes into consideration not only these numeric factors but also qualitative factors as well, and has the authority to establish higher capital requirements for individual institutions where necessary. The Bank, as a matter of prudent management, targets as its goal the maintenance of capital ratios which exceed these minimum
requirements and that are consistent with the Bank's risk profile. At June 30, 2008, the Bank exceeded each of its capital requirements as shown in the following table:
The Federal Deposit Insurance Corporation Improvement Act (the "FDICIA") requires that the OTS and other federal banking agencies revise their risk-based capital standards, with appropriate transition rules, to ensure that they take into account interest rate risk, concentration of risk and the risks of non-traditional activities. The OTS monitors the interest rate risk of individual institutions through the OTS requirements for interest rate risk management, the ability of the OTS to impose individual minimum capital requirements on institutions that exhibit a high degree of interest rate risk, and the requirements of Thrift Bulletin 13a, which provides guidance on the management of interest rate risk and the responsibility of boards of directors in that area.
The OTS continues to monitor the interest rate risk of individual institutions through analysis of the change in net portfolio value ("NPV"). NPV is defined as the net present value of the expected future cash flows of an entity's assets and liabilities and, therefore, hypothetically represents the value of an institution's net worth. The OTS has also used this NPV analysis as part of its evaluation of certain applications or notices submitted by savings banks. The OTS, through its general oversight of the safety and soundness of savings associations, retains the right to impose minimum capital requirements on individual institutions to the extent the institution is not in compliance with certain written guidelines established by the OTS regarding NPV analysis. The OTS has not imposed any such requirements on the Bank.
Limitations on Dividends and Other Capital Distributions. The OTS imposes various restrictions or requirements on the Bank's ability to make capital distributions, including cash dividends. A savings institution that is the subsidiary of a savings and loan holding company must file a notice with the OTS at least 30 days before making a capital distribution. The Bank must file an application for prior approval if the total amount of its capital distributions, including the proposed distribution, for the applicable calendar year would exceed an amount equal to the Bank's net income for that year plus retained net income for the previous two years.
OTS may disapprove of a notice or application if:
During the fiscal year ended June 30, 2008, the Bank paid cash dividends to the Company totaling $5.2 million.
Liquidity. All savings associations, including the Bank, are required to maintain a sufficient amount of liquid assets to ensure its safe and sound operation. For a discussion of what the Bank includes in liquid assets, see Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Form 10-K.
Branching. Subject to certain limitations, the HOLA and the OTS regulations permit federally chartered savings associations to establish branches in any state of the United States. The authority to establish such branches is available (a) in states that expressly authorize branches of savings associations located in another state or (b) to an association that qualifies as a "domestic building and loan association" under the Internal Revenue Code of 1986, as amended, which imposes qualification requirements similar to those for a "qualified thrift lender" under the HOLA. See the section below entitled "Qualified Thrift Lender Test." This authority under the HOLA and the OTS regulations preempts any state law purporting to regulate branching by federal savings associations.
Community Reinvestment. Under the Community Reinvestment Act (the "CRA"), as implemented by the OTS regulations, the Bank has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community. The CRA requires the OTS, in connection with its examination of a savings association, to assess the Bank's record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by the Bank. The CRA also requires all institutions to make public disclosure of their CRA ratings. The Bank received an "Outstanding" CRA rating in the OTS evaluation, which was last completed on May 29, 2008.
The CRA regulations rate an institution based on its actual performance in meeting community needs. In particular, the rating system focuses on three tests: (a) a lending test, to evaluate the institution's record of making loans in its assessment areas; (b) an investment test, to evaluate the institution's record of investing in community development projects, affordable housing, and programs benefiting low or moderate income individuals and businesses; and (c) a service test, to evaluate the institution's delivery of services through its branches, ATMs and other offices.
Qualified Thrift Lender ("QTL") Test. Under the HOLA, the Bank must comply with the qualified thrift lender, or "QTL" test. Under the QTL test, the Bank is required to maintain at least 65.00% of its "portfolio assets" (total assets less (a) specified liquid assets up to 20.00% of total assets, (b) intangibles, including goodwill, and (c) the value of property used to conduct business) in certain "qualified thrift investments" (primarily residential mortgages and related investments, including certain mortgage-backed securities, credit card loans, student loans and small business loans) in at least nine months of the most recent 12 month period. The Bank may also satisfy the QTL test by qualifying as a "domestic building and loan association" as defined in the Internal Revenue Code of 1986, as amended.
At June 30, 2008, the Bank held 74.82% of its portfolio assets in qualified thrift investments and had more than 65.00% of its portfolio assets in qualified thrift investments in 12 of the 12 months
during the fiscal year ended June 30, 2008, and thus qualified under the QTL test. The Bank has met the QTL test since its inception.
A savings bank that fails the QTL test and is unable to demonstrate a reasonable likelihood of meeting it in the future may be required to convert to a bank charter and will generally be prohibited from: (1) engaging in any new activity not permissible for a national bank, (2) paying dividends not permissible under national bank regulations, and (3) establishing any new branch office in a location not permissible for a national bank. In addition, if the institution does not re-qualify under the QTL test within three years after failing the test, the institution would be prohibited from engaging in any activity not permissible for a national bank and may have to repay any outstanding advances from the Federal Home Loan Bank as promptly as possible.
Transactions with Affiliates. The Bank's authority to engage in transactions with its "affiliates" is limited by the OTS regulations, Sections 22(g), 22(h) 23A and 23B of the Federal Reserve Act (the "FRA") and Regulation W issued by the Federal Reserve Board, Section 11 of the HOLA as well as any additional limitations adopted by the OTS. OTS regulations regarding transactions with affiliates conform to Regulation W. These provisions, among other things, prohibit or limit a savings bank from extending credit to, or entering into certain transactions with, its affiliates and principal stockholders, directors and executive officers.
In addition, the OTS regulations include additional restrictions on savings banks under Section 11 of the HOLA, including provisions prohibiting a savings bank from making a loan to an affiliate that is engaged in non-bank holding company activities and provisions prohibiting a savings association from purchasing or investing in securities issued by an affiliate that is not a subsidiary. OTS regulations also include certain specific exemptions from these prohibitions. The FRB and the OTS require each depository institution that is subject to Sections 23A and 23B to implement policies and procedures to ensure compliance with Regulation W and the OTS regulations regarding transactions with affiliates.
Section 402 of the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley") prohibits the extension of personal loans to directors and executive officers of issuers (as defined in Sarbanes-Oxley). The prohibition, however, does not apply to mortgages advanced by an insured depository institution, such as the Bank, that are subject to the insider lending restrictions of Section 22(h) of the FRA.
Real Estate Lending Standards. The OTS and the other federal banking agencies adopted regulations to prescribe standards for extensions of credit that (a) are secured by real estate or (b) are made for the purpose of financing the construction of improvements on real estate. The OTS regulations require the Bank to establish and maintain written internal real estate lending standards that are consistent with safe and sound banking practices and appropriate to the size of the association and the nature and scope of its real estate lending activities. The standards also must be consistent with accompanying OTS guidelines, which include loan-to-value ratios for the different types of real estate loans. The Bank is also permitted to make a limited amount of loans that do not conform to the proposed loan-to-value limitations so long as such exceptions are reviewed and justified appropriately. The guidelines also list a number of lending situations in which exceptions to the loan-to-value standards are justified.
Nontraditional Mortgage Products. The federal banking agencies recently published final guidance for institutions that originate or service nontraditional or alternative mortgage products, defined to include all residential mortgage loan products that allow borrowers to defer repayment on principal or interest, such as interest-only mortgages and payment option adjustable-rate mortgages. No portion of the Bank's adjustable rate residential mortgage loans consist of interest-only or payment option mortgage loans.
Recognizing that alternative mortgage products expose institutions to increased risks as compared to traditional loans where payments amortize or reduce the principal amount, the guidance required increased scrutiny for alternative mortgage products. Institutions that originate or service alternative mortgages should have (a) strong risk management practices that include maintenance of capital levels and allowance for loan losses commensurate with the risk; (b) prudent lending policies and underwriting standards that address a borrower's repayment capacity; and (c) programs and practices designed to ensure that consumers receive clear and balanced information to assist in making informed decisions about mortgage products. The guidance also recommends heightened controls and safeguards when an institution combines an alternative mortgage product with features that compound risk, such as a simultaneous second-lien or the use of reduced documentation to evaluate a loan application.
The Bank is required to comply with the guidance as it is interpreted and applied by the OTS.
Protection of Customer Information. In addition to certain state laws governing protection of customer information, the Bank is subject to federal regulatory guidelines establishing standards for safeguarding customer information. These regulations implement certain provisions of the Gramm-Leach-Bliley Act. The guidelines describe the agencies' expectations for the creation, implementation and maintenance of an information security program, which would include administrative, technical and physical safeguards appropriate to the size and complexity of the institution and the nature and scope of its activities. The standards set forth in the guidelines are intended to ensure the security and confidentiality of customer records and information, protect against any anticipated threats or hazards to the security or integrity of such records and protect against unauthorized access to or use of such records or information that could result in substantial harm or inconvenience to any customer. Federal guidelines also impose certain customer disclosures and other actions in the event of unauthorized access to customer information.
Trust Activities Regulation. The Bank derives its trust powers from Section 5(n) of the HOLA and the regulations and policies of the OTS. Under these laws, regulations and policies, the trust activities of federal savings banks are governed by both federal and state laws. Generally, the scope of trust activities that the Bank can provide will be governed by the laws of the states in which the Bank is "located" (as such term is defined under the regulations of the OTS), while other aspects of the trust operations of the Bank are governed by federal laws and regulations. If the trust activities of a federal savings bank are located in more than one state, however, then the scope of fiduciary services the federal savings bank can provide will vary depending on the laws of each state.
The Bank, through its trust department, acts as trustee, personal representative, administrator, guardian, custodian, record keeper, agent, registrar, advisor and manager for various accounts. As of June 30, 2008, the trust department of the Bank maintained approximately $95.0 million in assets under management.
Federal Reserve System. Under FRB regulations, the Bank is required to maintain noninterest-earning reserves against its transaction accounts. FRB regulations generally require that (a) reserves of 3.00% must be maintained against aggregate transaction account balances of $48.3 million or less,
subject to adjustment by the FRB, and (b) a reserve of 10% must be maintained against that portion of total transaction accounts in excess of $48.3 million. The first $7.8 million of otherwise reservable balances are exempted from the reserve requirements. The Bank is in compliance with these reserve requirements at June 30, 2008. Because required reserves must be maintained in the form of either vault cash, a noninterest bearing account at a FRB, or a pass-through account as defined by the FRB, the effect of this reserve requirement is to reduce the Bank's interest-earning assets to the extent that the requirement exceeds vault cash.
Federal Home Loan Bank System. The Bank is a member of the FHLB of Des Moines, which is one of 12 regional FHLBs that administers the home financing credit function of savings associations. Each FHLB serves as a reserve or central bank for its members within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It makes loans to members (i.e., advances) in accordance with policies and procedures established by the board of directors of the FHLB. These policies and procedures are subject to the regulation and oversight of the Federal Housing Finance Board. All advances from the FHLB are required to be fully secured by sufficient collateral as determined by the FHLB. The Bank, as a member of the FHLB of Des Moines, is required to acquire and hold shares of capital stock in the FHLB of Des Moines equal to 0.12% of the total assets of the Bank at December 31 annually. The Bank is also required to own activity-based stock, which is based on 4.45% of the Bank's outstanding advances. These percentages are subject to change at the discretion of the FHLB Board of Directors.
At June 30, 2008, the Bank had $11.2 million in FHLB stock, which was in compliance with this requirement. The Bank receives dividends on its FHLB stock, subject to approval by the FHLB. For the fiscal year ended June 30, 2008, dividends paid by the FHLB of Des Moines to the Bank totaled approximately $304,000, which constitutes a $17,000 decrease in the amount of dividends received in fiscal 2007.
USA Patriot Act. The Bank is subject to the OTS and Financial Crimes Enforcement Network regulations implementing the Bank Secrecy Act, as amended by the USA Patriot Act, which gives the federal government expanded powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USA Patriot Act takes measures intended to encourage information-sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III of the USA Patriot Act impose affirmative obligations on a broad range of financial institutions, including banks, thrifts, brokers, dealers, credit unions, money transfer agents and parties registered under the Commodity Exchange Act.
other requirements, Title III of the USA Patriot Act imposes the following requirements with respect to financial institutions:
specific and, where necessary, enhanced due diligence policies, procedures and controls designed to detect and report money laundering.
The Sarbanes-Oxley Act. As a public company, we are subject to the Sarbanes-Oxley Act, which implements a broad range of corporate governance and accounting measures for public companies designed to promote honesty and transparency in corporate America and to better protect investors from corporate wrongdoing.
Sarbanes-Oxley Act's principal legislation and the derivative rulemaking promulgated by the SEC include:
Furthermore, the NASDAQ Stock Market (the "NASDAQ") has also implemented corporate governance rules which implement the mandates of the Sarbanes-Oxley Act. The material NASDAQ rules include, among other things, ensuring that a majority of the board of directors are independent of management, establishing and publishing a code of conduct for directors, officers and employees, and requiring stockholder approval of all new stock option plans and all material modifications. These rules affect the Company because its common stock is listed on the NASDAQ Stock Market under the symbol "HFFC."
The Company anticipates additional expenses in complying with the provisions of the Sarbanes-Oxley Act and the resulting regulation. Management presently anticipates that the associated internal costs and third party expenses may be significant.
Holding Company Regulation. The Company is a unitary savings and loan holding company within the meaning of the HOLA. As such, the Company is required to register with and be subject to OTS examination and supervision as well as certain reporting requirements. In addition, the OTS has enforcement authority over the Company and any of its non-savings institution subsidiaries. Among other things, this authority permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the financial safety, soundness or stability of a subsidiary savings bank. Unlike bank holding companies, a savings and loan holding company is not subject to any regulatory capital requirements or to supervision by the Federal Reserve System.
"Grandfathered" Savings and Loan Holding Company Status. Because the Company acquired the Bank prior to May 4, 1999, the Company is a "grandfathered" unitary savings and loan holding company under the Gramm-Leach-Bliley Act. As such, the Company has restrictions on its business activities, provided the Bank continues to be a "qualified thrift lender." If, however, the Company is acquired by a non-financial company, or if it acquires another savings association subsidiary (and becomes a multiple savings and loan holding company), the Company will terminate its "grandfathered" unitary savings and loan holding company status, and become subject to certain additional limitations on the types of business activities in which the Company could engage. All "non-grandfathered" unitary savings and loan holding companies are limited to financially related activities permissible for bank holding companies, as defined under the Gramm-Leach-Bliley Act.
Restrictions Applicable to All Savings and Loan Holding Companies. Federal law prohibits a savings and loan holding company, including the Company, directly or
indirectly, from acquiring:
savings and loan holding company may not acquire as a separate subsidiary an insured institution that has a principal office outside of the state where the principal office of its
subsidiary institution is located, except:
chartered by the state where the acquiring savings institution or savings and loan holding company is located, or by a holding company that controls such a state chartered association.
In addition, if the Bank fails the QTL test (discussed above), the Company must register with the FRB as a bank holding company under the Bank Holding Company Act within one year of the Bank's failure to so qualify.
The HOLA prohibits a savings and loan holding company (directly or indirectly, or through one or more subsidiaries) from acquiring another savings association or holding company thereof without prior written approval of the OTS; acquiring or retaining, with certain exceptions, more than 5% of a non-subsidiary savings association, a non-subsidiary holding company, or a non-subsidiary company engaged in activities other than those permitted by the HOLA; or acquiring or retaining control of a depository institution that is not federally insured. In evaluating applications by holding companies to acquire savings associations, the OTS must consider the financial and managerial resources and future prospects of the company and institution involved, the effect of the acquisition on the risk to the insurance funds, the convenience and needs of the community and competitive factors.
Federal Securities Law. The common stock of the Company is registered with the SEC under the Exchange Act. The Company is subject to the information, proxy solicitation, insider trading restrictions and other requirements of the SEC under the Exchange Act.
Company stock held by persons who are affiliates (generally officers, directors and principal stockholders) of the Company may not be resold without registration or unless sold in accordance with certain resale restrictions. If the Company meets specified current public information requirements, each affiliate of the Company is able to sell in the public market, without registration, a limited number of shares in any three-month period.
Delaware General Corporation Law. The Company is incorporated under the laws of the State of Delaware. Thus, the Company is subject to regulation by the State of Delaware and the rights of the Company's stockholders are governed by the Delaware General Corporation Law.
Federal and State Taxation
The Company and its direct and indirect subsidiaries file a consolidated federal income tax return on a fiscal year basis. In addition, each of Trust III, Trust IV, Trust V and Trust VI are required to file individual trust returns on a calendar year basis.
In addition to the regular income tax, corporations, including savings associations such as the Bank, generally are subject to a minimum tax. An alternative minimum tax is imposed at a minimum tax rate of 20.00% on alternative minimum taxable income, which is the sum of a corporation's regular taxable income (with certain adjustments) and tax preference items, less any available exemption. The alternative minimum tax is imposed to the extent it exceeds the corporation's regular income tax and net operating losses can offset no more than 90.00% of alternative minimum taxable income.
To the extent earnings appropriated to a savings association's bad debt reserves for "qualifying real property loans" and deducted for federal income tax purposes exceed the allowable amount of such reserves computed under the experience method and to the extent of the association's supplemental reserves for losses on loans ("Excess"), such Excess may not, without adverse tax consequences, be utilized for the payment of cash dividends or other distributions to a shareholder (including distributions on redemption, dissolution or liquidation) or for any other purpose (except to absorb bad debt losses). As of June 30, 2008, the Bank's Excess for tax purposes totaled approximately $4.8 million.
South Dakota Taxation. The Bank is subject to the South Dakota Franchise tax to the extent that such corporations are engaged in business in the state of South Dakota. South Dakota does not have a
corporate income tax. The franchise tax will be imposed at a rate of 6.00% on franchise taxable income which is computed in the same manner as federal taxable income with some minor variations to comply with South Dakota law, other than the carryover of net operating losses which is not permitted under South Dakota law. A South Dakota return of franchise tax must be filed annually.
Minnesota Taxation. The Bank is subject to the Minnesota Corporate Income tax to the extent that such corporations are engaged in business in the state of Minnesota. The Corporate Income tax is imposed at a rate of 9.8% on corporate taxable income, which is computed in the same manner as federal taxable income with some minor variations to comply with Minnesota law. A Minnesota return of Corporate Income tax must be filed annually.
Delaware Taxation. As a Delaware holding company, the Company is exempted from Delaware corporate income tax but is required to file an annual report with and pay an annual fee to the State of Delaware. The Company is also subject to an annual franchise tax imposed by the State of Delaware, which is made in quarterly payments.
Taxation in Other States. Mid America Capital is required to file state income tax returns in those states which lessees have operations. The total taxes paid in the year ended June 30, 2008 were not material to the operation of the Company.
Executive Officers of the Company
Information regarding the executive officers of the Company and the Bank is set forth below.
Curtis L. HageMr. Hage, age 62, is Chairman, President and Chief Executive Officer of the Company. He was elected to the position of Chairman of the Board of Directors of the Company in September 1996 and has held the positions of President and Chief Executive Officer since February 1991. Prior to such time, Mr. Hage served as Executive Vice President of the Bank since 1986. Since joining the Bank in 1968, he served in various capacities prior to being elected Executive Vice President. Mr. Hage received his M.B.A. from the University of South Dakota and attended the Graduate School of Savings Institution Management at the University of Texas.
Darrel L. PosegateMr. Posegate, age 50, has served as Executive Vice President, Chief Financial Officer and Treasurer of the Company since January 2002. He has served as President of the Bank since October 2006 and as Executive Vice President, Chief Financial Officer and Treasurer of the Bank from January 2002 until October 2006. Prior to such time, he was employed in senior leadership roles in the banking industry since 1983. Mr. Posegate received his B.A. degree from Luther College, Decorah, Iowa, and is a Certified Public Accountant.
David A. BrownMr. Brown, age 47, has served as the Senior Vice President/Business Banking of the Bank from November 1999 until May 2008 at which time he was promoted to the position of Senior Vice President/Community Banking. Prior to joining the Bank, Mr. Brown served as Vice President/Manager Commercial Banking of Firstar Bank, Sioux City, Iowa, a national banking institution, a position he held since December 1998. Mr. Brown received his M.B.A. and a B.S. in Business Administration from the University of South Dakota.
Jon M. GadberryMr. Gadberry, age 46, has served as Senior Vice President/Wealth Management of the Bank since December 2007. Prior to joining the Bank, Mr. Gadberry was employed by Bank of the West as Vice President/Trust Manager from November 2004 to December 2007. Mr. Gadberry received his B.S. in Business Administration from Concordia College in Moorhead, Minnesota.
Mary F. HitzemannMs. Hitzemann, age 55, has served as the Senior Vice President/Human Resources of the Bank since October 1993. Ms. Hitzemann joined the Bank in January 1993. Prior to that time, she was employed as Vice President of Human Resources for Rapid City Regional Hospital from May 1989 to May 1992. Ms. Hitzemann received her B.A. degree from Augustana College.
Brent R. OlthoffMr. Olthoff, age 37, has served as Senior Vice President, Chief Financial Officer and Treasurer of the Bank since April 2007. Mr. Olthoff joined the Bank in July 2001, and was promoted to Vice President/Finance in July 2004. Prior to serving in his current role, Mr. Olthoff was employed by FTN Financial, a capital markets firm in Memphis, Tennessee, where he was Vice President/Asset Strategies from February 2006 to April 2007. Mr. Olthoff received his B.B.A degree in Finance from Iowa State University.
Natalie A. Sundvold, formerly Natalie A. SolbergMs. Sundvold, age 45, has served as the Senior Vice President/Service & Support of the Bank since October 2002. She joined the Bank in February 1994 as manager of the phone banking center and was promoted to Vice President/In-Touch Banking in October 1995. Prior to joining the Bank, she was employed by the Bank of New York from October 1989 to October 1993. Ms. Sundvold received her B.S. from Northern State University.
Michael WestbergMr. Westberg, age 41, has served as the Senior Vice President/Retail Banking of the Bank from July 2006 to May 2008 at which time he was promoted to the position of Senior Vice President/Corporate Strategy. Mr. Westberg joined the Bank in February 1996 as a branch manager. Prior to joining the Bank, he was employed with First Savings Bank, Beresford (South Dakota) from 1992 to 1996; and The Associates, Dallas, Texas, from 1989 to 1992. Mr. Westberg attended Illinois State University majoring in business and is a graduate of the American Bankers Association National School of Banking.
The following are certain material risks that our management believes are specific to us and our business. You should understand that it is not possible to predict or identify all such potential risks and, as such, this list of risk factors should not be viewed as all-inclusive or in any particular order. An investment in shares of our common stock involves various risks. Before deciding to make an investment decision regarding our common stock, you should carefully consider the risks described below in conjunction with the other information in this Form 10-K and information incorporated by reference into this Form 10-K, including our consolidated financial statements and related notes which are set forth in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K. Our business, financial condition and results of operations could be harmed by any of the following risks or by other risks that have not been identified or that the Company may believe are immaterial or unlikely. The value or market price of our common stock could decline due to any of these risks, and you may lose all or part of your investment. The risks discussed below also include forward-looking statements and our actual results may differ substantially from those discussed in these forward-looking statements.
Risks Related to Our Business
We face strong competition for customers, which could prevent us from obtaining customers and may cause us to pay higher interest rates to attract deposits and charge lower rates to obtain the loan volume we need to grow, any of which may reduce our profitability. The banking business is highly competitive and we experience competition in each of our markets from many other financial institutions, many of which are larger and may have significantly greater financial and other resources than we have. Specifically, we compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as super-regional, national and international financial institutions, that operate offices in our primary market areas and elsewhere. Many of these competitors are also well-established financial institutions.
Competitors that are not depository institutions are generally not subject to the extensive regulations that apply to us. We compete with these institutions both in attracting deposits and in
making loans. In addition, we must attract our customer base from other existing financial institutions and from new residents. There is a risk that we will not be able to compete successfully with these other financial institutions in our markets, and that we may have to pay higher interest rates to attract deposits or charge lower interest rates to obtain loan volume, resulting in reduced profitability. In new markets that we may enter, we will also compete against well-established community banks that have developed relationships within the community.
Changes in interest rates may reduce our profitability. Our profitability depends in large part on our net interest income, which is the difference between interest earned from interest-earning assets, such as loans and mortgage-backed securities, and interest paid on interest-bearing liabilities, such as deposits and borrowings. Our net interest income will be adversely affected if market interest rates change such that the interest we pay on deposits and borrowings increases faster than the interest we earn on loans and investments. Many factors cause changes in interest rates, including governmental monetary policies and domestic and international economic and political conditions. While we intend to manage the effects of changes in interest rates by adjusting the terms, maturities, and pricing of our assets and liabilities, our efforts may not be effective in a changing rate environment and our financial condition and results of operations may suffer.
Interest rates were at historically low levels until June 2004 at which time the Federal Reserve began increasing short-term interest rates 17 times or 425 basis points through June 29, 2006. Beginning September 18, 2007, the Federal Reserve began an interest rate easing of 325 basis points through April 30, 2008. During this period, a flattening and slight inversion of the treasury yield curve caused by increasing short-term rates and lagging long-term rates had a negative impact on our net interest margin. In fiscal 2008, as short-term interest rates decreased, the Company experienced a positive effect to its net interest margin If short-term interest rates rise, and if rates on our deposits and borrowings re-price upwards faster than the rates on our long-term loans and investments, the Company may experience compression of our net interest margin, which will have a negative effect on our profitability.
Our growth may require us to raise additional capital that may not be available when it is needed or may not be available on terms acceptable to us. We are required by regulatory authorities to maintain adequate levels of capital to support our operations. To support our future continued growth, we may need to raise additional capital. Our ability to raise additional capital, if needed, will depend in part on conditions in the capital markets at that time, which are outside our control. Accordingly, we cannot assure you of our ability to raise additional capital, if needed, on terms acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations through internal growth could be materially impaired.
In the event that we are able to raise capital through the issuance of additional shares of common stock or other securities, the ownership interests of current investors would be diluted and the per share book value of our common stock may be diluted. New investors may also have rights, preferences and privileges senior to the holders of our common stock, which may adversely affect the holders of our common stock.
We may look to sell production assets, such as mortgage loans, into the secondary market as a means to manage the size of the balance sheet and manage the use of capital. The demand for these products in the capital markets is not driven by us and may not benefit us at the time we look to sell the loans.
We are subject to extensive regulations that may limit or restrict our activities and the cost of compliance is high. We operate in a highly regulated industry and are subject to examination, supervision and comprehensive regulation by various regulatory agencies. Banking regulations are primarily intended to protect the federal deposit insurance funds and depositors, not stockholders. Our compliance with these
regulations is costly and restricts certain of our activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits and locations of offices. We are also subject to regulatory capital requirements, which require us to maintain adequate capital to support our growth. If we fail to meet these capital and other regulatory requirements, our ability to grow, our cost of funds and FDIC insurance, our ability to pay dividends on common stock, and our ability to make acquisitions could be materially and adversely affected.
Congress and federal agencies continually review laws, regulations and policies applicable to the banking industry for possible changes, and we cannot predict the effects of these changes on our business and profitability. Because, like all banks and bank holding companies, government regulation greatly affects our business and financial results, our cost of compliance could adversely affect our ability to operate profitably. See "Regulation" under Part I, Item 1 "Business" of this Form 10-K for a detailed discussion of regulation requirements.
Changes in or interpretations of accounting standards may materially impact our financial statements. Accounting principles generally accepted in the United States of America and accompanying accounting pronouncements, implementation guidelines, interpretations and practices for many aspects of our business are complex and involve subjective judgments, including, but not limited to accounting for the allowance for loan and lease losses and pending and incurred but not reported health claims. Changes in these estimates or changes in other accounting rules and principles, or their interpretation, could significantly change our reported earnings and operating results, and could add significant volatility to those measures, without a comparable underlying change in cash flow from operations.
Our success is influenced by growth in South Dakota and lack of growth or changes in national and South Dakota economic and political conditions could adversely affect our earnings, as our borrowers' ability to repay loans and the value of the collateral securing our loans decline and as loans and deposits decline. Our success and growth is significantly influenced by the growth in population and income levels and deposits in our primary market areas, which are mainly in South Dakota. If the communities in which we operate do not grow or if prevailing economic conditions locally or nationally are unfavorable, our business may be negatively affected.
Additionally, there are inherent risks associated with our lending activities, including credit risk, which is the risk that borrowers may not repay outstanding loans or the value of the collateral securing loans will decrease. Conditions such as inflation, recessions, unemployment, changes in interest rates and money supply and other factors beyond our control may adversely affect the ability of our borrowers to repay their loans and the value of collateral securing the loans, which could adversely affect our earnings. Because our business operations and activities are concentrated in the State of South Dakota and most of our credit exposure is in that state, we are specifically at risk from adverse economic, political and business conditions that affect South Dakota.
Our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolios, which could adversely affect our operating results. Like all financial institutions, we maintain an allowance for loan losses to provide for loans in our portfolio that may not be repaid in their entirety. Although we believe that our allowance for loan losses is maintained at a level adequate to absorb probable losses inherent in our loan portfolio as of the corresponding balance sheet date, the determination of the appropriate level of the allowance for loan losses 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. Accordingly, our allowance for loan losses may not be sufficient to cover actual loan losses, and future provisions for loan losses could materially adversely affect our operating results by decreasing our net income.
In evaluating the adequacy of our allowance for loan losses, we consider numerous quantitative factors, including our historical charge-off experience, growth of our loan portfolio, changes in the
composition of our loan portfolio and the volume of delinquent and criticized loans. In addition, we use information about specific borrower situations, including their financial position and estimated collateral values, to estimate the risk and amount of loss for those borrowers. Finally, we also consider many qualitative factors, including general and economic business conditions, duration of the current business cycle, current general market collateral valuations, trends apparent in any of the factors we take into account and other matters, which are by nature more subjective and fluid. Our estimates of the risk of loss and amount of loss on any loan are complicated by the significant uncertainties surrounding our borrowers' abilities to successfully execute their business models through changing economic environments, competitive challenges and other factors. In considering information about specific borrower situations our analysis is subject to the risk that we are provided inaccurate or incomplete information. Because of the degree of uncertainty and susceptibility of these factors to change, our actual losses may vary from our current estimates.
Additionally, bank regulators periodically review our allowance for loan losses and may require an increase in the provision for loan losses or recognize loan charge-offs based upon their judgments, which may be different from ours. Any increase in our allowance for loan losses or loan charge-offs required by these regulatory authorities may adversely affect our operating results.
The net realizable value of our investment securities could be lower than the fair value assigned under generally accepted accounting principles. We determine the fair value of our investment securities based on the most recent quoted market price for such securities as of the applicable balance sheet date. We use quoted market prices to determine the amount of any unrealized losses that may be reflected in our other comprehensive income and the net book value of our investment securities. The price at which a security could be sold in a market transaction could be significantly lower than the quoted market price for the security, particularly if the quoted market price is based on infrequent trading history, the market for the security is illiquid, or could be dependent on the size of the trade. The risk that there will be a material difference between the fair value that we assign to a security and its net realizable value is particularly significant for certain securities that we hold in our investment portfolio, including our "private label" collateralized mortgage obligation and our rated pooled trust preferred securities. If the net realizable value is lower than the fair value that we assign to a security, impairment losses could be required in the future.
Our ability to secure wholesale funding to supplement core deposits may prove insufficient. We must maintain sufficient funds to respond to the obligations of our depositors and borrowers. As part of our liquidity management, we use a number of funding sources to supplement our core deposit growth. These sources include brokered certificates of deposit, federal funds purchased, Federal Reserve Bank and FHLB advances. Adverse operating results or changes in industry conditions could lead to an inability to replace these additional funding sources at maturity. Our financial flexibility will be severely constrained if we are unable to maintain our access to funding or if adequate financing is not available to accommodate future growth at acceptable interest rates. If we are required to rely more heavily on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs, and our profitability would be adversely affected.
Our ability to retain and attract qualified employees is critical to the success of our business and the failure to do so may materially adversely affect our performance. Our people are our most important resource and competition for qualified employees is intense. In order to retain and attract qualified employees, we must compensate such employees at market levels. Typically, those levels have caused employee compensation to be our greatest noninterest expense. In addition, because certain information concerning our employee compensation is included in our filings with the SEC and is, therefore, available to our competitors, we believe that our employees may be more highly recruited by our competitors. If we are unable to continue to retain and attract qualified employees, or if
compensation costs required to retain and attract qualified employees becomes more expensive, our performance, including our competitive position, could be affected.
Our ability to maintain our reputation is critical to the success of our business and the failure to do so may materially adversely affect our performance. Our reputation is one of the most valuable components of our business. As such, we strive to conduct our business in a manner that enhances our reputation. This is done, in part, by recruiting, hiring and retaining employees who share our core values of being an integral part of the communities we serve, delivering superior service to our customers and caring about our customers and associates. If our reputation is negatively affected, by the actions of our employees or otherwise, our business and, therefore, our operating results may be materially adversely affected.
Revenues from our Trust and Asset Management business are significant to our earnings. We believe that the revenues which are derived from our Trust and Asset Management business are significant to our business. The success of our Trust and Asset Management business is dependent on our ability to produce investment returns which meet the expectations of our clients. Administering or managing assets in accordance with the terms of governing documents and applicable laws is also important to client satisfaction. Our inability to succeed in either of the foregoing areas could negatively affect our revenues we receive from our Trust and Asset Management business.
Natural disasters, acts of war or terrorism, and other external events could significantly impact our business. Severe weather, natural disasters, acts of war or terrorism, and other adverse external events could have a significant impact on our ability to conduct business. Such events could affect the stability of our deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause us to incur additional expenses. Although management has established disaster recovery policies and procedures, the occurrence of any such event could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.
Risks Related to Our Common Shares
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 Stock 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.
Our ability to pay dividends depends primarily on dividends from our banking subsidiary, Home Federal Bank, which is subject to regulatory limits. We are a unitary thrift holding company and our operations are conducted primarily by our banking subsidiary, Home Federal Bank. Since we receive substantially all of our revenue from dividends from Home Federal Bank, our ability to pay dividends on our common stock depends on our receipt of dividends from Home Federal Bank. Dividend payments from Home Federal Bank are subject to legal and regulatory limitations, generally based on net income and retained earnings. The ability of Home Federal Bank to pay dividends to us is also subject to its profitability, financial condition, capital expenditures and other cash flow requirements. There is no assurance that Home Federal Bank will be able to pay dividends to us in the future or that we will generate adequate cash flow to pay dividends in the future. The inability to receive dividends from Home Federal Bank could have an adverse affect on our business and financial conditions. Additionally, we may elect in the future to defer interest payments on our subordinated debentures payable to trusts. The indenture agreements prohibit dividend payments on common stock following the
deferral of interest payments on the subordinated debentures underlying trust preferred securities. Similarly, our failure to pay dividends on our common stock could have a material adverse effect on the market price of our common stock.
We are subject to security and operational risks relating to our use of technology that could damage our reputation and our business. Security breaches in our internet banking activities or other communication and information systems could damage our reputation, result in a loss of customer 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. We rely on standard internet and other security systems to provide the security and authentication necessary to effect secure transmission of data. These precautions may not protect our systems from compromises or breaches of our security measures.
Certain provisions of our certificate of incorporation and bylaws, as well as Delaware and federal law, may discourage, delay or prevent an acquisition of control of us. Certain provisions included in our certificate of incorporation and bylaws, as well as certain provisions of the Delaware General Corporation Law and federal law, may discourage, delay or prevent potential acquisitions of control of us, particularly when attempted in a transaction that is not negotiated directly with, and approved by, our Board of Directors, despite possible benefits to our stockholders.
our certificate of incorporation and bylaws include certain provisions that:
Furthermore, federal law requires OTS approval prior to any direct or indirect acquisition of "control" (as defined in OTS regulations) of the Bank, including any acquisition of control of us.
The Company and its direct and indirect subsidiaries conduct their business at the main office located at 225 South Main Avenue, Sioux Falls, South Dakota, 57104. Currently, the Bank also conducts business from 32 other offices located in its primary market area. Of such 33 total business offices, the Company owns 15, including the main office, and leases 18 others.
The total net book value of the Company's premises and equipment (including land, building, leasehold improvements and furniture, fixtures and equipment) at June 30, 2008 was $14.8 million. The Company previously announced a new facility in Watertown, South Dakota to be constructed in fiscal 2009 which will replace an existing branch office. Management believes there is a continuing need to keep facilities and equipment up-to-date and continued investment will be necessary in the future.
On June 26, 2006, the Company filed a $3.8 million lawsuit against MetaBank and two individuals, J. Tyler Haahr and Daniel A. Nelson, for their role in a participation loan, alleging fraud, breach of fiduciary duty, conspiracy and negligent misrepresentation. These damages were the result of a failure by the lead bank to make disclosures regarding an investigation of the commercial customer by the Iowa Attorney General at the time the Bank agreed to an extension of loan participation agreements. Legal proceedings are currently pending in the Second Judicial Circuit Court, Minnehaha County, South Dakota. Summary judgment motions have been denied, which management believes are favorable to the Company, and the lawsuit is scheduled for trial during the Company's second fiscal quarter.
In addition, the Company, the Bank and each of their subsidiaries are, from time to time, involved as plaintiff or defendant in various legal actions arising in the normal course of their businesses. While the ultimate outcome of any such proceedings cannot be predicted with certainty, it is generally the opinion of management, after consultation with counsel representing the Bank and the Company in any such proceedings, that the resolution of any such proceedings should not have a material effect on the Company's consolidated financial position or results of operations. The Company, the Bank and each of their subsidiaries are not aware of any legal actions or other proceedings contemplated by governmental authorities outside of the normal course of business.
No matter was submitted to a vote of stockholders, through the solicitation of proxies or otherwise, during the quarterly period ended June 30, 2008.
The Company's common stock is traded under the symbol "HFFC" on the NASDAQ Stock Market.
The following table sets forth the range of high and low sale prices for the Company's common stock for each of the fiscal quarters of the two years ended June 30, 2008 and 2007. Quotations for such periods are as reported by the NASDAQ Stock Market.
As of September 16, 2008, the Company had 486 holders of record of its common stock.
The transfer agent for the Company's common stock is Mellon Investor Services, PO Box 3315, South Hackensack, New Jersey, 07606-1915.
The Company paid cash dividends on a quarterly basis of $0.1050, $0.1075, $0.1075 and $0.1075 per share throughout fiscal 2008. The Company paid cash dividends on a quarterly basis of $0.1025, $0.1050, $0.1050 and $0.1050 per share in fiscal 2007. The Board of Directors intends to continue the payment of quarterly cash dividends, dependent on the results of operations and financial condition of the Company, tax considerations, industry standards, economic conditions, general business practices and other factors the Board of Directors deems relevant. On July 28, 2008, the Board of Directors announced the approval of a cash dividend of $0.1125 per share and the Company paid the respective cash dividends on August 15, 2008 to shareholders of record on August 8, 2008. The Company's ability to pay dividends is dependent on the dividend payments it receives from its subsidiary, the Bank, which are subject to OTS regulations. See Item 1, "BusinessRegulation" of this Form 10-K. The ability of the Company to pay dividends is also subject to the terms of the agreements on subordinated debentures payable to trusts, should the Company elect to defer interest payments. In addition, the Company's ability to pay dividends is subject to the terms of its line of credit with First Tennessee Bank, NA. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of OperationsLiquidity and Capital Resources" of this Form 10-K.
Stockholder Return Performance
The following line graph compares the cumulative total stockholder return on the Company's common stock to the comparable cumulative total return of the NASDAQ Market Index and the NASDAQ Bank Index for the last five years.
The performance graph assumes that on July 1, 2003, $100 was invested in the Company's common stock (at the closing price of the previous trading day) and in each of the indexes. The comparison assumes the reinvestment of all dividends. Cumulative total stockholder returns for the Company's common stock, NASDAQ Market Index and the NASDAQ Bank Index are based on the Company's fiscal year ending June 30.
$100 INVESTED ON JULY 1, 2003
Equity Compensation Plan
The following table sets forth certain information about the common stock that may be issued upon exercise of options, warrants and rights under all of the Company's existing equity compensation plans, including the 2002 Stock Option and Incentive Plan, the 1996 Director Restricted Stock Plan, and the 1991 Stock Option Plan (collectively, the "Incentive Plans"). The 1996 Director Restricted Stock Plan expired on January 1, 2007, and the 1991 Stock Option Plan expired on October 27, 2002. Although the column below entitled "Number of Shares to be Issued Upon Exercise of Outstanding Options, Warrants and Rights" includes common stock to be issued upon unexpired options issued under the 1991 Stock Option Plan, no common stock remains available for future awards under the
1991 Stock Option Plan. Additionally, no common stock remains available for future awards under the 1996 Director Restricted Stock Plan.
Sales of Unregistered Stock
The Company had no sales of unregistered stock during the fiscal year ended June 30, 2008.
Issuer Purchases of Equity Securities
The following table sets forth the purchases by the Company of its common stock during the quarterly period ended June 30, 2008:
The following table sets forth selected consolidated financial statement and operations data with respect to the Company for the periods indicated. This information should be read in conjunction with the Financial Statements and related notes appearing in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K and with Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Form 10-K. The Company's selected financial statement and operations data for fiscal year 2004 have been derived from audited consolidated financial statements, which have been audited by McGladrey & Pullen, LLP, independent public accountants. The Company's selected financial statement and operations data for each of the fiscal years 2005 through 2008 have been derived from audited consolidated financial statements, which have been audited by Eide Bailly, LLP, independent public accountants.
This section should be read in conjunction with the following parts of this Form 10-K: Part II, Item 8 "Financial Statements and Supplementary Data," Part II, Item 7A, "Quantitative and Qualitative Disclosures About Market Risk," and Part I, Item 1 "Business."
The Company's net income for fiscal 2008 was $5.8 million, or $1.45 per diluted share, compared to $5.4 million, or $1.33 per diluted share for fiscal 2007. Return on average equity was 9.12% at June 30, 2008, compared to 9.01% at June 30, 2007.
Net interest income for fiscal 2008 was $29.9 million, an increase of $4.2 million or 16.5% over the same period a year ago. The net interest margin was 3.11%, compared to 2.80% for the same period a year ago, an increase of 31 basis points. On a fully taxable equivalent basis, the net interest margin for fiscal 2008 was 3.16%, compared to 2.85% in fiscal 2007. The cost of funds rate on interest-bearing liabilities decreased from 4.39% in fiscal 2007 to 3.87% in fiscal 2008, a change of 52 basis points. For the same period, yields on earning assets decreased from 6.75% to 6.58%, a decrease of 17 basis points. Increases in volume from fiscal 2007 to fiscal 2008 of average earning assets and interest-bearing liabilities were 4.8% and 4.2% respectively. The Company was positioned to benefit from a steeper, more positive yield curve slope, and as such the net interest margin ratio benefitted as the Federal Funds Rate decreased 325 basis points in fiscal 2008.
Variability of the net interest margin ratio may be affected by many aspects, including Federal Reserve policies for short-term interest rates, competitive and global economic factors and customer preferences for various products and services.
The Company held $12.4 million in trust preferred securities at June 30, 2008. These are comprised of rated, pooled securities issued primarily by banks throughout the United States. The cash flows of the securities are derived from interest spreads between the issuer and the investor. These cash flows are used primarily to pay contractual interest. Principal payments are received primarily by the issuer paying off the securities at redeemable dates. In general, if certain ratios within the investment structure are reduced below established levels, excess interest cash flows are redirected to pay down principal in various tranches established by the investment structure.
The allowance for loan and lease losses remained at $5.9 million at June 30, 2008, compared to $5.9 million at June 30, 2007, an increase of $61,000 or 1.0%. The ratio of allowance for loan and lease losses to total loans and leases was 0.75% as of June 30, 2008 compared to 0.76% at June 30, 2007. Total nonperforming assets at June 30, 2008 were $3.7 million as compared to $4.0 million at June 30, 2007. The ratio of nonperforming assets to total assets improved to 0.34% for June 30, 2008, compared to 0.40% at June 30, 2007. The allowance for loan and lease losses is calculated based on loan and lease levels, loan and lease loss history, credit quality of the loan and lease portfolio, and environmental factors such as economic health of the region and management experience. This risk rating analysis is designed to give the Company a consistent and systematic methodology to determine proper levels for the allowance at a given time.
As of June 30, 2008, the Company continued to record a receivable in the amount of $223,000 from the sale of certain loan participation interests in December 2005. The balance of this receivable represents the remaining amount the Company expects to be paid on the receivable and the Company
has requested such payment from the lead bank. In addition, on June 26, 2006, the Company filed a $3.8 million lawsuit against this lead bank for their role in this participation loan, alleging fraud, breach of fiduciary duty, conspiracy, and negligent misrepresentation. See Part 1, Item 3 "Legal Proceedings" of this Form 10-K.
Total deposits at June 30, 2008, were $784.2 million, a decrease of $31.6 million, or 3.9%, from June 30, 2007. Out-of-market certificates of deposit declined $44.3 million to $27.3 million at June 30, 2008, as the Company pursued other sources of wholesale funding. Interest expense on deposits was $24.7 million for fiscal 2008, a decrease of $3.8 million, or 13.4%, over the same period a year ago. A primary factor affecting interest expense was the decrease in money market rates and other non-maturity deposit product rates.
The total risk-based capital ratio was 10.83% at June 30, 2008, compared to 11.05% at June 30, 2007. This continues to place the Bank in the "well-capitalized" category within OTS regulation at June 30, 2008, and is consistent within the "well-capitalized" OTS category in which the Company plans to operate. The Company historically has been able to manage the size of its assets through secondary market loan sales of single-family mortgages, student loans and a loan securitization.
Noninterest expense for fiscal 2008 was $30.6 million, compared to $29.6 million a year ago, an increase of $1.0 million or 3.4%. Compensation and employee benefits for fiscal 2008 accounted for an increase of $1.2 million, or 6.7%, from the same period a year ago. Net healthcare costs, inclusive of self-funded health claims, administration fees and fully-insured dental premiums offset by stop loss insurance receivable and employee reimbursements for fiscal 2008 were $1.5 million, compared to $2.1 million for the same period a year ago, a decrease of $667,000 or 31.0%. This change is primarily due to lower health claims expense and recognition of stop loss insurance receipts.
Noninterest income for fiscal 2008 was $11.3 million, compared to $13.2 million for the same period a year ago, a decrease of $1.9 million or 14.1%. Excluding the one-time $2.8 million gain on sale of branches during fiscal 2007, the increase was $900,000 or 8.6%. This core increase was driven primarily by increases in loan servicing income and fees on deposits. Loan servicing income increased in fiscal 2008 by $408,000 or 22.6% from fiscal 2007. Fees on deposits increased in fiscal 2008 by $256,000 or 5.0% from fiscal 2007.
The Company focuses on balancing operating costs with operating revenue levels in order to provide better efficiency ratios over time and continues to review its operations for ways to reduce its cost structure while continuing to support long-term revenue enhancements. The operating efficiency ratio for fiscal 2008 was 70.75%, compared to 76.56% for the same period a year ago, a decrease of 581 basis points. The operating efficiency ratio excludes the impact of net interest expense on the variable priced trust preferred securities and the one-time gain on sale of branches. The Company has issued trust preferred securities primarily to provide funding for stock repurchases and to repay other borrowings. Net interest expense on the $27.8 million of trust preferred securities outstanding decreased to $2.1 million for fiscal 2008, compared to $2.7 million for the same period a year ago, a decrease of $563,000 or 20.9%. The average rate paid on these securities decreased 203 basis points, from 9.61% in fiscal 2007 to 7.58% in fiscal 2008. The total efficiency ratio was 74.27% at June 30, 2008, compared to 76.24% for the same period a year ago, a decrease of 197 basis points. Contributing to this improvement in the efficiency ratio from a year ago include an increase in Company revenue to $41.2 million for fiscal 2008, or a 14.3% increase compared to the same period a year ago excluding the one-time gain on sale of branches of $2.8 million. It is the Company's continuing goal to move the operating efficiency ratio towards the 50% level over the long term. Management believes that this can be accomplished through steady growth of the balance sheet and the containment of incremental operating expenses.
Recent events in the financial markets produce uncertainties to management about future operating results and the future financial condition of the Company. The interdependencies of the
national economy and financial markets do affect the macro economics reviewed by management and may produce outcomes in the future which have not impacted the Company previously.
The Company is a financial services provider and, as such, has inherent risks that must be managed in order to achieve net income. Primary risks that affect net income include credit risk, liquidity risk, operational risk, regulatory compliance risk and reputation risk. The Company's net income is derived by management of the net interest margin, the ability to collect fees from services provided, by controlling the costs of delivering services and the management of loan and lease losses. The primary source of revenues comes from the net interest margin, which represents the difference between income on interest-earning assets (i.e. loans and investment securities) and expense on interest-bearing liabilities (i.e. deposits and borrowed funding). The net interest margin is affected by regulatory, economic and competitive factors that influence interest rates, loan demand and deposit flows. Fees earned include charges for deposit services, trust services and loan services. Personnel costs are the primary expenses required to deliver the services to customers. Other costs include occupancy and equipment and general and administrative expenses.
Financial Condition Data
At June 30, 2008 the Company had total assets of $1,103.5 million, an increase of $102.0 million from the level at June 30, 2007. The increase in assets was due primarily to increases in securities of $82.8 million, FHLB stock of $6.2 million, and net loans and leases receivable of $16.2 million offset by a decrease in cash and cash equivalents of $1.3 million. The increase in liabilities of $100.1 million was due to increases in advances from the FHLB and other borrowing of $129.9 million, offset by a decrease in deposits of $31.6 million from the levels at June 30, 2007. In addition, stockholders' equity increased to $64.2 million at June 30, 2008, from $62.3 million at June 30, 2007, primarily due to net income of $5.8 million offset by cash dividends paid of $1.7 million.
The increase in securities of $82.8 million was due primarily to an increase in purchases of U.S. agency mortgage-backed securities, over sales, amortization and repayments of principal. The increase in FHLB stock of $6.2 million was the result of increased stock requirement by FHLB based upon an increase in outstanding advances.
The increase in net loans and leases receivable of $16.2 million was due primarily to an increase in purchases and originations over sales, amortization and repayments of principal. During the first quarter of fiscal 2008, the Company announced that it had ceased origination of indirect auto loans. Indirect auto loan outstanding balances declined $38.8 million during the fiscal year to $44.3 million at June 30, 2008. In addition, deferred fees and discounts decreased by $775,000 primarily due to a decrease of $832,000 for deferred fees and discounts on indirect automobile loans that include prepaid dealer reserves.
The decrease in cash and cash equivalents of $1.3 million was primarily due to the timing of items in clearing.
Advances from the FHLB and other borrowings increased $129.9 million for the year ended June 30, 2008, primarily due to the Company increasing its short- and long-term advances by a net of $99.9 million, while increasing overnight Federal Funds advances by $29.9 million during the fiscal year ended June 30, 2008.
The $31.6 million decrease in deposits was primarily due to decreases in out-of-market certificates of deposit of $44.3 million, and money market accounts of $40.9 million, offset by increases in in-market certificates of deposit of $34.1 million and savings accounts of $12.3 million.
Net interest income represents the difference between income on interest-earning assets and expense on interest-bearing liabilities. Net interest income depends upon the volume of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on them.
Average Balances, Interest Rates and Yields. The following table presents for the periods indicated, the total dollar amount of interest income from average interest-earning assets and the resulting yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates, and the net interest margin. The table does not reflect any effect of income taxes. Average balances consist of daily average balances for the Bank with simple average balances for all other companies. The average balances include nonaccruing loans and leases. The yields on loans and leases include origination fees, net of costs, which are considered adjustments to yield.
Rate/Volume Analysis of Net Interest Income
The following schedule presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between the increases and decreases due to fluctuating outstanding balances that are due to the levels and volatility of interest rates. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii) changes in rate (i.e., changes in rate multiplied by old volume). For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change due to volume and the change due to rate.
Application of Critical Accounting Policies
GAAP requires management to utilize estimates when reporting financial results. The Company has identified the policies discussed below as Critical Accounting Policies because the accounting estimates require management to make certain assumptions about matters that may be uncertain at the time the estimate was made and a different method of estimating could have been reasonably made that could have a material impact on the presentation of the Company's financial condition, changes in financial condition or results of operations.
Allowance for Loan and Lease LossesGAAP requires the Company to set aside reserves or maintain an allowance against probable loan and lease losses in the loan and lease portfolio. Management must develop a consistent and systematic approach to estimate the appropriate balances that will cover the probable losses. Due to the uncertainty of future events, the approach includes a process that may differ significantly from other methodologies and still produce an estimate that is in accordance with GAAP.
The allowance is compiled by utilizing the Company's loan and lease risk rating system, which is structured to identify weaknesses in the loan and lease portfolio. The risk rating system has evolved to a process whereby management believes the system will properly identify the credit risk associated with the loan and lease portfolio. Due to the stratification of loans and leases for the allowance calculation, the estimate of the allowance for loan and lease losses could change materially if the loan and lease risk rating system would not properly identify the strength of a large or a few large loan and lease customers. Although management believes that it uses the best information available to determine the allowance, unforeseen market or borrower conditions could result in adjustments and net earnings being significantly affected if circumstances differ substantially from the assumptions used in making the final determinations.
Mortgage Servicing Rights ("MSR")The Company records a servicing asset for contractually separated servicing from the underlying mortgage loans. The asset is initially recorded at fair value and represents an intangible asset backed by an income stream from the serviced assets. The asset is amortized in proportion to and over the period of estimated net servicing income.
At each balance sheet date, the MSRs are analyzed for impairment, which occurs when the fair value of the MSRs is lower than the amortized book value. The Company's MSRs are primarily servicing rights acquired on South Dakota Housing Development Authority first time homebuyers program. Due to the lack of quoted markets for the Company's servicing portfolio, the Company estimates the fair value of the MSRs using present value of future cash flow analysis. If the analysis produces a fair value that is greater than or equal to the amortized book value of the MSRs, no impairment is recognized. If the fair value is less than the book value, an expense for the difference is charged to earnings by initiating a MSR valuation account. If the Company determines this impairment is temporary, any future changes in fair value are recorded as a change in earnings and the valuation. If the Company determines the impairment to be permanent, the valuation is written off against the MSRs which results in a new amortized balance.
The Company has included MSRs as a critical accounting policy because the use of estimates for determining fair value using present value concepts may produce results which may significantly differ from other fair value analysis perhaps even to the point of recording impairment. The risk to earnings is when the underlying mortgages payoff significantly faster than the assumptions used in the previously recorded amortization. Estimating future cash flows on the underlying mortgages is a difficult analysis and requires judgment based on the best information available. The Company looks at alternative assumptions and projections when preparing a reasonable and supportable analysis. Based on the Company's quarterly analysis of MSRs, there was no impairment to the MSRs at June 30, 2008.
Self-InsuranceThe Company has a self-insured healthcare plan for its employees up to certain limits. To mitigate a portion of these risks, the Company has a stop-loss insurance policy through a commercial insurance carrier for coverage in excess of $65,000 per individual occurrence. The estimate of self-insurance liability is based upon known claims and an estimate of incurred, but not reported ("IBNR") claims. IBNR claims are estimated using historical claims lag information received by a third party claims administrator. Due to the uncertainty of health claims, the approach includes a process that may differ significantly from other methodologies and still produce an estimate that is in accordance with GAAP. Although management believes that it uses the best information available to determine the accrual, unforeseen health claims could result in adjustments to the accrual. These adjustments could significantly affect net earnings if circumstances differ substantially from the assumptions used in estimating the accrual.
When a borrower fails to make a required payment on a loan within 10 to 15 days after the payment is due, the Bank generally institutes collection procedures by issuing a late notice. The
customer is contacted again when the payment is between 17 and 40 days past due. In most cases, delinquencies are cured promptly; however, if a loan has been delinquent for more than 40 days, the Bank attempts additional written as well as verbal contacts and, if necessary, personal contact with the borrower in order to determine the reason for the delinquency and to effect a cure, and, where appropriate, reviews the condition of the property and the financial circumstances of the borrower. Based upon the results of any such investigation, the Bank may: (i) accept a repayment program which under appropriate circumstances could involve an extension in the case of consumer loans for the arrearage from the borrower, (ii) seek evidence, in the form of a listing contract, of efforts by the borrower to sell the property if the borrower has stated that he is attempting to sell, or (iii) initiate foreclosure proceedings. When a loan payment is delinquent for 90 days, the Bank generally will initiate foreclosure proceedings unless management is satisfied the credit problem is correctable.
Loans are generally classified as nonaccrual when there are reasonable doubts as to the collectability of principal and/or interest and/or when payment becomes 90 days past due, except loans which are well secured and in the process of collection. Interest collections on nonaccrual loans, for which the ultimate collectability of principal is uncertain, are applied as principal reductions.
Leases are generally classified as nonaccrual when there are reasonable doubts as to the collectability of principal and/or interest. Leases may be placed on nonaccrual when the lease has experienced either four consecutive months with no payments or once the account is five months in arrears. Interest collections on nonaccrual leases, for which the ultimate collectability of principal is uncertain, are applied as principal reductions.
When a lessee fails to make a required lease payment within 10 days after the payment is due, Mid America Capital generally institutes collection procedures. The lessee may be contacted by telephone on the 10th, but no later than the 30th day of delinquency. A late notice is automatically issued by the system on the 11th day of delinquency and is sent to the lessee. The lease may be referred to legal counsel when the lease is past due beyond four payments and no positive response has been received or when other considerations are present.
Nonperforming assets (nonaccrual loans and leases, accruing loans and leases delinquent more than 90 days and foreclosed assets) decreased to $3.7 million at June 30, 2008 from $4.0 million at June 30, 2007, a decrease of $258,000. In addition, the ratio of nonperforming assets to total assets, which is one indicator of credit risk exposure, improved to 0.34% at June 30, 2008, from 0.40% at June 30, 2007.
Nonaccruing loans and leases increased $134,000 to $2.3 million at June 30, 2008 compared to $2.2 million at June 30, 2007. Included in nonaccruing loans and leases at June 30, 2008 were eight loans totaling $503,000 secured by one- to four-family real estate, two commercial real estate loans totaling $429,000, one agricultural real estate loan totaling $42,000, eleven commercial business loans totaling $555,000, two agricultural business loans totaling $201,000, one equipment finance lease totaling $27,000 and 37 consumer loans totaling $566,000.
The Company's nonperforming loans and leases, which represent nonaccrual and past due 90 days and still accruing, have decreased $393,000 from the levels at June 30, 2007. The risk rating system in place is designed to identify and manage the nonperforming loans and leases. Commercial and agricultural loans and equipment finance leases will have specific reserve allocations based on collateral values or based on the present value of expected cash flows if the loans or leases are deemed impaired. Loans and leases that are not performing do not necessarily result in a loss.
As of June 30, 2008, the Company had $643,000 of foreclosed assets. The balance of foreclosed assets at June 30, 2008 consisted of $443,000 in equipment finance leases, $124,000 in consumer collateral and $76,000 in single-family residences.
At June 30, 2008, the Company had designated $22.2 million of its assets as special mention and classified $11.5 million of its assets that management has determined need to be closely monitored because of possible credit problems of the borrowers or the cash flows of the secured properties. At June 30, 2008, the Company had $21.8 million in multi-family, commercial real estate and agricultural participation loans purchased, of which $3.9 million were classified at June 30, 2008. These loans and leases were considered in determining the adequacy of the allowance for loan and lease losses. The allowance for loan and lease losses is established based on management's evaluation of the risks probable in the loan and lease portfolio and changes in the nature and volume of loan and lease activity. Such evaluation, which includes a review of all loans and leases for which full collectability may not be reasonably assured, considers the estimated fair market value of the underlying collateral, present value of expected principal and interest payments, economic conditions, historical loss experience and other factors that warrant recognition in providing for an adequate loan and lease loss allowance.
Although the Company's management believes that the June 30, 2008 recorded allowance for loan and lease losses was adequate to provide for probable losses on the related loans and leases, there can be no assurance that the allowance existing at June 30, 2008 will be adequate in the future.
In accordance with the Company's internal classification of assets policy, management evaluates the loan and lease portfolio on a monthly basis to identify loss potential and determines the adequacy of the allowance for loan and lease losses quarterly. Loans are placed on nonaccrual status when the collection of principal and/or interest becomes doubtful. Foreclosed assets include assets acquired in settlement of loans.
The following table sets forth the amounts and categories of the Company's nonperforming assets from continuing operations for the periods indicated.
The following table sets forth information with respect to activity in the Company's allowance for loan and lease losses from continuing operations during the periods indicated.
The distribution of the Company's allowance for loan and lease losses and impaired loss summary are summarized in the following tables.
The allowance for loan and lease losses was $5.9 million at June 30, 2008, as compared to $5.9 million at June 30, 2007. The ratio of the allowance for loan and lease losses to total loans and leases was 0.75% at June 30, 2008, compared to 0.76% at June 30, 2007. The Company's management has considered nonperforming assets and other assets of concern in establishing the allowance for loan and lease losses. The Company continues to monitor its allowance for possible loan and lease losses and make future additions or reductions in light of the level of loans and leases in its portfolio and as economic conditions dictate. The current level of the allowance for loan and lease losses is a result of management's assessment of the risks within the portfolio based on the information revealed in credit reporting processes. The Company utilizes a risk-rating system on commercial business, agricultural, construction, multi-family and commercial real estate loans, including purchased loans. A periodic credit review is performed on all types of loans and leases to establish the necessary reserve based on the estimated risk within the portfolio. This assessment of risk takes into account the composition of the loan and lease portfolio, historical loss experience for each loan and lease category, previous loan and lease experience, concentrations of credit, current economic conditions and other factors that in management's judgment deserve recognition. OTS regulators have reviewed the Company's methodology for determining allowance requirements on the Company's loan and lease portfolio and have made no required recommendations for changes in methodology in the allowances during the three year period ended June 30, 2008.
Real estate properties acquired through foreclosure are recorded at the lower of cost or fair value (less a deduction for disposition costs). Valuations are periodically updated by management and a specific provision for losses on such properties is established by a charge to operations if the carrying values of the properties exceed their estimated net realizable values.
Although management believes that it uses the best information available to determine the allowances, unforeseen market conditions could result in adjustments and net earnings being significantly affected if circumstances differ substantially from the assumptions used in making the final
determinations. Future additions to the Company's allowances result from periodic loan, property and collateral reviews and thus cannot be predicted in advance. See Note 1 of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K for a description of the Company's policy regarding the provision for losses on loans and leases.
Comparison of the Years Ended June 30, 2008 and June 30, 2007
General. The Company's income was $5.8 million or $1.47 and $1.45 for basic and diluted earnings per share, respectively, for the year ended June 30, 2008, a $460,000 increase in earnings compared to $5.4 million or $1.35 and $1.33 for basic and diluted earnings per share, respectively, for the prior year. Fiscal year 2007 second quarter net income included a non-recurring after-tax gain on sale of branches of $1.7 million or $0.42 diluted earnings per share. For the year ended June 30, 2008, the return on average equity was 9.12%, a 1.2% increase compared to 9.01% in the prior year. For the year ended June 30, 2008, the return on average assets was 0.57%, a 3.6% increase compared to 0.55% in the prior year. As discussed in more detail below, the increases were due to a variety of key factors, including increases in net interest income of $4.2 million, offset by increases in provision for losses on loans and leases of $796,000 and increases in noninterest expense of $1.0 million.
Interest and Dividend Income. Interest and dividend income was $63.2 million for the year ended June 30, 2008, as compared to $61.9 million for the prior year, an increase of $1.3 million or 2.1%. A $1.2 million decrease in interest and dividend income was the result of a 2.5% decrease in the average yield on interest-earning assets and a $2.5 million increase in interest and dividend income was the result of a 4.8% increase in the average volume of total interest-earning assets. The average yield on interest-earning assets was 6.58% for the year ended June 30, 2008, as compared to 6.75% for the prior year. The average volume of loans and leases receivable increased from $758.5 million for the year ended June 30, 2007, to $775.6 million for the year ended June 30, 2008. For the year ended June 30, 2008, the average yield on loans and leases receivable was 6.96%, a decrease of 2.9% from 7.17% in the prior year. The overall increase in interest and dividend income was due in part to the repricing of loans and investments that generally reflected national interest rates.
Interest Expense. Interest expense was $33.3 million for the year ended June 30, 2008, as compared to $36.2 million for the prior year, a decrease of $2.9 million or 8.12%. A $3.2 million decrease was the result of an 11.9% decrease in the average rate paid on interest-bearing deposits. The average rate on interest-bearing deposits was 3.63% for the year ended June 30, 2008, as compared to 4.13% for the prior year. A $766,000 decrease in interest expense was the result of a 10.6% decrease in the average yield on FHLB advances and other borrowings to 4.26% for the year ended June 30, 2008, compared to 4.77% for the prior fiscal year, and a $2.2 million increase in interest expense was the result of a 43.5% increase in the average balance of FHLB advances and other borrowings. In addition, interest expense decreased $563,000 due to the average yield on subordinated debentures payable to trust decreasing to 7.58% for the year ended June 30, 2008, compared to 9.61% for the prior fiscal year.
Net Interest Income. The Company's net interest income for the year ended June 30, 2008, increased $4.2 million or 16.55%, to $29.8 million compared to $25.6 million for the prior year. The Company's net interest margin increased to 3.11% for the year ended June 30, 2008, as compared to 2.80% for the prior year. The Company continues to have a diversified loan portfolio comprised of a mix of consumer and business type lending. This mix helps the Company manage the net interest margin and interest rate risk by retaining loan and lease production on the balance sheet or looking at alternatives through secondary markets.
Provision for Losses on Loans and Leases. The allowance for loan and lease losses is maintained at a level which is considered by management to be adequate to absorb probable losses on existing
loans and leases that may become uncollectible, based on an evaluation of the collectability of the loans and leases and prior loan and lease loss experience. The evaluation takes into consideration such factors as changes in the nature and volume of the loan and lease portfolio, overall portfolio quality, review of specific problem loans and leases, and current economic conditions that may affect the borrower's ability to pay. The allowance for loan and lease losses is established through a provision for losses on loans and leases charged to expense. See "Asset Quality" above for further discussion.
Provision for losses on loans and leases increased $796,000 or 66.4%, to $2.0 million for the year ended June 30, 2008, as compared to $1.2 million in the prior year. Net charge-offs increased from $1.0 million during fiscal 2007 to $1.9 million during fiscal 2008. Nonperforming assets decreased $258,000 for the year ended June 30, 2008.
The allowance for losses on loans and leases at June 30, 2008 was $5.9 million. The allowance remained from the June 30, 2007, balance of $5.9 million primarily as a result of charge-offs exceeding recoveries by $1.9 million offset by the provision for losses on loans and leases of $2.0 million. The ratio of allowance for loan and lease losses to nonperforming loans and leases at June 30, 2008, was 191.08% compared to 167.87% at June 30, 2007. The allowance for loan and lease losses to total loans and leases at June 30, 2008, was 0.75% compared to 0.76% at June 30, 2007. The Bank's management believes that the June 30, 2008, recorded allowance for loan and lease losses is adequate to provide for probable losses on the related loans and leases, based on its evaluation of the collectability of loans and leases and prior loss experience.
Noninterest Income. Noninterest income was $11.3 million for the year ended June 30, 2008, as compared to $13.2 million for the year ended June 30, 2007, a decrease of $1.9 million or 14.12%. The decrease in noninterest income was due primarily to a one-time gain on sale of branches of $2.8 million in fiscal 2007. During fiscal 2008 the Company experienced increases in loan servicing income of $408,000, gain on sale of loans of $274,000, fees on deposits of $256,000, and trust income of $30,000, offset by decreases in other noninterest income of $71,000.
The net gain on sale of branches of $2.8 million in fiscal 2007 was due to the sale of three branches and their associated book of business, as well as one physical location. The sale was completed during the second quarter of fiscal 2007 and produced the one-time gain on sale. The proceeds of the sale were invested in new market locations and new marketing initiatives.
Loan servicing income increased by $408,000 to $2.2 million for the year ended June 30, 2008, as compared to $1.8 million for the prior year, primarily due to increased originated and purchased servicing rights for SDHDA mortgage loans. At June 30, 2008, the Bank serviced $932.9 million of mortgage loans for the SDHDA.
Fees on deposits increased by $256,000 to $5.4 million during the year ended June 30, 2008, as compared to $5.1 million for the prior year, primarily due to a $278,000 net increase in income from point-of-sale purchases by customers and ATM service fees, and a $21,000 increase in net NSF/OD fees.
Trust income increased by $30,000 to $966,000 during the year ended June 30, 2008, as compared to the prior year primarily due to further diversification of trust activities. Assets under management decreased from $126.4 million to $95.0 million.
Other noninterest income for the year ended June 30, 2008, was $1.6 million as compared to $1.6 million for the prior year, a decrease of $71,000.
Noninterest Expense. Noninterest expense was $30.6 million for the year ended June 30, 2008, as compared to $29.6 million for the prior year, an increase of $1.0 million. The increase in noninterest expense was due primarily to increases in compensation and employee benefits of $1.2 million, and occupancy and equipment of $35,000, offset by a decrease in advertising costs of $464,000.
Compensation and employee benefits increased $1.2 million during the year ended June 30, 2008, as compared to the prior fiscal year primarily due