HF Financial 10-K 2009
Documents found in this filing:
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
registered pursuant to Section 12(g) of the Act:
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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes o No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 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. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
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, 2008, was approximately $51.6 million.
As of September 17, 2009, there were 4,044,418 shares of the registrant's common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
The information regarding (i) compliance with Section 16(a) of the Exchange Act, the code of ethics, director nominations and the audit committee and the audit committee financial expert called for in Item 10 of Part III of this report and (ii) principal accounting fees and services and the pre-approval policies and procedures of the Audit Committee called for in Item 14 of Part III of this report, are incorporated by reference herein from the registrant's definitive proxy statement to be delivered to stockholders in connection with the 2009 Annual Meeting of Stockholders to be held on November 18, 2009.
Table of Contents
This Annual Report on Form 10-K ("Form 10-K"), as well as other reports issued by HF Financial Corp. (the "Company") include "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. In addition, the Company's management may make forward-looking statements orally to the media, securities analyst, investors and others from time to time. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Words such as "optimism," "look-forward," "bright," "believe," "expect," "anticipate," "intend," "hope," "plan," "estimate" or words of similar meaning, or future or conditional verbs such as "will," "would," "should," "could" or "may," are intended to identify these forward-looking statements.
These forward-looking statements might include one or more of the following:
Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our historical experience and our present expectations or projections. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to:
Forward-looking statements speak only as of the date they are made. Forward-looking statements are based upon management's then-current beliefs and assumptions, but management does not give any assurance that such beliefs and assumptions will prove to be correct. We undertake no obligation to publicly update or revise any forward-looking statements included or incorporated by reference in this Form 10-K or to update the reasons why actual results could differ from those contained in such statements, whether as a result of new information, future events or otherwise, except to the extent required by federal securities laws. Based upon changing conditions, should any one or more of the above risks or uncertainties materialize, or should any of our underlying beliefs or assumptions prove incorrect, actual results may vary materially from those described in any forward-looking statement.
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 and services, to meet the needs of its marketplace. 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 loans, commercial business loans, agriculture loans, consumer loans, multi-family and commercial real estate loans, and construction loans. The Bank's consumer direct loan portfolio includes, among other things, automobile loans, home equity loans, loans secured by deposit accounts and student loans.
Through its trust department, the Bank acts as trustee, personal representative, administrator, guardian, custodian, agent, advisor and manager for various accounts. As of June 30, 2009, the trust department of the Bank maintained approximately $77.5 million in assets under management. Wealth management has become a strategic focus of the Bank, and the Bank has added expertise in portfolio management and business development to enhance this business line to drive future growth in assets under management and fee income.
The Bank also purchases residential mortgage-backed securities and invests in U.S. Government and agency obligations and other permissible investments. 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 services, as well as 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, 2009: 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. HF Group previously marketed software to facilitate employee benefits administration, payroll processing and management and governmental reporting. HF Group no longer actively markets this software and had immaterial operations in 2009. HF Group has an approved line of credit with the Company of $100,000, with no funds advanced as of June 30, 2009. 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 formed in September 1994, 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 and fiscal 2009.
As a federally chartered thrift institution, the Bank is permitted by OTS regulations to invest up to 2% of its assets in the stock of, or loans to, service corporation subsidiaries. The Bank may invest an additional 1% 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% 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 Investment Services, Inc. ("Hometown"), Mid America Capital Services, Inc. ("Mid America Capital"), Home Federal Securitization Corp. ("HFSC"), Mid-America Service Corporation ("Mid-America") and PMD, Inc. ("PMD").
Hometown, a South Dakota corporation formed in February 1951, 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, 2009, the Bank had advanced $40,000 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 formed in October 1990, 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, 2009, Mid America Capital had advanced $13.4 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 formed in January 2003, existed for the sole purpose of buying motor vehicle installment loans from the Bank to be securitized. HFSC had no activity during fiscal 2008 and fiscal 2009.
Mid-America, a South Dakota corporation formed in August 1971, 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 and fiscal 2009.
PMD, a South Dakota corporation formed in January 1992, in the past was engaged in the business of buying, selling and managing repossessed real estate properties. PMD had no activity during fiscal 2008 and fiscal 2009.
Based on total assets at June 30, 2009, 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), and the cities of Pierre, Mitchell, Aberdeen, Brookings, Dakota Dunes, Watertown, and Yankton. The Bank also has a banking center in Marshall, Minnesota, which serves customers located in southwestern Minnesota. The banking center located in Dakota Dunes also serves customers located in northwestern Iowa. The Bank's primary market area features a variety of agribusiness, 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.
The Company's business strategy is to remain a community-focused financial institution and to grow and improve its profitability by:
The Bank originates a variety of loans including one- to four-family residential loans, commercial business loans, agriculture loans, consumer loans, multi-family and commercial real estate loans, and construction loans. Consumer loans include 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 "RegulationLoan and Investment Powers" 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 typically 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, including loans to builders and developers for the construction of one- to four-family residences and condominiums and the development of one- to four-family lots.
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% of the appraised value of the collateral property and with debt service coverage ratios of 115% or higher. The debt service coverage is the ratio of net cash from operations divided by payments of debt obligations. 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 borrower's financial condition, credit history, prior record for producing sufficient income from similar loans, and references as well as 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 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), and land development loans are generally originated with a maximum loan-to-value ratio of 65% based upon an independent appraisal.
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, 2009 was $400.3 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% of the Bank's unimpaired capital and surplus, or $15.5 million at June 30, 2009. Loans in an amount equal to an additional 10% 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% 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 Lending. The Bank makes construction loans to individuals for the construction of their residences, as well as loans to builders and developers for the construction of multi-family residential properties, 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 twelve 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 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%, 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: (i) operating loans that are used to fund the borrower's operating expenses, which typically have a one year term and are
indexed to the national prime rate; (ii) term loans on machinery, equipment and breeding stock that may have a term up to seven years and require annual payments; (iii) agricultural farmland term loans that are used to finance (or refinance) land purchases; (iv) specialized loans to fund facilities and equipment for livestock confinement enterprises; and (v) 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 at loan-to-value ratios consistent with FNMA/FHLMC guidelines. Loan-to-values exceeding 80% are required to include private mortgage insurance in an amount sufficient to reduce the Bank's exposure at or below the 80% 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 annual rate reset ARM 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 a portfolio loan product that is a seven-year balloon loan that is fully payable at the end of the balloon term.
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% 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, 2009, the Bank serviced $930.8 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. The Bank ceased originations of consumer indirect automobile loans in the first quarter of fiscal year 2008 in order to pursue other lending opportunities and a re-allocation of the use of capital. The Bank also participates in Federal student loan programs, whereby loans are serviced by a third party until sold to the secondary loan market.
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% 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% of the account balance (although historically the Bank has loaned up to 100% 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% above the contract rate.
Loans secured by second mortgages, together with loans secured by all prior liens, are generally limited to less than 100% 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 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 to 60 months. The leases generally are 100% financed with either
the first or first and last months' payments due at lease inception. As a result of the 100% 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 value of as little as $1.00 up to 20% to 25% 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. Residual values 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. Over the past several years, the Company has transformed the loan and lease portfolio away from predominantly one-to four-family residential and consumer loans to a more diverse portfolio including commercial and agriculture loans. As part of the Company's business strategy to build its commercial and agriculture loan portfolio, the Bank has hired several bankers with significant commercial and agriculture lending experience, which has led to successful growth results across these business lines. The Company's commercial and agricultural loan portfolio has increased from 59.17% of its total loan and lease portfolio at June 30, 2008 to 65.04% at June 30, 2009, while its one- to- four family residential and consumer loan portfolio has decreased from 31.90% of its total loan and lease portfolio to 26.20% over that period. Nevertheless, the Company continues to prioritize and invest in mortgage lending as it believes this to be a core component of its personal banking strategy.
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. Adjustable-rate 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, 2009. 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 year 2009, the net deferred fees and discounts on loans and leases decreased by $269,000. This decrease was primarily due to a $390,000 reduction in dealer reserve, as a result of lower indirect automobile loan balances as the Company ceased consumer indirect loan originations in the first quarter of fiscal year 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% 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, as well as investment securities, in accordance with applicable regulations. On the basis of management's monthly review of its assets, at June 30, 2009, the Company had designated $21.0 million of its assets as special mention and $30.0 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, 2009, approximately 89.6% of our investment portfolio was in AAA-rated, liquid residential mortgage-backed securities. Our $199.6 million of residential mortgage-backed securities at June 30, 2009 consisted of agency securities, with a single $1.8 million private label collateralized mortgage obligation security.
At June 30, 2009, the Company's investments in residential mortgage-backed securities totaled $199.6 million, or 17.0% of its total assets. As of such date, the Bank also had a $12.5 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 residential mortgage-backed securities are much shorter due to the combination of prepayments and the variable-rate nature of $137.3 million of residential 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.
Management has implemented a process to identify securities that could potentially have a credit impairment that is other-than-temporary. This process involves evaluation of the length of time and extent to which the fair value has been less than the amortized cost basis, review of available information regarding the financial position of the issuer, monitoring the rating of the security, cash flow projections, and the Company's intent to sell a security or whether it is more likely than not we will be required to sell the security before the recovery of its amortized cost which, in some cases, may extend to maturity. To the extent we determine that a security is deemed to be other-than-temporarily impaired, an impairment loss is recognized. In fiscal year 2009, the total other-than-temporary impairment losses taken against the pooled trust preferred securities was $3.9 million, of which $3.5 million was recognized on the balance sheet in other comprehensive income with $397,000 of credit loss recognized through earnings. Additionally, the company recorded a net impairment loss of $8,000 attributed to Fannie Mae common stock held in the investment securities portfolio.
No other-than-temporary impairments were recorded against earnings during fiscal years 2008 or 2007. 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 securities portfolio is managed in accordance with a written investment policy adopted by the Bank's Board of Directors. Investments may be made by the Bank's officers within specified limits and approved in advance by the Bank's chief executive officer or president 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, 2009, the Company had $222.9 million of securities available for sale, including residential mortgage-backed securities of $199.6 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, residential 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, with a strategic focus of multiple-service household growth. 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 in those circumstances where wholesale funding offers either a maturity or cost efficiency not available with retail deposits. At June 30, 2009, out-of-market deposits accounted for less than 3% of total 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 following table sets forth the amount of the Company's certificates of deposit and other deposits by time remaining until maturity as of June 30, 2009.
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, 2009, and 2008 included $78.1 million and $76.5 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, residential 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, 2009, the Bank's FHLB advances totaled $207.2 million, representing 18.7% of total liabilities.
The Company has a line of credit for $6.0 million with First Tennessee Bank, NA for liquidity needs. Outstanding advances were $5.5 million and $0 at June 30, 2009 and 2008, respectively. The Company pledged 25% of the stock of the Bank as collateral upon drawing on the line of credit. The line of credit matures on September 30, 2009. 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 of the Company 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, 2009, the Bank had a total of 323 full-time equivalent employees ("FTEs") including 7 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.
The Bank is a federally chartered thrift institution, the deposits of which are federally insured by the FDIC under the Deposit Insurance Fund (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 Federal Home Loan Bank of Des Moines ("FHLB" or "FHLB of Des Moines") and is subject to certain limited regulation by the Federal Reserve. As the unitary thrift holding company of the Bank, we are also subject to federal regulation and oversight by the OTS. The purpose of the regulation of us, like other depository institution holding companies, is to protect subsidiary institutions where deposits are federally insured and their depositors.
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 is not intended 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 Bank and its operations and on us and our 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 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, 2009, was approximately $240,000.
The OTS has primary enforcement responsibility over federal savings associations, including the Bank. In general, these enforcement actions may be initiated in response to violations of laws and regulations and to unsafe or unsound practices and can result in, among other things, assessments of civil money penalties, issuance of cease and desist orders and removal of directors and officers. 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 the OTS to order a bank that has been given notice by the OTS that it is not satisfying applicable safety and soundness standards to submit a compliance plan. If, after being so ordered, a bank 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 a bank 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 Action Regulations
Under the OTS prompt corrective action regulations, the OTS is required to take certain, and is authorized to take other, supervisory actions against undercapitalized banks. For this purpose, a 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.
An undercapitalized bank is required to file a capital restoration plan within 45 days of the date the bank receives notice 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 of:
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, 2009, the Bank met the criteria for being considered "well-capitalized."
The activities of federal savings associations are generally 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 Home Owners' Loan Act ("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 (i) a prohibition against the acquisition of any corporate debt security that is not rated in one of the four highest rating categories; (ii) a limit of 400% of an association's capital on the aggregate amount of loans secured by non-residential real estate property; (iii) a limit of 20% 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% of assets being limited to small business loans; (iv) a limit of 35% 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% of assets being limited to loans made directly to the original obligor and where no third-party finder or referral fees were paid; (v) a limit of 5% of assets on non-conforming loans (loans in excess of the specific limitations of the HOLA); and (vi) a limit of the greater of 5% 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% of its assets in tangible personal property for leasing purposes. At June 30, 2009, the Bank met the 10% leasing limitation with 1.36% 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, 2009, the Bank met the 20% limitation on commercial and agricultural loans and leases with such loans and leases equal to 15.58% of total Bank assets.
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% of the association's unimpaired capital and surplus. Additional amounts may be loaned, not in excess of 10% of unimpaired capital and surplus, if such loans or extensions of credit are fully secured by readily-marketable collateral. At June 30, 2009, the Bank's lending limit under this restriction was $15.5 million.
Federal Deposit 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. Effective April 1, 2006, through the Federal Deposit Insurance Reform Act of 2005, the maximum insurance coverage for self-directed retirement plan deposits increased from $100,000 to $250,000 permanently. All other deposits are presently insured up to $250,000 per depositor until December 31, 2013. This federal deposit insurance coverage limit was temporarily raised from $100,000 to its current level under the Emergency Economic Stabilization Act of 2008, and on May 20, 2009, this temporary insurance limit was extended from an original termination date of December 31, 2009 to December 31, 2013. FDIC insurance of deposits is backed by the full faith and credit of the U.S. government. 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 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 generally 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 four risk categories, with the first category having two sub-categories based on the institution's most recent supervisory and capital evaluations, designed to measure risk. In October 2008, the FDIC proposed raising assessment rates to implement a Restoration Plan for the DIF, which had fallen significantly below the minimum target level of 1.15% as a result of recent bank failures. On February 27, 2009, the FDIC approved an amended Restoration Plan, under which the FDIC implemented an assessment rate schedule to raise the DIF reserve ratio to 1.15% within seven years. Pursuant to the Plan, the FDIC is implementing a final rule that sets assessment rates and makes adjustments based on risk. Under the final rule, banks in the lowest risk category will pay initial base rates ranging from 12 basis points to 16 basis points of assessable deposits on an annual basis, beginning on April 1, 2009 (applicable to assessments for the second quarter of 2009 and thereafter); but this may be further adjusted to between 7 and 24 basis points of assessable deposits for banks holding unsecured debt, certain secured liabilities and brokered deposits beyond a certain amount. Banks in the highest risk category will pay an initial base rate of 45 basis points of assessable deposits, which may also be adjusted to between 40 basis points and 77.5 basis points of assessable deposits for excess amounts of unsecured debt, certain secured liabilities and brokered deposits. The FDIC also has the ability to adjust the assessment rate schedule from quarter to quarter. On May 22, 2009, the Board of Directors of the FDIC adopted a final rule establishing a special assessment of five basis points on each FDIC-insured depository institution's assets, minus its Tier 1 capital, as of June 30, 2009. The special assessment will be collected September 30, 2009. The FDIC is authorized to raise the assessment rates as necessary to maintain the DIF and has authority to declare additional special assessments during 2009. The FDIC has indicated that it is probable that an additional special assessment will be necessary in the fourth calendar quarter of 2009.
The Deposit Insurance Fund Act 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 of $114,000 at June 30, 2008, was applied to reduce deposit insurance assessments during the first and second quarters of fiscal year 2009.
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, 2009, was 0.1248% and the premium paid for Fiscal 2009 was $563,000. In addition, the Bank accrued $266,000 for the fourth quarter assessment and accrued $536,000 for a special assessment payable September 30, 2009. 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 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, 2009, the Bank exceeded each of its capital requirements as shown in the following table:
The Federal Deposit Insurance Corporation Improvement Act, or the FDICIA, required that the OTS and other federal banking agencies revise their risk-based capital standards 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 (i) the OTS requirements for interest rate risk management, (ii) the ability of the OTS to impose individual minimum capital requirements on institutions that exhibit a high degree of interest rate risk, and (iii) regulatory requirements that provide guidance on the management of interest rate risk and outline the responsibility of boards of directors in that area.
The OTS monitors the interest rate risk of individual institutions through analysis of the change in net portfolio value, or 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.
The OTS may disapprove of a notice or application if:
During the fiscal year ended June 30, 2009, the Bank paid cash dividends to the Company totaling $2.4 million.
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.
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 (i) in states that expressly authorize branches of savings associations located in another state or (ii) 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.
Under the Community Reinvestment Act, or 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 regulatory 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: (i) a lending test, to evaluate the institution's record of making loans in its assessment areas; (ii) 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 (iii) a service test, to evaluate the institution's delivery of services through its branches, ATMs and other offices.
Qualified Thrift Lender Test
Under the HOLA, the Bank must comply with the qualified thrift lender test, or the QTL test. Under the QTL test, the Bank is required to maintain at least 65% of its "portfolio assets" (total assets less (i) specified liquid assets up to 20% of total assets, (ii) intangibles, including goodwill, and (iii) 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, 2009, the Bank held 75.20% of its portfolio assets in qualified thrift investments and had more than 65% of its portfolio assets in qualified thrift investments in 12 of the 12 months during the fiscal year ended June 30, 2009, 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: (i) engaging in any new activity not permissible for a national bank, (ii) paying dividends not permissible under national bank regulations, and (iii) 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, or the FRA, and Regulation W issued by the Federal Reserve, Section 11 of the HOLA as well as any additional limitations adopted by the OTS. OTS regulations regarding transactions with affiliates generally 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 Federal Reserve 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, or the Sarbanes-Oxley Act, prohibits the extension of personal loans to directors and executive officers of issuers (as defined in the Sarbanes-Oxley Act). 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.
The aggregate amount of covered transactions with any individual affiliate is limited to 10% of the unimpaired capital and surplus of the savings institution. The aggregate amount of covered transactions with all affiliates is limited to 20% of the savings institution's unimpaired capital and surplus. Loans and other specified transactions with affiliates are required to be secured by collateral in an amount and of a type described in federal law. The purchase of low-quality assets from affiliates is permitted only under certain circumstances. Transactions with affiliates must be on terms and under circumstances that are at least as favorable to the institution as those prevailing at the time for comparable transactions with non-affiliates.
Real Estate Lending Standards
The OTS and the other federal banking agencies adopted regulations to prescribe standards for extensions of credit that (i) are secured by real estate or (ii) 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. The Bank has established and implemented these required policies regarding real estate lending activities.
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.
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 (i) strong risk management practices that include maintenance of capital levels and allowance for loan losses commensurate with the risk; (ii) prudent lending policies and underwriting standards that address a borrower's repayment capacity; and (iii) 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 federal banking 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.
Consumer Protection and Compliance Provisions
The Bank is subject to various laws and regulations dealing generally with consumer protection matters. The Bank may be subject to potential liability under these laws and regulations for material violations. The Bank's loan operations are also subject to federal laws applicable to credit transactions, such as the:
The Bank's deposit operations are also subject to federal laws applicable to deposit transactions, such as the:
Identity Theft Prevention
The federal banking agencies, including the OTS, finalized a joint rule implementing Section 315 of the Fair and Accurate Credit Transactions Act, requiring each financial institution or creditor to develop and implement a written identity theft prevention program to detect, prevent, and mitigate
identity theft in connection with the opening of certain accounts or certain existing accounts. The rule became effective January 1, 2008 and mandatory compliance commenced on November 1, 2008.
Among the requirements under the rule, the Bank is required to adopt "reasonable policies and procedures" to:
Prohibitions Against Tying Arrangements
Federal savings associations are subject to statutory prohibitions on certain tying arrangements. A depository institution is prohibited, subject to some exceptions, from extending credit to or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or its affiliates or not obtain services of a competitor of the institution.
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 associations 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 association are located in more than one state, however, then the scope of fiduciary services that the federal savings association 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, 2009, the trust department of the Bank maintained approximately $77.5 million in assets under management.
Federal Reserve System
Under Federal Reserve regulations, the Bank is required to maintain noninterest-earning reserves against its transaction accounts. Federal Reserve regulations generally require that (i) reserves of 3% must be maintained against aggregate transaction account balances of $44.4 million or less, subject to adjustment by the Federal Reserve, and (ii) a reserve of 10% must be maintained against that portion of total transaction accounts in excess of $44.4 million. The first $10.3 million of otherwise reservable balances are exempted from the reserve requirements. The Bank was in compliance with these reserve requirements at June 30, 2009. Because required reserves must be maintained in the form of either vault cash, a noninterest bearing account at a Federal Reserve bank, or a pass-through account as defined by the Federal Reserve, 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 administer 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, 2009, the Bank had $12.5 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, 2009, dividends paid by the FHLB of Des Moines to the Bank totaled approximately $269,000, which constitutes a $35,000 decrease in the amount of dividends received in fiscal 2008.
Anti-Money Laundering / Terrorist Financing Provisions
The Bank is subject to the OTS and Financial Crimes Enforcement Network regulations implementing the Bank Secrecy Act, as amended by the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, commonly known as 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.
Among other requirements, Title III of the USA PATRIOT Act imposes the following requirements with respect to financial institutions:
Holding Company Regulation
We are a unitary savings and loan holding company within the meaning of the HOLA. As such, we are 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 us and any of our 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 of, or to supervision by, the Federal Reserve.
"Grandfathered" Savings and Loan Holding Company Status
Because we acquired the Bank prior to May 4, 1999, we are a "grandfathered" unitary savings and loan holding company under the Gramm-Leach-Bliley Act. As such, we are exempt from the limitations on certain unrelated business activities that apply to other savings and loan holding companies and their subsidiaries that are not savings associations, provided the Bank continues to be a "qualified thrift lender." If, however, we are acquired by a non-financial company, if we acquire another savings association subsidiary (and we become a multiple savings and loan holding company) or, as a result of proposed legislative changes, we will terminate our "grandfathered" unitary savings and loan holding company status, and become subject to certain additional limitations on the types of business activities in which we 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 us, directly or indirectly, from acquiring:
A 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:
In addition, if the Bank fails the QTL test (discussed above), we must register with the Federal Reserve as a bank holding company under the Bank Holding Company Act within one year of the Bank's failure to so qualify.
The HOLA also prohibits a savings and loan holding company (directly or indirectly, or through one or more subsidiaries) from 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. 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 DIF, the convenience and needs of the community and competitive factors.
Developments in Regulation of the Financial Sector
In response to the ongoing deteriorating conditions in the U.S. financial system, the Obama Administration, Congress and federal banking agencies have taken various actions as part of a comprehensive strategy to stabilize the financial system and housing markets, and to strengthen U.S. financial institutions.
Emergency Economic Stabilization Act of 2008
The Emergency Economic Stabilization Act, enacted on October 3, 2008, provided the Secretary of the Treasury with authority to, among other things, establish the Troubled Asset Relief Program ("TARP") to purchase from financial institutions up to $700 billion of troubled assets, which include residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008. The term "troubled assets" also included any other financial instrument that the Secretary, after consultation with the Chairman of the Federal Reserve determines the purchase of which is necessary to promote financial market stability, upon transmittal of such determination in writing, to the appropriate committees of the U.S. Congress.
On October 14, 2008, the Treasury announced the Capital Purchase Program ("CPP") under the Emergency Economic Stabilization Act, pursuant to which the Treasury would purchase up to $250 billion of senior preferred shares from qualifying financial institutions on standardized terms. The program was voluntary and required an institution to comply with a number of restrictions and provisions, including limits on executive compensation, stock redemptions and declaration of dividends. On November 21, 2008, we entered into a purchase agreement with the Treasury under the CPP, pursuant to which we agreed to issue and sell (i) 25,000 shares of our Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par value $0.01 per share (the "Preferred Stock") and (ii) a warrant to purchase up to 302,419 shares of our common stock, par value $0.01 per share, at an initial exercise price of $12.40 per share (the "Warrant"), for an aggregate purchase price of $25.0 million in cash. On June 3, 2009, we entered into a Repurchase Letter Agreement with the Treasury pursuant to which we completed the repurchase of the Preferred Stock from the Treasury. The repurchase price of the Preferred Stock was $25.0 million, plus a final accrued dividend of $62,500. On June 30, 2009, we entered into a Warrant Repurchase Letter Agreement with the Treasury pursuant to which we repurchased the Warrant from the Treasury for a purchase price of $650,000.
On February 25, 2009, the Treasury announced the Capital Assistance Program ("CAP"), which is a new capital program under the Treasury's Financial Stability Plan. The purpose of the CAP is to
restore confidence throughout the financial system by ensuring that the nation's largest banking institutions have a sufficient capital cushion against larger than expected future losses, should they occur due to a more severe economic environment, and to support lending to creditworthy borrowers. The CAP does not replace the CPP and is open to qualifying institutions regardless of whether they participated in the CPP. The deadline to apply for the CAP has been extended to November 9, 2009. We have not applied for the CAP. Recipients of CAP funding issue mandatory convertible preferred stock to the Treasury and are subject to requirements governing executive compensation and corporate governance for the entire period during which the Treasury holds equity issued under the CAP.
American Recovery and Reinvestment Act of 2009
On February 17, 2009, the President signed the American Recovery and Reinvestment Act of 2009 into law as a $787 billion dollar economic stimulus. The stimulus included discretionary spending for among other things, infrastructure projects, increased unemployment benefits and food stamps, as well as tax relief for individuals and businesses. This act also implemented new executive compensation and corporate governance requirements applicable to CPP participants.
Temporary Liquidity Guarantee Program
The FDIC established a Temporary Liquidity Guarantee Program ("TLG") on October 14, 2008 (i) guaranteeing certain debt issued by FDIC-insured institutions and certain holding companies on or after October 14, 2008 through June 30, 2009, which was extended to October 31, 2009, and (ii) providing unlimited insurance coverage for non-interest bearing transaction accounts through December 31, 2009, which was extended to June 30, 2010.
The Debt Guarantee Program ("DGP") component of the TLG program provides liquidity to the inter-bank lending market and promotes stability in the unsecured funding market. Under the DGP, the FDIC temporarily guarantees all newly issued senior unsecured debt up to prescribed limits. In general, the maximum amount of outstanding debt that is guaranteed under the DGP for each participating entity at any time is limited to 125 percent of the par value of the participating entity's senior unsecured debt. The DGP ensures that such debt would be fully protected in the event the issuing institution subsequently fails or its holding company files for bankruptcy. Entities that did not wish to participate in the DGP had to opt out by December 5, 2008. We did not opt out of the DGP. On June 3, 2009, the FDIC issued a final rule providing a limited four-month extension for the issuance of debt under the DGP until October 31, 2009. For debt issued on or after April 1, 2009, FDIC-guarantee of senior unsecured debt expires on the earliest of the mandatory conversion date for mandatory convertible debt, the stated date of maturity, or December 31, 2012. Proposed alternatives for phasing out the DGP is currently the subject of a notice of proposed rulemaking issued by the FDIC.
Under the Transaction Account Guarantee Program ("TAGP") component of the TLG program, non-interest bearing transaction accounts are fully insured through December 31, 2009. On August 26, 2009, the FDIC adopted a final rule extending the TAGP for six months, through June 30, 2010. For institutions choosing to remain in the program for the extended period, the annual assessment rate that will apply to such institutions during the extension period will be either 15 basis points, 20 basis points or 25 basis points, depending on the risk category assigned to the institution under the FDIC's risk-based premium system. Any institution currently participating in the TAGP that wishes to opt out of the TAGP extension must submit its opt-out election to the FDIC on or before November 2, 2009.
Non-interest bearing transaction accounts are any deposit accounts with respect to which interest is neither accrued nor paid and on which the insured depository institution does not reserve the right to require advance notice of an intended withdrawal, including traditional demand deposit checking accounts that allow for an unlimited number of deposits and withdrawals at any time. Transaction accounts do not include interest-bearing money market deposit accounts or sweep arrangements that
result in funds being placed in an interest-bearing account as the result of the sweep. The unlimited guarantee under the TAGP is in addition to, and separate from, the general deposit insurance coverage provided for under the DIF, currently at $250,000 per depositor, per institution until December 31, 2013. We have opted to participate in the TAGP and as such are bound by the requirements of the program, including the quarterly payment of an annualized 10 basis point assessment on any deposit amounts exceeding the existing deposit insurance limit of $250,000. This assessment is in addition to our usual risk-based assessment, as discussed above under "Federal Deposit Insurance of Accounts and Regulation by the FDIC."
Term Asset-Backed Securities Loan Facility
Under the Term Asset-Backed Securities Loan Facility ("TALF"), the Federal Reserve Bank of New York will lend up to $200 billion to eligible owners of certain AAA-rated asset backed securities backed by newly and recently originated auto loans, credit card loans, student loans, and SBA-guaranteed small business loans. The TALF has the potential to generate up to $1 trillion of lending for businesses and households. Any U.S. company that owns eligible collateral may borrow from the TALF, provided the company maintains an account relationship with a primary dealer. The facility will cease making loans collateralized by newly issued commercial mortgage-backed securities ("CMBS") on June 30, 2010, and loans collateralized by all other types of TALF-eligible newly issued and legacy asset backed securities on March 31, 2010, unless the Federal Reserve Board extends the facility.
Unfair and Deceptive Practices
On January 29, 2009, the OTS, along with other federal banking agencies ("the Agencies") issued a joint final rule under Section 5 of the Federal Trade Commission Act, or the FTC Act, that provides clarification to the body of law surrounding unfair or deceptive acts or practices. In adopting the rule, the Agencies drew on the statutory definition of what constitutes an "unfair" act or practice under the FTC Act, and also drew on the definition of what constitutes a "deceptive" act or practice under applicable FTC guidance. The Agencies identified five credit card practices that they conclusively determined to be unfair, and therefore unlawful under the FTC Act. Furthermore, the Agencies reserved the right to regulate all other unfair or deceptive acts or practices of depository institutions on a case-by-case basis. The effective date of the final rule is July 1, 2010. As discussed below, however, recently enacted legislation overrides any provisions of the final rule that are inconsistent with the legislation, including effective dates. Therefore, to the extent that any provision of the final rule does not conform to the enacted legislation or the applicable deadlines, such provisions are no longer applicable.
Truth-in-Lending Act Amendments
On January 29, 2009, the Federal Reserve also issued a final rule amending Regulation Z (which implements the Truth-in-Lending Act) to revise the disclosures that consumers receive in connection with credit card accounts and other revolving credit plans. The final rule requires changes to the format, timing, and content requirements for credit card applications and solicitations and for the disclosures that consumers receive with regard to open-end accounts. Under the final rule, affected institutions have until July 1, 2010 to comply with the new rules. However, as discussed in the next paragraph, recently enacted legislation amends the Truth-in-Lending Act. Therefore, to the extent that the Federal Reserve's regulatory amendments to Regulation Z do not conform to the legislative amendments to the Truth-in-Lending Act or the applicable deadlines, such provisions are no longer applicable.
On May 22, 2009, President Obama signed into law the Credit Card Accountability Responsibility and Disclosure Act of 2009, or the Credit CARD Act. The Credit CARD Act amends various acts,
including the Fair Credit Reporting Act, the Electronic Fund Transfer Act and the Truth-in-Lending Act. The Credit CARD Act also covers many of the practices addressed in the joint final rule issued by the Agencies relating to unfair and deceptive acts or practices, as well as the Federal Reserve's final rule relating to Regulation Z amendments. The Credit CARD Act overrides any inconsistent provisions of the final rules promulgated by the Agencies, including the Federal Reserve.
Truth in Savings Act Regulatory Amendments
In conjunction with issuing the joint, final rule regarding unfair or deceptive acts or practices, the Federal Reserve also adopted a final rule amending its regulations that implement the Truth in Savings Act. The final rule, published in the Federal Register on January 29, 2009, addresses depository institutions' disclosure practices related to overdrafts. The final rule extends to all institutions the requirement to disclose on periodic statements the total amounts charged for overdraft fees and returned items fees, for both the statement period as well as the year-to-date. The final rule also requires institutions that provide account balance information through an automated system to provide a balance that excludes additional funds that may be made available to cover overdrafts. The Bank has until January 1, 2010 to comply with the amendments.
Proposed Legislative and Regulatory Actions
On June 17, 2009, the Treasury issued a white paper detailing the Obama Administration's plans for reorganizing the regulatory system for financial institutions and their holding companies. The proposal raises many issues for banks and savings associations. The five key objectives articulated under the proposal are to: (i) promote robust supervision and regulation of financial firms; (ii) establish comprehensive supervision of financial markets; (iii) protect consumers and investors from financial abuse; (iv) provide the government with the tools it needs to manage financial crises; and (v) raise international regulatory standards and improve international cooperation. Among the ideas proposed to accomplish the objective of promoting robust supervision and regulation of financial firms is the creation of a new federal government agency, the National Bank Supervisor (NBS), to conduct prudential supervision and regulation of all federally chartered depository institutions, and all federal branches and agencies of foreign banks. As proposed, the NBS would take over the prudential responsibilities of the Office of the Comptroller of the Currency, which currently charters and supervises nationally chartered banks and federal branches and agencies of foreign banks, and responsibility for the institutions currently supervised by the OTS, which supervises federally chartered thrifts and thrift holding companies. Under the proposal, the thrift charter would be eliminated, which directly impacts all federal savings associations and their holding companies subject to the supervision of the OTS, including the Company and the Bank. Legislation to implement the objectives of the proposal is expected.
New statutes, regulations and guidance are regularly proposed that contain wide-ranging potential changes to the statutes, regulations and competitive relationships of financial institutions operating and doing business in the United States. We cannot predict whether or in what form any proposed regulation or statute will be adopted or the extent to which our business may be affected by any new regulation or statute.
The Sarbanes-Oxley Act
As a public company, we are subject to the Sarbanes-Oxley Act, which implements a broad range of disclosure, corporate governance and accounting measures for public companies designed to promote honesty and transparency and to protect investors from corporate wrongdoing. Furthermore, The NASDAQ Global Market enacted corporate governance rules that implement some of the mandates of the Sarbanes-Oxley Act. The NASDAQ rules include, among other things, requirements 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 calling for stockholder approval of all new stock option plans and all material modifications. These rules affect us because our common stock is listed on The NASDAQ Global Market.
Federal Securities Law
Our common stock is registered with the SEC under the Exchange Act. We are subject to the information, proxy solicitation, insider trading restrictions and other requirements of the SEC under the Exchange Act.
Our stock held by persons who are affiliates (generally officers, directors and principal stockholders) of us may not be resold without registration or unless sold in accordance with certain resale restrictions. If we meet specified current public information requirements, each of our affiliates is able to sell in the public market, without registration, a limited number of shares in any three-month period.
Delaware General Corporation Law
We are incorporated under the laws of the State of Delaware. Thus, the rights of our 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% 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% 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, 2009, the Bank's Excess for tax purposes totaled approximately $7.6 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% 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, 2009 were not material to the operation of the Company.
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 Industry and Business
Difficult economic and market conditions have adversely affected our industry.
Dramatic declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, have negatively impacted the credit performance of mortgage and construction loans and resulted in significant write-downs of assets by many financial institutions across the United States. General downward economic trends, reduced availability of commercial credit and increasing unemployment have negatively impacted the credit performance of commercial and consumer credit, resulting in additional write-downs. Concerns over the stability of the financial markets and the economy have resulted in decreased lending by financial institutions to their customers and to each other. This market turmoil and tightening of credit has led to increased commercial and consumer deficiencies, lack of customer confidence, increased market volatility and widespread reduction in general business activity. Financial institutions have experienced decreased access to deposits and borrowings. The resulting economic pressure on consumers and businesses and the lack of confidence in the financial markets may adversely affect our business, financial condition, results of operations and stock price. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry. In particular, we may face the following risks in connection with these events:
There can be no assurance that recently enacted legislation will help stabilize the U.S. financial system.
Recent legislative and regulatory initiatives to address difficult market and economic conditions may not stabilize the U.S. banking system. On October 3, 2008, the President signed into law the Emergency Economic Stabilization Act of 2008, or the Emergency Economic Stabilization Act, in response to the current crisis in the financial sector. The Treasury and various banking regulators have implemented a number of programs under this legislation to address capital and liquidity issues in the banking system. On February 17, 2009, the President signed into law the American Recovery and Reinvestment Act of 2009, or the American Recovery and Reinvestment Act. There can be no assurance, however, as to the actual impact that the Emergency Economic Stabilization Act or the American Recovery and Reinvestment Act, and the various programs implemented in association with these legislative efforts, will have on the financial markets, including the extreme levels of volatility and limited credit availability currently being experienced. The failure of the Emergency Economic Stabilization Act or American Recovery and Reinvestment Act and the associated programs to help stabilize the financial markets and a continuation or worsening of current financial market conditions could have a material, adverse effect on our business, financial condition, results of operations, access to credit or the value of our securities. Moreover, the Treasury recently issued a white paper detailing the Obama Administration's plans for reorganizing the regulatory system for financial institutions, which could impact our operations significantly.
We recorded other-than-temporary impairment ("OTTI") charges in our trust preferred securities ("TRUPS") portfolio in the third and fourth quarters of 2009, and we could record additional losses in the future.
We determine the fair value of our investment securities based on GAAP and three levels of informational inputs that may be used to measure fair value. The price at which a security may 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 a significant amount of securities are being sold.
We own shares of six TRUPS pools with an adjusted cost basis of $11.9 million and a fair value of $6.1 million at June 30, 2009. Rating downgrades on these investments occurred during fiscal year 2009, placing each below investment grade rating. Due to an inactive market for these securities, management utilized a "Level 3" fair value input according to Statement of Financial Accounting Standard No. 157, utilizing discounted cash flow methodologies to determine fair value and OTTI. During fiscal 2009, we determined that three debt securities exhibited OTTI. The aggregate OTTI losses recorded for the three securities for the fiscal year 2009 were $3.9 million, of which $3.5 million was recognized on the balance sheet in other comprehensive income, with the balance being $397,000 of credit loss recognized through earnings. The remaining difference between amortized cost basis and fair value of $2.3 million recognized in other comprehensive income is primarily attributable to the three TRUPS for which OTTI was not recognized for the fiscal year 2009.
The valuation of our TRUPS will continue to be influenced by external market and other factors, including implementation of Securities and Exchange Commission and Financial Accounting Standards Board guidance on fair value accounting, the financial condition of specific issuers within our pooled securities (including any credit deterioration thereof), deferral and default rates of specific issuer financial institutions, rating agency actions, and the prices at which observable market transactions occur. If we are required to record additional OTTI charges on our TRUPS portfolio, we could experience potentially significant earnings losses as well as an adverse impact to our capital position.
As a result of current economic conditions, the Bank's allowance for loan losses may prove to be insufficient to absorb losses in its loan portfolios, which could adversely affect its operating results.
At June 30, 2009, the Bank's nonperforming loans (which consist of non-accrual loans and loans still accruing but past due greater than 90 days) totaled $11.5 million, or 1.32% of its loan portfolio. At June 30, 2009, the Bank's nonperforming assets (which include foreclosed real estate) were $12.6 million, or 1.07% of assets. In addition, the Bank had $3.9 million in accruing loans that were 30 to 89 days delinquent at June 30, 2009. At June 30, 2009, the Bank held $8.5 million of loan and lease loss reserves, or 0.98% of total loans, and 73.83% of non-performing loans.
Until economic and market conditions improve, the Bank may continue to incur additional losses relating to an increase in nonperforming loans. The Bank does not record interest income on non-accrual loans or other real estate owned, thereby adversely affecting its income, and increasing its loan administration costs. When the Bank takes collateral in foreclosures and similar proceedings, it is required to mark the related loan to the then fair market value of the collateral, which may result in a loss. These loans and other real estate owned also increase its risk profile and the capital its regulators believe is appropriate in light of such risks. As a result of current economic conditions, additional provisions for loan losses may be necessary.
Determination of the appropriate level of the allowance for loan losses involves a high degree of subjectivity and requires significant estimates, and actual losses may vary from current estimates.
The Bank maintains an allowance for loan losses to provide for loans in its portfolio that may not be repaid in their entirety. The determination of the appropriate level of the allowance for loan losses involves a high degree of subjectivity and requires us and the Bank to make significant estimates of current credit risks and future trends, all of which may undergo material changes.
In evaluating the adequacy of the Bank's 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 classified 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 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 subjective and fluid. Our estimates of the risk of loss and amount of loss on any loan are complicated by the significant uncertainties surrounding the Bank's 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, the Bank's actual losses may vary from our current estimates.
Additionally, bank regulators periodically review the Bank's 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 the Bank's allowance for loan losses or loan charge-offs required by these regulatory authorities may adversely affect our operating results.
We are a community bank and 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.
We are a community bank, and 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.
Our financial success is dependant on the prevailing economic, political and business conditions as well as the population growth in South Dakota.
Our success and growth is dependant on the income levels, deposits and population growth in our primary market area, which are communities located in eastern and central South Dakota, including the Sioux Falls metropolitan statistical area (MSA), and the cities of Pierre, Mitchell, Aberdeen, Brookings, Dakota Dunes, Watertown and Yankton. If the communities in which we operate do not grow or if prevailing economic conditions locally are unfavorable, our business will 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 decreases. Our business operations and activities are concentrated in the state of South Dakota and most of our credit exposure is in that state, so we are specifically at risk from adverse economic, political and business conditions that affect South Dakota. Accordingly, economic and business conditions in South Dakota, such as increases in unemployment, commercial and consumer delinquencies and real estate foreclosures, as well as decreases in real gross domestic product, home and land prices or home sales, will each adversely impact our credit risk.
For example, credit card issuers, a significant employer in the Sioux Falls MSA, are subject to recently enacted legislation that may result in their interest income and loan fee income being significantly reduced, which could cause these companies to scale back their operations and reduce personnel. A reduction in such operations and personnel could negatively affect the economic conditions in South Dakota, which in return could negatively impact our credit risk and business.
Our financial success is dependent on our ability to compete effectively in highly competitive markets.
We operate in the highly competitive markets of South Dakota. Our future growth and success will depend on our ability to compete effectively in these markets. Through the Bank, we compete for loans, deposits and other financial services in geographic markets with other local, regional and national 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. Many of our competitors offer products and services different from us, and have substantially greater resources, name recognition and market presence than we do, which benefits them in attracting business. Larger competitors may be able to price loans and deposits more aggressively than we can and have broader customer and geographic bases to draw upon.
Competitors that are not depository institutions are generally not subject to the extensive regulations that apply to us. Through the Bank, 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.
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, including the OTS and the FDIC, and to a limited extent, the Federal Reserve. Banking regulations are primarily intended to protect the DIF 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 our common stock, and our ability to make acquisitions could be materially and adversely affected.
Federal bank regulatory agencies, as well as the U.S. Congress and the President, are in the process of evaluating the regulation of banks, other financial institutions and the financial markets and such changes, if any, could require us to maintain more capital, liquidity and risk management that could adversely affect our growth, profitability and financial condition, as well as change our charter, regulator and/or subject us to new or additional regulations and regulators. Furthermore, various proposals to eliminate the federal thrift charter, create a uniform financial institutions charter and abolish the OTS have been introduced in past sessions of the U.S. Congress. We are unable to predict whether such legislation would be enacted or the extent to which the legislation would restrict or disrupt our or the Bank's operations.
Liquidity risks could affect operations and jeopardize our financial condition.
Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources to accommodate our existing and future lending and investment activities could have a substantial negative effect on our liquidity and severely constrain our financial flexibility. Our primary source of funding is retail deposits gathered through our network of branch offices. Our alternative funding sources include, without limitation, brokered certificates of deposit, federal funds purchased, Federal Reserve Discount Window borrowings, Federal Home Loan Bank of Des Moines (FHLB) advances and short- and long-term debt.
Until recently, the Bank has historically obtained funds principally through local deposits and it has a base of lower cost transaction deposits. Generally, we believe local deposits are a cheaper and more stable source of funds than other borrowings, because interest rates paid for local deposits are typically lower than interest rates charged for borrowings from other institutional lenders and reflect a mix of transaction and time deposits, whereas brokered deposits typically are higher cost time deposits.
Our costs of funds, profitability and liquidity will be adversely affected to the extent we have to rely upon higher cost borrowings from other institutional lenders or brokers to fund loan demand or liquidity needs, and changes in our deposit mix and growth could adversely affect our profitability and the ability to expand our loan portfolio.
On May 15, 2009, we entered into a Commitment Letter/Letter Agreement with First Tennessee Bank National Association ("FTB"), which renewed our existing $6.0 million line of credit. Borrowings under the line of credit accrue interest at the FTB base rate minus one-quarter percent, with a
minimum interest rate of 4.0% per annum. As of June 30, 2009, the FTB base rate was 3.25% and we had aggregate borrowings of $5.5 million outstanding under our line of credit with FTB. The line of credit matures on September 30, 2009. To the extent we have to borrow funds from other institutional lenders to repay the line of credit, our costs of funds, profitability and liquidity may be adversely affected.
We may look to sell production assets, such as mortgage loans, into the secondary market as a means to manage the size of our balance sheet and manage the use of our 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.
Our liquidity, on a parent only basis, is adversely affected by certain restrictions on receiving dividends from the Bank without prior regulatory approval.
Higher FDIC deposit insurance premiums and assessments could adversely affect our financial condition.
FDIC insurance premiums have increased substantially in 2009 and we expect to pay significantly higher FDIC premiums in the future. Market developments have significantly depleted the DIF and reduced the ratio of reserves to insured deposits. The FDIC adopted a revised risk-based deposit insurance assessment schedule on February 27, 2009, which raised deposit insurance premiums. On May 22, 2009, the FDIC also implemented a five basis point special assessment of each insured depository institution's assets minus Tier 1 capital as of June 30, 2009, but no more than 10 basis points times the institution's assessment base for the second quarter of 2009, to be collected on September 30, 2009. Additional special assessments may be imposed by the FDIC for future periods.
The Bank participates in the FDIC's Temporary Liquidity Guarantee Program, or TLG, for noninterest-bearing transaction deposit accounts. Banks that participate in the TLG's noninterest- bearing transaction account guarantee will pay the FDIC an annual assessment of 10 basis points on the amounts in such accounts above the amounts covered by FDIC deposit insurance. To the extent that these TLG assessments are insufficient to cover any loss or expenses arising from the TLG program, the FDIC is authorized to impose an emergency special assessment on all FDIC-insured depository institutions. The FDIC has authority to impose charges for the TLG program upon depository institution holding companies as well. These changes, along with the full utilization of the Bank's FDIC insurance assessment credit in the first and second quarters of 2009, have caused the premiums and TLG assessments charged by the FDIC to increase. Continued actions by the FDIC could significantly increase the Bank's noninterest expense in fiscal 2010 and for the foreseeable future.
Our profitability may be affected by changes in market interest rates.
Through our banking subsidiary, the Bank, 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 increase faster than the interest earned on loans and investments.
Our results of operations will be affected by domestic economic conditions and the monetary and fiscal policies of the U.S. government and its agencies. The Federal Reserve has, and is likely to continue to have, an important impact on the operating results of lending institutions through its power to implement national monetary policy, among other things, in order to curb inflation or combat a recession. The Federal Reserve affects the levels of bank loans, investments and deposits through its control over the issuance of U.S. government securities, its regulation of the discount rate applicable to member banks and its influence over reserve requirements to which member banks are subject. 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. As the yield curve assumed a more normalized slope after short-term interest rates decreased in fiscal 2008 and 2009, we experienced a positive effect to our net interest margin. In the second quarter of fiscal 2009, the Federal Reserve decreased the Fed Funds Target Rate by a total of 175 basis points on three separate occasions. This was the first decrease in short-term interest rates since April 30, 2008. 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, we may experience compression of our net interest margin, which will have a negative effect on our results of operations. We cannot predict the nature or impact of future changes in monetary and fiscal policies.
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.
A significant portion of our loan portfolio is secured by real estate; therefore, we have a high degree of risk from a downturn in our real estate markets and the local economy.
A further downturn in the real estate market and local economy in South Dakota could hurt our business because a significant portion of our loans are secured by real estate located in South Dakota. Real estate values and real estate markets are generally affected by, among other things, changes in regional or local economic conditions, fluctuations in interest rates, and the availability of loans to potential purchasers. If real estate values decline in South Dakota, the value of real estate collateral securing our loans could be significantly reduced. Our ability to recover on defaulted loans by foreclosing and selling the real estate collateral would then be diminished and we would be more likely to suffer losses on defaulted loans.
Our loan concentration presents a business risk if the agriculture industry suffers a downturn.
Agricultural loans comprised 27.2% of our total loan and lease portfolio at June 30, 2009. A number of these loans have relatively large balances. The deterioration of one or a few of these loans may cause a significant increase in nonperforming loans. Furthermore, any extended period of low commodity prices, significantly reduced yields on crops, reduced levels of government assistance to the agricultural industry and/or reduced farmland values could result in a significant increase in our nonperforming loans. An increase in nonperforming loans could result in a loss of earnings from these loans, an increase in the provision for loan losses, and/or an increase in loan charge-offs, which would have an adverse impact on our results of operations and financial condition.
The soundness of other financial institutions could adversely affect us.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the financial instrument exposure. There is no assurance that any such losses would not materially and adversely affect our results of operations.
Negative developments in the financial industry and the credit markets may subject us to additional regulation.
As a result of ongoing challenges facing the U.S. economy, the potential exists for new laws and regulations regarding lending and funding practices and liquidity standards to be promulgated, and bank regulatory agencies are expected to be active in responding to concerns and trends identified in examinations, including the expected issuance of many formal enforcement orders. Negative developments in the financial industry and credit markets, and the impact of new legislation in response to those developments, may negatively impact our operations by restricting our business operations, including our ability to originate or sell loans, and may adversely impact our financial performance.
Future acquisitions and expansion activities may disrupt our business, dilute existing stockholders and adversely affect our operating results.
We intend to continue to evaluate potential acquisitions and expansion opportunities in the normal course of our business. To the extent that we grow through acquisitions, we may not be able to adequately or profitably manage this growth. Acquiring other banks, thrifts, or financial service companies, as well as other geographic and product expansion activities, involve various risks including:
Attractive acquisition opportunities may not be available to us in the future.
We expect that other banking and financial service companies, many of which have significantly greater resources than us, will compete with us in acquiring other banks, thrifts, and financial service companies. This competition could increase prices for potential acquisitions that we believe are attractive. Also, acquisitions are subject to various regulatory approvals. If we fail to receive the appropriate regulatory approvals, we will not be able to consummate an acquisition that we believe is in our best interests. Among other things, our regulators consider our capital, liquidity, profitability, regulatory compliance and levels of goodwill and intangibles when considering acquisition and expansion proposals. Any acquisition could be dilutive to our earnings and stockholders' equity per share of our common stock.
Our ability to complete acquisitions and expansion activities, if any, 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 agencies to maintain adequate levels of capital to support our operations and such levels may be increased by legislative and regulatory developments. To complete any future acquisitions and expansion activities, 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 may not be able 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 organic or external 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 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.
The loss of one or more of our key personnel, or our failure to attract, assimilate and retain other highly qualified personnel in the future, could harm our business.
As a community bank, we expect our future growth to be driven in large part by the relationships that our key personnel, including Curtis L. Hage, our Chairman, President and Chief Executive Officer, and Darrel L. Posegate, our Executive Vice President, Chief Financial Officer and Treasurer, maintain with our customers. We do not have long-term employment agreements with any of our officers or key employees. Messrs. Hage's and Posegate's employment agreements have a term of one year, which automatically renew on July 1 for an additional year unless, no later than December 31 of the previous year in the case of Mr. Hage, or March 31 of the previous year in the case of Mr. Posegate, either the Bank or the executive gives notice that the employment agreement shall not be extended.
The unexpected loss of any of our key employees could have a material adverse effect on our business and possibly result in reduced revenues and earnings.
Changes in or interpretations of accounting standards may materially impact our financial statements.
Accounting principles generally accepted in the United States 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.
The holders of our junior subordinated debentures have rights that are senior to those of our stockholders.
We have supported our continued growth through the issuance of trust preferred securities from special purpose trusts and accompanying sales of junior subordinated debentures to these trusts. The accompanying junior subordinated debentures have an aggregate liquidation amount totaling $27.8 million as of June 30, 2009. Payments of the principal and interest on the trust preferred securities of these trusts are conditionally guaranteed by us. Further, the accompanying junior subordinated debentures that we issued to the trusts are senior to our shares of common stock. As a result, we must make payments on the junior subordinated debentures before any dividends can be paid on our common stock and, in the event of our bankruptcy, dissolution or liquidation, the holders of the junior subordinated debentures must be satisfied before any distributions can be made on our common stock.
Risks Related to Our Common Stock
The price of our common stock may fluctuate significantly, and this may make it difficult for you to resell shares of our common stock at times or at prices you find attractive.
The stock market and, in particular, the market for financial institution stocks, has experienced significant volatility, which has reached unprecedented levels in past months. In some cases, the markets have produced downward pressure on stock prices for certain issuers without regard to those issuers' underlying financial strength. As a result, the trading volume in our common stock may fluctuate more than usual and cause significant price variations to occur. This may make it difficult for you to resell shares of our common stock at times or at prices you find attractive.
The trading price of the shares of our common stock will depend on many factors that may change from time to time and may be beyond our control. Among the factors that could affect our stock price are those identified in the section entitled "Forward-Looking Statements" and as follows:
A significant decline in our stock price could result in substantial losses for individual stockholders and could lead to costly and disruptive securities litigation.
Our ability to pay dividends depends primarily on dividends from our banking subsidiary, the Bank, which is subject to regulatory limits.
We are a unitary thrift holding company and our operations are conducted primarily by our banking subsidiary, the Bank. Since we receive substantially all of our revenue from dividends from the Bank, our ability to pay dividends on our common stock depends on our receipt of dividends from the Bank.
Dividend payments from the Bank are subject to legal and regulatory limitations, generally based on net income and retained earnings. The ability of the Bank to pay dividends to us is also subject to its profitability, financial condition, capital expenditures and other cash flow requirements. The Bank may not be able to generate adequate cash flow to pay us dividends in the future. The inability to receive dividends from the Bank could have an adverse effect on our business and financial condition.
Furthermore, holders of our common stock are only entitled to receive the dividends as our Board of Directors may declare out of funds legally available for such payments. Although we have historically paid cash dividends on our common stock, we are not required to do so and our Board of Directors could reduce or eliminate our common stock dividend in the future. This could adversely affect the market price of our common stock.
Additionally, we may elect in the future to defer interest payments on our junior subordinated debentures discussed above. The debenture agreements prohibit dividend payments on our common stock following the deferral of interest payments on the subordinated debentures underlying the trust preferred securities.
The trading volume in our common stock has been low, and the sale of a substantial number of shares of our common stock in the public market could depress the price of our common stock and make it difficult for you to sell your shares.
Our common stock is listed to trade on The NASDAQ Global Market but is thinly traded. As a result, you may not be able to sell your shares of common stock on short notice. Additionally, thinly traded stock can be more volatile than stock trading in an active public market. The sale of a substantial number of shares of our common stock at one time could depress the market price of our common stock, making it difficult for you to sell your shares and impairing our ability to raise capital.
We may raise additional capital, which could have a dilutive effect on the existing holders of our common stock and adversely affect the market price of our common stock.
We are not restricted from issuing additional shares of common stock or securities that are convertible into or exchangeable for, or that represent the right to receive, common stock. We may evaluate opportunities to access the capital markets taking into account our regulatory capital ratios, financial condition and other relevant considerations. For example, we may issue additional shares of common stock in public or private transactions in order to, among other things, further increase our capital levels above the requirements for a well-capitalized institution established by the federal bank regulatory agencies as well as other regulatory targets.
We face significant regulatory and other governmental risks as a financial institution, and it is possible that capital requirements and directives could in the future require us to change the amount or composition of our current capital, including common equity.
The issuance of any additional shares of common stock or securities convertible into or exchangeable for common stock or that represent the right to receive common stock, or the exercise of such securities, could be substantially dilutive to holders of our common stock. Holders of our shares of common stock have no preemptive rights that entitle holders to purchase their pro rata share of any offering of shares of any class or series and, therefore, such sales or offerings could result in increased dilution to our stockholders. The market price of our common stock could decline as a result of sales of shares of our common stock or the perception that such sales could occur.
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.
Specifically, our Certificate of Incorporation and Bylaws, as the case may be, include certain provisions that:
then-outstanding capital stock entitled to vote generally in the election of directors, voting together as a single class.
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. Under OTS regulations, an acquiror is deemed, subject to rebuttal, to have acquired control of a savings association if the acquiror, directly or indirectly, or through one or more subsidiaries or transactions or acting in concert with one or more persons or companies, acquires more than 10 percent of any class of voting stock of a savings association and is subject to any of the enumerated control factors under the regulation.
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 has a total of 33 banking centers in its market area and one Internet branch located at www.homefederal.com. Of such 33 total banking centers, the Company owns 15, including the main office, and leases 18 others. For a description of the Bank's market area, see Item 1, "BusinessMarket Area" of this Form 10-K.
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, 2009 was $16.9 million. The Company previously announced a new facility in Watertown, South Dakota constructed in fiscal 2009, which replaces 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.
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, 2009.
The Company's common stock is traded under the symbol "HFFC" on The NASDAQ Global 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, 2009 and 2008. Quotations for such periods are as reported by the NASDAQ Global Market.
As of September 17, 2009, the Company had 478 holders of record of its common stock.
The transfer agent for the Company's common stock is BNY Mellon Shareowner Services, P.O. Box 358015 Pittsburgh, PA 15252.
The Company paid cash dividends on a quarterly basis of $0.1125, $0.1125, $0.1125 and $0.1125 per share throughout fiscal 2009. The Company paid cash dividends on a quarterly basis of $0.1050, $0.1075, $0.1075 and $0.1075 per share in fiscal 2008. On July 27, 2009, 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 14, 2009 to stockholders of record on August 7, 2009.
The Company's ability to pay dividends on its common stock is dependent on the dividend payments it receives from the Bank, since the Company receives substantially all of its revenue in the form of dividends from the Bank. Future dividends are not guaranteed and will depend on the Company's ability to pay them.
The Company and the Bank are subject to the oversight of the OTS and the Bank is also subject to the oversight of the FDIC. The OTS imposes various restrictions on the Bank's ability to make capital distributions, including cash dividends. The Bank must file a notice with the OTS at least 30 days before making a capital distribution. The Bank must also file an application for prior approval to make a dividend 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.
The OTS may disapprove of a notice or application if:
The Company's ability to pay dividends is also subject to the terms of its outstanding trust preferred securities and the accompanying junior subordinated debentures. Under the terms of these debentures, the Company may defer interest payments on the debentures for up to five years. If the Company defers such interest payments, the Company may not declare or pay any cash dividends on any shares of its common stock during the deferral period.
In addition, the Company has a line of credit for $6.0 million with First Tennessee Bank, NA, with $5.5 million outstanding at June 30, 2009. The line of credit matures on September 30, 2009. In case of default on the line of credit, the Company's ability to pay cash dividends may be restricted.
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, 2004, $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. The performance graph represents past performance and should not be considered to be an indication of future performance.
Equity Compensation Plan Information
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 as of June 30, 2009, including the 2002 Stock Option and Incentive Plan, the 1996 Director Restricted Stock Plan, and the 1991 Stock Option and Incentive Plan (collectively, the "Incentive Plans"). The 1996 Director Restricted Stock Plan expired on January 1, 2007, and the 1991 Stock Option and Incentive Plan expired on October 27, 2002. Although the column below entitled "Number of Securities 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 and Incentive Plan, no common stock remains available for future awards under the 1991 Stock Option and Incentive Plan. Additionally, no common stock remains available for future awards under the 1996 Director Restricted Stock Plan
Sales of Unregistered Stock
Except for the Company's participation in the Capital Purchase Program (the "CPP") during the second quarter of fiscal 2009, the Company had no sales of unregistered stock during the fiscal year ended June 30, 2009. For further discussion of the Company's participation in the CPP, see Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of OperationsExecutive Summary" of this Form 10-K.
Issuer Purchases of Equity Securities
The Company had in effect a stock buy back program which was publicly announced on April 28, 2008, in which the Company was permitted to repurchase up to 10% of the common stock of the Company that was outstanding on May 1, 2008, which equaled 395,321 shares. In conjunction with the Company's participation in the CPP, the Company's Board of Directors terminated the stock buyback program in the second quarter of fiscal year 2009. A total of 6,527 shares were purchased under this
program during fiscal year 2008. The Company did not repurchase any shares of its common stock through the stock buyback program or otherwise during fiscal year 2009.
During the fourth quarter of the 2009 fiscal year, the Company discontinued its participation in the CPP and entered into a Repurchase Letter Agreement with the Treasury pursuant to which we completed the repurchase of our Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the "Preferred Stock") from the Treasury. The repurchase price of our Preferred Stock was $25.0 million, plus a final accrued dividend of $62,500. Also during the fourth quarter of fiscal year 2009, the Company entered into a Warrant Repurchase Letter Agreement with the Treasury pursuant to which we repurchased the related warrant from the Treasury for a purchase price of $650,000. For further discussion of the Company discontinuing its participation in the CPP, see Part II, Item 7 "Management Discussion and AnalysisExecutive Summary" of this Form 10-K.
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 each of the fiscal years 2005 through 2009 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: Forward-Looking Statements, 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 2009 was $7.8 million and net income available to common stockholders was $6.5 million, or $1.61 per diluted share, compared to $5.8 million, or $1.45 per diluted share for fiscal 2008. Preferred share dividends, amortization and warrant repurchase related to the Fixed Rate Cumulative Perpetual Preferred Stock, Series A, issued to the U.S. Department of the Treasury under the CPP accounted for the $1.3 million, or $0.33 per diluted share, difference between reported net income and net income available to common stockholders. Return on average equity was 9.73% at June 30, 2009, compared to 9.12% at June 30, 2008.
Net interest income for fiscal 2009 was $35.3 million, an increase of $5.5 million or 18.3% over the same period a year ago. The net interest margin was 3.26%, compared to 3.11% for the same period a year ago, an increase of 15 basis points. On a fully taxable equivalent basis, the net interest margin for fiscal 2009 was 3.32%, compared to 3.16% in fiscal 2008. The cost of funds rate on interest-bearing liabilities decreased from 3.87% in fiscal 2008 to 2.65% in fiscal 2009, a change of 122 basis points. For the same period, yields on earning assets decreased from 6.58% to 5.60%, a decrease of 98 basis points. Increases in volume from fiscal 2008 to fiscal 2009 of average earning assets and interest-bearing liabilities were 12.7% and 11.1% 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 175 basis points in fiscal 2009.
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.
Agricultural loans accounted for the majority of the loan growth between fiscal 2009 and 2008. Agricultural real estate loans were $102.2 million at the end of 2009, up $30.1 million or 41.7% since fiscal year 2008, and comprised 11.8% of total loans outstanding, up from 9.1% at the end of 2008. Agricultural business loans were $129.1 million at the end of 2009, up $41.0 million or 46.5% since fiscal year 2008, and comprised 14.9% of total loans outstanding, up from 11.1% at the end of 2008. Loans of this type are in a diverse range of agricultural enterprises, including grain production, dairy and livestock operations. The credit risk related to agricultural loans is largely influenced by general economic conditions and the resulting impact on a borrower's operations or on the value of underlying collateral, if any. Credit risk is managed by employing sound underwriting guidelines, lending primarily to borrowers in local markets, periodically evaluating the underlying collateral, and formally reviewing the borrower's financial soundness and relationship on an ongoing basis.
The allowance for loan and lease losses increased $2.5 million to $8.5 million at June 30, 2009, an increase of 42.8%. The ratio of allowance for loan and lease losses to total loans and leases was 0.98% as of June 30, 2009 compared to 0.75% at June 30, 2008. Total nonperforming assets at June 30, 2009 were $12.6 million as compared to $3.7 million at June 30, 2008. The increase in non-performing assets was primarily attributable to one credit relationship. The ratio of nonperforming assets to total assets was 1.07% for June 30, 2009, compared to 0.34% at June 30, 2008. The allowance for loan and lease losses is calculated based on loan and lease levels, loan and lease loss history over 12, 36, and 60 month time periods, 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.
On June 26, 2006, the Company filed a $3.8 million lawsuit against MetaBank for their role in certain loan participation interests, alleging fraud, breach of fiduciary duty, conspiracy, and negligent misrepresentation. In October 2008, the Company settled for $2.8 million inclusive of the remaining amount of receivables from certain loan participation interests in the amount of $223,000. The settlement amount, less attorney fees of $292,000, was recorded as a recovery of loan and leases losses in the second quarter of fiscal 2009.
During the second quarter of fiscal year 2009, an increase in equity occurred with participation in the CPP. As referenced in the 8-K filed November 24, 2008, the Company entered into an agreement with the Treasury pursuant to which the Company agreed to issue and sell to the Treasury (i) 25,000 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par value $0.01 per share (the "Preferred Stock") and having a liquidation preference of $1,000 per share, and (ii) a warrant to purchase up to 302,419 shares of the Company's common stock, par value $0.01 per share, at an initial exercise price of $12.40 per share (the "Warrant"), for an aggregate purchase price of $25.0 million in cash. The securities were issued and sold in a private placement exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended. Cumulative dividends on the Preferred Stock accrued on the liquidation preference at a rate of 5% per annum for the first five years, and at a rate of 9% per annum thereafter, only to be paid if, as and when declared by the Company's Board of Directors.
In conjunction with the Company's participation in the CPP, the Company's Board of Directors terminated the stock buyback program in the second quarter which had been in place through November 21, 2008, in which up to 10% of the common stock of the Company outstanding on May 1, 2008 could be acquired through April 30, 2009.
The Company repurchased all of its outstanding shares of the Preferred Stock on June 3, 2009 and completed its repurchase of the Warrant on June 30, 2009. The repurchase price of the Preferred Stock was $25.0 million plus a final accrued dividend of $62,500, while the Warrant was repurchased at a price of $650,000.
The Company held $11.9 million in trust preferred securities at June 30, 2009 that are currently impaired under applicable accounting rules. These are comprised of pooled securities issued primarily by banks throughout the United States, and were downgraded below investment grade by Moody's during the 2009 fiscal year. The Company performed analysis to determine if any of the securities had a credit loss by estimating if any of the cash flows are not expected to be received as contracted. Based upon the analysis, the total other-than-temporary impairment losses taken against the pooled trust preferred securities was $3.9 million, of which $3.5 million was recognized on the balance sheet in other comprehensive income with $397,000 of credit loss recognized through earnings.
Total deposits at June 30, 2009, were $837.9 million, an increase of $53.6 million, or 6.8%, from June 30, 2008. Due to a historically low interest rate environment and a steeper yield curve, the Company experienced a preference of customers favoring in-market certificates of deposit, which
increased $75.3 million or 23.1% from June 30, 2008, while lower yielding money market accounts decreased $26.5 million or 15.4% from June 30, 2008. Interest expense on deposits was $15.7 million for fiscal 2009, a decrease of $9.0 million, or 36.5%, over the same period a year ago. A primary factor affecting interest expense was a decrease in money market rates and certificate of deposit rates.
The Company has a line of credit for $6.0 million with First Tennessee Bank, NA for liquidity needs in the Company. The note is short-term in duration and is subject to annual review. In case of default on the notes, the Company's ability to pay cash dividends may be restricted. At June 30, 2009, $5.5 million was advanced on the line of credit. 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, Part II, Item 7 "Financial Condition Data" of this Form 10-K and Exhibit 10.11 of this Form 10-K for additional information.
The total risk-based capital ratio was 11.05% at June 30, 2009, compared to 10.83% at June 30, 2008. This continues to place the Bank in the "well-capitalized" category within OTS regulation at June 30, 2009, 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 income for fiscal 2009 was $12.6 million, compared to $11.3 million for the same period a year ago, an increase of $1.3 million or 11.2%. The increases in fees on deposits, net gain on sale of loans and net gain on sale of securities of $372,000, $709,000, and $901,000, respectively, primarily contributed to the noninterest income increase from fiscal 2008 to fiscal 2009. Increased mortgage loan originations arising from reduced interest rates contributed to the increase in the net gain on sale of loans. The net gain on sale of securities increased primarily due to the sales of longer term fixed rate residential mortgage-backed securities. Trust income decreased $290,000 and net impairment losses recognized in earnings increased $405,000, which combined to somewhat offset the previously mentioned increases from fiscal 2008 to fiscal 2009.
Noninterest expense for fiscal 2009 was $34.6 million, compared to $30.6 million a year ago, an increase of $4.0 million or 12.9%. Employee compensation and benefits, FDIC insurance, and professional fees increased $1.3 million, $1.3 million, and $634,000, respectively, as compared to fiscal 2008. Employee compensation increased $887,000 or 7.2%, variable pay related to employee incentives and commissions decreased $606,000 or 24.6% and net healthcare costs increased $1.1 million or 72.9%. Employee compensation increased due to annual raises awarded and sales-related personnel additions. Variable pay relating to employee incentive programs decreased due to a reduced change in performance outcomes compared to the prior year. 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 2009 were $2.6 million, compared to $1.5 million for the same period a year ago. This change is primarily due to higher claim activity in the second and third quarters of fiscal 2009. Management continues to believe the current structure is a reasonable alternative to traditional healthcare plans over the long term. Since the plan is a self-insured plan, the costs will vary from year to year. FDIC insurance costs increased due to the exhaustion of previously earned credits in the second quarter of fiscal 2009, increased assessment rates in the third quarter of fiscal 2009, and a special assessment of $536,000 accrued on June 30, 2009.
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 (i.e., non-interest expense divided by total revenue adjusted for interest expense of trust preferred debt securities) for fiscal 2009 was 69.83%, compared to 70.75% for the same period a year ago, a decrease of 92 basis points. The operating efficiency ratio excludes the impact of net interest expense on the variable priced trust preferred securities. 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 $1.8 million for fiscal 2009, compared to $2.1 million for the same period a year ago, a decrease of $299,000 or 14.0%. The average rate paid on these securities decreased 107 basis points, from 7.68% in fiscal 2008 to 6.61% in fiscal 2009. The total efficiency ratio (i.e., non-interest expense divided by total revenue) was 72.12% at June 30, 2009, compared to 74.27% for the same period a year ago, a decrease of 215 basis points. Contributing to this improvement in the efficiency ratio from a year ago includes an increase in Company revenue to $47.9 million for fiscal 2009, or a 16.3% increase compared to the same period a year ago. 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 that 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, 2009, the Company had total assets of $1,176.8 million, an increase of $73.3 million from the level at June 30, 2008. The increase in assets was due primarily to increases in net loans and leases receivable of $65.0 million and loans held for sale of $6.1 million offset by a decrease in cash and cash equivalents of $2.7 million. The increase in liabilities of $68.8 million was primarily due to increases in deposits of $53.6 million and advances from the FHLB and other borrowings of $14.4 million. In addition, stockholders' equity increased to $68.7 million at June 30, 2009, from $64.2 million at June 30, 2008, primarily due to net income of $7.8 million offset by cash dividends paid of $2.5 million.
The increase in net loans and leases receivable of $65.0 million was due primarily to an increase in 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 $22.9 million during the fiscal year to $21.4 million at June 30, 2009. In addition, deferred fees and discounts decreased by $269,000 primarily due to a decrease of $390,000 for deferred fees and discounts on indirect automobile loans that include prepaid dealer reserves.
See the Consolidated Statement of Cash Flows for an in-depth analysis of the change in cash and cash equivalents.
Deposits and advances from the FHLB and other borrowings increased $53.6 million and $14.4 million, respectively, at June 30, 2009 as compared to June 30, 2008. The increase in advances from FHLB and other borrowings were utilized to offset the net increases in outflows for net loans and leases receivable which were greater than the overall increase in deposits.
The $53.6 million increase in deposits was due primarily to the in-market certificates of deposit increase in the amount of $75.3 million, inclusive of an increase of $16.1 million in the Certificate of Deposit Account Registry Service program. Public funds have increased to $182.5 million at June 30, 2009 from $156.3 million at June 30, 2008, which are categorized in multiple deposit categories. The noninterest bearing and interest bearing checking accounts increased $8.2 million, while the savings increased $2.8 million. These increases were offset by decreases in money market accounts and out-of-market deposits of $26.5 million and $6.2 million, respectively, when compared to the totals at June 30, 2008.
Analysis of Net Interest Income
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 Losses. GAAP 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, 2009.
Security Impairment. Management continually monitors the investment security portfolio for impairment on a security by security basis. During the third quarter of Fiscal 2009, the Company early adopted FASB Staff Position ("FSP") No. FAS 115-2, The Recognition and Presentation of Other-Than-Temporary Impairments, which changed the recognition and presentation of other-than-temporary impairment for securities. Management has a process in place to identify securities that could potentially have a credit impairment that is other than temporary. This process involves the length of time and extent to which the fair value has been less than the amortized cost basis, review of available information regarding the financial position of the issuer, monitoring the rating of the security, cash flow projections, and the Company's intent to sell a security or whether it is more likely than not the Company will be required to sell the security before the recovery of its amortized cost which, in some cases, may extend to maturity. To the extent we determine that a
security is deemed to be other-than-temporarily impaired, an impairment loss is recognized. If the Company intends to sell a security or it is more likely than not that the Company would be required to sell a security before the recovery of its amortized cost, less any current period credit loss, the Company recognizes an other-than-temporary impairment in earnings for the difference between amortized cost and fair value. If we do not expect to recover the amortized cost basis, we do not plan to sell the security and if it is not more likely than not that the Company would be required to sell a security before the recovery of it amortized cost, less any current period credit loss, the recognition of the other-than-temporary impairment is bifurcated. For those securities, the Company separates the total impairment into a credit loss component recognized in earnings, and the amount of the loss related to other factors is recognized in other comprehensive income net of taxes.
The amount of the credit loss component of a debt security impairment is estimated as the difference between amortized cost and the present value of the expected cash flows of the security. The present value is determined using the best estimate cash flows discounted at the effective interest rate implicit to the security at the date of purchase or the current yield to accrete an asset-backed or floating rate security. Cash flow estimates for trust preferred securities are derived from scenario-based outcomes of forecasted default rates, loss severity, prepayment speeds and structural support.
Level 3 Fair Value Measurement. GAAP requires the Company to measure the fair value of financial instruments under a standard which describes three levels of inputs that may be used to measure fair value. Level 3 measurement includes significant unobservable inputs that reflect the Company's own assumptions about the assumptions that market participants would use in pricing an asset or liability. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. Although management believes that it uses a best estimate of information available to determine fair value, 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.
Self-Insurance. The 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 (i.e., nonaccrual loans and leases, accruing loans and leases delinquent more than 90 days and foreclosed assets) increased $8.8 million to $12.6 million at June 30, 2009. The increase in non-performing assets was primarily attributable to one credit relationship. The ratio of nonperforming assets to total assets, which is one indicator of credit risk exposure, increased to 1.07% at June 30, 2009, from 0.34% at June 30, 2008.
Nonaccruing loans and leases increased $7.1 million to $9.4 million at June 30, 2009 compared to $2.3 million at June 30, 2008. Included in nonaccruing loans and leases at June 30, 2009 were 13 loans totaling $977,000 secured by one- to four-family real estate, two commercial real estate loans totaling $177,000, one agricultural real estate loan totaling $740,000, nine commercial business loans totaling $405,000, three agricultural business loans totaling $6.5 million, 20 equipment finance leases totaling $272,000 and 24 consumer loans totaling $355,000.
The Company's nonperforming loans and leases, which represent nonaccrual and past due 90 days and still accruing, have increased $8.4 million from the levels at June 30, 2008. 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, 2009 the Company had $1.1 million of foreclosed assets. The balance of foreclosed assets at June 30, 2009 consisted of $406,000 in single-family residences, $105,000 in equipment finance leases, $92,000 in consumer collateral and $482,000 in agricultural collateral.
At June 30, 2009, the Company had designated $21.0 million of its assets as special mention and classified $30.0 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 and investment securities. At June 30, 2009, the Company had $13.6 million in multi-family, commercial real estate and agricultural participation loans purchased, of which none of the amounts were classified at June 30, 2009. 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, 2009, 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, 2009 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.