1 THIS DOCUMENT IS A COPY OF THE FORM 10-K FILED ON DECEMBER 30, 2004 PURSUANT TO A RULE 201 TEMPORARY HARDSHIP EXEMPTION UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K [ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 30, 2004 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____________ to ______________. Commission file number: 0-26467 GREATER ATLANTIC FINANCIAL CORP. -------------------------------- (Exact Name of Registrant as Specified in its Charter) DELAWARE 54-1873112 -------------------------------- ------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 10700 Parkridge Boulevard, Suite P50, Reston, Virginia 20191 ------------------------------------------------------ ----- (Address of Principal Executive Offices) (Zip Code) 703-391-1300 ------------ (Registrant's Telephone Number, Including Area Code) Securities registered pursuant to Section 12 (b) of the Act: None Securities registered pursuant to Section 12 (g) of the Act: Common Stock, par value $.01 per share (Title of class) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceeding 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 [ X ] No [ ] Indicate by check mark whether disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (ss.299.405 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. [ X ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act. Yes [ ]. No [ X ]. The aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant computed by reference to the price at which the common equity was sold, or the average bid and asked prices of such stock, as of the last business day of the registrant's most recently completed second fiscal quarter was $22.9 million. As of December 17, 2004, there were 3,012,434 shares of the registrant's Common Stock, par value $0.01 per share, outstanding. DOCUMENTS INCORPORATED BY REFERENCE None 2 INDEX PART I Page ---- Item 1. Business....................................................................................... 3 Description of Business........................................................................ 3 Market Area and Competition.................................................................... 3 Market Risk.................................................................................... 3 Lending Activities............................................................................. 3 Mortgage Banking Activities.................................................................... 7 Asset Quality.................................................................................. 8 Allowance for Loan Losses...................................................................... 9 Investment Activities.......................................................................... 11 Sources of Funds............................................................................... 14 Subsidiary Activities.......................................................................... 16 Personnel...................................................................................... 16 Regulation and Supervision..................................................................... 17 Federal and State Taxation..................................................................... 22 Item 2. Properties..................................................................................... 23 Item 3. Legal Proceedings.............................................................................. 23 Item 4. Submission of Matters to a Vote of Security Holders............................................ 23 PART II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.............................................................................. 24 Item 6. Selected Financial Data........................................................................ 25 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation........... 27 Item 7A. Quantitative and Qualitative Disclosures About Market Risk..................................... 40 Item 8. Consolidated Financial Statements and Supplementary Information................................ 40 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure........... 40 Item 9A. Controls and Procedures........................................................................ 40 Item 9B. Other Information.............................................................................. 41 PART III Item 10. Directors and Executive Officers of the Registrant............................................. 41 Item 11. Executive Compensation......................................................................... 43 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters................................................................ 45 Item 13. Certain Relationships and Related Transactions................................................. 48 Item 14. Principal Accountant Fees and Services......................................................... 48 PART IV Item 15. Exhibits and Financial Statement Schedules..................................................... 48 Signatures ............................................................................................... 49 2 3 PART I ITEM 1. BUSINESS DESCRIPTION OF BUSINESS We are a savings and loan holding company which was organized in June 1997. We conduct substantially all of our business through our wholly-owned subsidiary, Greater Atlantic Bank ("Bank"), a federally-chartered savings bank, and its wholly-owned subsidiary, Greater Atlantic Mortgage Corporation ("Greater Atlantic Mortgage"). We offer traditional banking services to customers through our bank branches located throughout the greater Washington, DC/Baltimore metropolitan area. We also originate mortgage loans for sale in the secondary market through Greater Atlantic Mortgage. We established the Greater Atlantic Capital Trust I ("Trust") in January 2002 to issue certain convertible preferred securities which we completed in March 2002. MARKET AREA AND COMPETITION We operate in a competitive environment, competing for deposits and loans with other thrifts, commercial banks and other financial entities. Numerous mergers and consolidations involving banks in the market in which we operate have occurred resulting in an intensification of competition in the banking industry in our geographic market. Many of the financial intermediaries operating in our market area offer certain services, such as trust, investment and international banking services, which we do not offer. In addition, banks with a larger capitalization than ours, and financial intermediaries not subject to bank regulatory restrictions, have larger lending limits and are thereby able to serve the needs of larger customers. MARKET RISK Market risk is the risk of loss from adverse changes in market prices and rates. Our market risk arises primarily from interest-rate risk inherent in our lending and deposit taking activities. To that end, management actively monitors and manages interest-rate risk exposure. The measurement of market risk associated with financial instruments is meaningful only when all related and offsetting on- and off-balance-sheet transactions are aggregated, and the resulting net positions are identified. Disclosures about the fair value of financial instruments, which reflect changes in market prices and rates, can be found in Note 16 of Notes to Consolidated Financial Statements. Our primary objective in managing interest-rate risk is to minimize the adverse impact of changes in interest rates on our net interest income and capital, while adjusting our asset-liability structure to obtain the maximum yield-cost spread on that structure. We rely primarily on our asset-liability structure to control interest-rate risk. However, a sudden and substantial increase in interest rates may adversely impact our earnings, to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent, or on the same basis. LENDING ACTIVITIES GENERAL. Net loans receivable at September 30, 2004 were $246.4 million, an increase of $4.1 million or 1.71% from the $242.3 million held at September 30, 2003. The increase in loans consisted of consumer, commercial business loans, and construction loans, offset by a decrease in real estate loans secured by first mortgages on residential properties. Loans held for sale, net, amounted to $5.5 million at September 30, 2004 compared to $6.6 million at September 30, 2003, a decrease of $1.1 million. That decrease resulted primarily from the sale of loans exceeding loan originations by Greater Atlantic Mortgage. 3 4 The following table shows the bank's loan originations, purchases, sales and principal repayments during the periods indicated: Year Ended September 30, ---------------------------------------- 2004 2003 2002 --------------------------------------------------------------------------------------------------------- (In Thousands) Total loans at beginning of period (1) $257,247 $273,646 $191,431 Originations of loans for investment: Single-family residential 16,202 58,245 91,333 Multifamily 145 1,465 - Commercial real estate 11,265 14,819 3,715 Construction 17,405 8,489 15,021 Land loans 11,543 11,108 7,042 Second trust - - 652 Commercial business 38,345 31,790 29,799 Consumer 50,937 49,975 51,893 --------------------------------------------------------------------------------------------------------- Total originations and purchases for investment 145,842 175,891 199,455 Loans originated for resale by Greater Atlantic Bank - - 1,135 Loans originated for resale by Greater Atlantic Mortgage 402,988 722,121 424,280 --------------------------------------------------------------------------------------------------------- Total originations 548,830 898,012 624,870 Repayments (139,465) (184,386) (117,644) Sale of loans originated for resale by Greater Atlantic Bank - - (1,241) Sale of loans originated for resale by Greater Atlantic Mortgage (404,013) (730,025) (423,770) --------------------------------------------------------------------------------------------------------- Net activity in loans 5,352 (16,399) 82,215 --------------------------------------------------------------------------------------------------------- Total loans at end of period (1) $262,599 $257,247 $273,646 ========================================================================================================= (1) Includes loans held for sale of $5.5 million and $6.6 million at September 30, 2004 and 2003, respectively. 4 5 LOAN PORTFOLIO. The following table sets forth the composition of the bank's loan portfolio in dollar amounts and as a percentage of the portfolio at the dates indicated. At September 30, ---------------------------------------------------------------------------------------- 2004 2003 2002 2001 2000 ----------------- ----------------- ----------------- --------------- ----------------- Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent - ------------------------------------------------------------------------------------------------------------------------------ (Dollars in Thousands) Mortgage loans: Single-family (1) $ 74,620 29.02% $ 95,818 38.20% $122,143 47.11% $ 84,570 47.84% $ 78,736 55.70% Multi-family 1,074 0.42 1,445 0.58 536 0.21 634 0.36 1,053 0.74 Construction 16,696 6.49 11,996 4.78 18,993 7.32 19,110 10.81 14,537 10.28 Commercial real estate 23,023 8.95 20,533 8.19 18,932 7.30 17,977 10.17 10,765 7.62 Land 20,668 8.04 17,258 6.88 9,947 3.84 5,431 3.07 3,158 2.23 -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ Total mortgage loans 136,081 52.92 147,050 58.63 170,551 65.78 127,722 72.25 108,249 76.57 -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ Commercial business and consumer loans: Commercial business 47,654 18.53 39,043 15.57 28,880 11.14 11,675 6.61 11,221 7.94 Consumer: Home equity 72,814 28.32 63,888 25.47 58,531 22.58 35,353 20.00 20,116 14.23 Automobile 271 0.11 428 0.17 771 0.30 1,269 0.72 477 0.34 Other 315 0.12 409 0.16 533 0.20 750 0.42 1,294 0.92 -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ Total commercial business and consumer loans 121,054 47.08 103,768 41.37 88,715 34.22 49,047 27.75 33,108 23.43 -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ Total loans 257,135 100.00% 250,818 100.00% 259,266 100.00% 176,769 100.00% 141,357 100.00% ====== ====== ====== ====== ====== Less: Allowance for loan losses (1,600) (1,550) (1,699) (810) (765) Loans in process (10,453) (8,394) (11,103) (11,756) (7,953) Unearned premium 1,305 1,379 1,617 400 59 -------- -------- -------- -------- -------- Loans receivable, net $246,387 $242,253 $248,081 $164,603 $132,698 ======== ======== ======== ======== ======== (1) Includes loans secured by second trusts on single-family residential property. LOAN MATURITY. The following table shows the remaining contractual maturity of the bank's total loans at September 30, 2004. Loans that have adjustable rates are shown as amortizing when the interest rates are next subject to change. The table does not include the effect of future principal prepayments. At September 30, 2004 --------------------------------------------------------------- Multi- Commercial One- to Family and Business Four- Commercial and Total Family Real Estate Consumer Loans --------------------------------------------------------------------------------------------------------- (In Thousands) Amounts due in: One year or less $ 30,342 $ 16,835 $ 97,613 $144,790 After one year: More than one year to three years 22,206 1,433 836 24,475 More than three years to five years 4,897 4,194 4,812 13,903 More than five years to 15 years 18,360 9,732 6,553 34,645 More than 15 years 17,460 168 11,241 28,869 --------------------------------------------------------------------------------------------------------- Total amount due $ 93,265 $ 32,362 $ 121,055 $246,682 ========================================================================================================= 5 6 The following table sets forth, at September 30, 2004, the dollar amount of loans contractually due after September 30, 2005, identifying whether such loans have fixed interest rates or adjustable interest rates. At September 30, 2004, the bank had $23.5 million of construction, acquisition and development, land and commercial business loans that were contractually due after September 30, 2005. Due After September 30, 2005 ----------------------------------------------- Fixed Adjustable Total ------------------------------------------------------------------------------------------------------------ (In Thousands) Real estate loans: One- to four-family $36,166 $26,758 $62,924 Multi-family and commercial 10,728 4,799 15,527 ------------------------------------------------------------------------------------------------------------ Total real estate loans 46,894 31,557 78,451 Commercial business and consumer loans 6,771 16,670 23,441 ------------------------------------------------------------------------------------------------------------ Total loans $53,665 $48,227 $101,892 ============================================================================================================ ONE- TO FOUR-FAMILY MORTGAGE LENDING. The bank currently offers both fixed-rate and adjustable-rate mortgage ("ARM") loans with maturities of up to 30 years secured by single-family residences, which term includes real property containing from one to four residences. At September 30, 2004, the bank's one- to four-family mortgage loans totaled $74.6 million, or 29.02% of total loans. Of the one- to four-family mortgage loans outstanding at that date, 48.18% were fixed-rate loans and 51.82% were ARM loans. CONSTRUCTION AND DEVELOPMENT LENDING. The bank originates construction and development loans primarily to finance the construction of one- to four-family, owner-occupied residential real estate properties located in the bank's primary market area. The bank also originates land loans to local contractors and developers for the purpose of making improvements thereon, including small residential subdivisions in the bank's primary market area or for the purpose of holding or developing land for sale. At September 30, 2004, construction and development loans (including land loans) totaled $37.4 million, or 14.53%, of the bank's total loans, of which, land loans totaled $20.7 million or 8.04% of total loans. Such loans are secured by a lien on the property, are limited to 75% of the lower of the acquisition price or the appraised value of the land and have a term of up to three years with a floating interest rate generally based on the prime rate as reported in THE WALL STREET Journal. All the bank's land loans are secured by property in its primary market area. MULTI-FAMILY AND COMMERCIAL REAL ESTATE LENDING. The bank originates multi-family and commercial real estate loans that are generally secured by five or more unit apartment buildings and properties used for business purposes such as small office buildings or retail facilities located primarily in the bank's market area. The bank's multi-family and commercial real estate underwriting policies provide that such real estate loans may be made in amounts of up to 75-80% of the appraised value of the property. The bank's multi-family and commercial real estate loan portfolio at September 30, 2004 was $24.1 million, or 9.37% of total loans. The largest multi-family or commercial real estate loan in the bank's portfolio at September 30, 2004, was a $4.5 million commercial real estate loan secured by real property in South Carolina. COMMERCIAL BUSINESS LENDING. At September 30, 2004, the bank had $47.7 million in commercial business loans which amounted to 18.53% of total loans. The bank makes commercial business loans primarily in its market area to a variety of professionals, sole proprietorships and small businesses. The bank offers a variety of commercial lending products, including term loans for fixed assets and working capital, revolving lines of credit and letters of credit. Term loans are generally offered with initial fixed rates of interest for the first five years and with terms of up to 7 years. Business lines of credit have adjustable rates of interest and are payable on demand, subject to annual review and renewal. Business loans with variable rates of interest adjust on a monthly basis and generally indexed to the prime rate as published in THE WALL STREET JOURNAL. CONSUMER LENDING. Consumer loans at September 30, 2004 amounted to $73.4 million or 28.55% of the bank's total loans, and consisted primarily of home equity loans, home equity lines of credit, and, to a significantly lesser extent, secured and unsecured personal loans and loans on new and used automobiles. These loans are generally made to residents of the bank's primary market area and generally are secured by real estate, deposit accounts and automobiles. These loans are typically shorter term and generally have higher interest rates than one- to four-family mortgage loans. The bank offers home equity loans and home equity lines of credit (collectively, "home equity loans"). Most of the bank's home equity loans are secured by second mortgages on one- to four-family residences located in the bank's primary market area. At September 30, 2004, these loans totaled $72.8 million or 28.32% of the bank's total loans and 60.15% of commercial business and consumer loans. Other types of consumer loans, primarily consisting of secured and unsecured 6 7 personal loans and new and used automobile loans, totaled $586,000, or 0.23% of the bank's total loans and 0.48% of commercial business and consumer loans at September 30, 2004. MORTGAGE BANKING ACTIVITIES GENERAL. The bank's mortgage banking activities primarily consist of mortgage loans secured by single-family properties. Mortgage banking involves the origination and sale of mortgage loans for the purpose of generating gains on sale of loans and fee income on the origination of loans, in addition to loan interest income. Given current pricing in the mortgage markets, the bank generally sells the majority of its loans on a servicing-released basis. Generally, the level of loan sale activity and, therefore, its contribution to the bank's profitability depends on maintaining a sufficient volume of loan originations. Changes in the level of interest rates and the local economy affect the number of loans originated by the bank and, thus, the amount of loan sales, net interest income and loan fees earned. Greater Atlantic Mortgage originated $403.0 million, $722.1 million and $424.7 million of loans for sale during fiscal 2004, 2003 and 2002, respectively and sold $404.0 million, $730.0 million and $424.9 million of loans during fiscal 2004, 2003 and 2002, respectively. The bank requires evidence of marketable title, lien position, loan-to-value, a title insurance policy and appraisals on all properties. The bank also requires evidence of fire and casualty insurance on the value of improvements. As stipulated by federal regulations, the bank requires flood insurance to protect the property securing its interest if such property is located in a designated flood area. LOAN COMMITMENTS AND RATE LOCKS Greater Atlantic Mortgage issues commitments for residential mortgage loans conditioned upon the occurrence of certain events. Such commitments are made with specified terms and conditions. Interest rate locks are generally offered to prospective borrowers for up to a 60-day period. The borrower may lock in the rate at any time from application until the time they wish to close the loan. The outstanding commitments of Greater Atlantic Mortgage to originate loans to be held for sale were $24.5 million at September 30, 2004. When Greater Atlantic Mortgage issues a commitment to a borrower, there is a risk that a rise in interest rates will reduce the value of the mortgage before it can be closed and sold. To control the interest rate risk caused by mortgage banking activities, the bank uses forward loan sale agreements. DERIVATIVE ACTIVITIES Mortgage banking involves the risk that a rise in interest rates will reduce the value of a mortgage before it can be sold. This type of risk occurs when a mortgage company commits to an interest rate lock on a borrower's application during the origination process and interest rates increase before the loan can be sold. Such interest rate risk also arises when mortgages are placed in the warehouse (i.e., held for sale) without locking in an interest rate for their eventual sale in the secondary market. The bank seeks to control or limit the interest rate risk caused by mortgage banking activities. The method used to help reduce interest rate risk from its mortgage banking activities are forward loan sale agreements. At various times, depending on loan origination volume and management's assessment of projected loan fallout, the Bank may reduce or increase its derivative positions. Under forward loan sale agreements the mortgage company is obligated to sell certain dollar amounts of mortgage loans that meet specific underwriting and legal criteria before the expiration of the commitment period. These terms include the maturity of the individual loans, the yield to the purchaser and the maximum principal amount of the individual loans. Forward loan sales protect loan sale prices from interest rate fluctuations that may occur from the time the interest rate of the loan if fixed to the time of its sale. The amount of the delivery date of the forward loan sale commitments are based upon management's estimates as to the volume of loans that will close and length of the origination commitment. Forward loan sales do not provide complete interest-rate protection, however, because of the possibility of fallout (i.e., the failure to close) during the origination process. Differences between the estimated volume and timing of loan originations and the actual volume and timing of loan originations can expose a mortgage company to significant losses. If a mortgage company is not able to deliver the mortgage loans during the appropriate delivery period, the mortgage company may be required to pay a non-delivery fee or repurchase the delivery commitments at current market prices. Similarly, if a mortgage company has too many loans to deliver, the mortgage company must execute additional forward loan sale commitments at current market prices, which may be unfavorable to the mortgage company. Generally, Greater Atlantic Mortgage seeks to maintain forward loan sale agreements equal to the closed loans held for sale plus those applications that it has rate locked and/or committed to close, as adjusted by the projected fallout. The ultimate accuracy of such projections will directly bear upon the amount of interest rate risk incurred by the bank. For the year ended September 30, 2004, the mortgage company had a net loss of $23,000 attributable to the underlying derivative financial instruments. At September 30, 2004, the mortgage company had outstanding commitments to sell loans of $29.1 million and commitments to originate loans of $24.5 million. The activities described above are managed continually as markets change; however, there can be no assurance that the bank will be successful in its effort to eliminate the risk of interest rate fluctuations between the time origination 7 8 commitments are issued and the ultimate sale of the loan. The bank's interest rate risk management activities are conducted in accordance with a written policy that has been approved by the bank's board of directors, which covers objectives, functions, instruments to be used, monitoring and internal controls. The bank does not enter into option positions for trading or speculative purposes and does not enter into option contracts that could generate a financial obligation beyond the initial premium paid. The bank does not apply hedge accounting to its derivative financial instruments; therefore, all changes in fair value are recorded in earnings. ASSET QUALITY DELINQUENT LOANS AND CLASSIFIED ASSETS. Reports listing all delinquent accounts are generated and reviewed monthly by management and all loans or lending relationships delinquent 30 days or more and all real estate owned ("REO") are reviewed monthly by the board of directors. The procedures taken by the bank with respect to delinquencies vary depending on the nature of the loan, the length and cause of delinquency and whether the borrower has previously been delinquent. Federal regulations and the bank's Asset Classification Policy require that the bank utilize an internal asset classification system as a means of reporting problem and potential problem assets. The bank has incorporated the internal asset classifications of the Office of Thrift Supervision (the "OTS") as a part of its credit monitoring system. The bank currently classifies problem and potential problem assets as "Substandard," "Doubtful" or "Loss" assets. 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 insured institution 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 insured institution to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are required to be designated "Special Mention." The bank's management reviews and classifies the bank's assets on a regular basis and the Board of Directors reviews management's reports on a quarterly basis. The bank classifies assets in accordance with the management guidelines described above. At September 30, 2004, the bank had $1.1 million of loans designated as Substandard which consisted of one commercial business loan, five residential loans, one commercial real estate loan, one consumer loan, three home equity loans, and one land loan. At that same date, the bank had $66,000 of assets classified as Doubtful, consisting of one commercial business loan. At September 30, 2004, the bank had no loans classified as Loss. As of September 30, 2004, the bank also had one residential loan, one construction loan, one home equity loan and two commercial business loans, totaling $2.4 million, designated as Special Mention. The following table sets forth delinquencies in the bank's loans as of the dates indicated. At September 30, ---------------------------------------------------------------------------------------------------------- 2004 2003 2002 ---------------------------------- ----------------------------------- ----------------------------------- 60 - 89 Days 90 Days or More 60 - 89 Days 90 Days or More 60 - 89 Days 90 Days or More ---------------- ---------------- ----------------- ------------------ ---------------- ----------------- Number Principal Number Principal Number Principal Number Principal Number Principal Number Principal of Balance of Balance of Balance of Balance of Balance of Balance Loans of Loans Loans of Loans Loans of Loans Loans of Loans Loans of Loans Loans of Loans --------------------------------------------------------------------------------------------------------------------------------- (Dollars in Thousands) Mortgage loans: Single-family - $ - 6 $ 563 2 $ 368 5 $ 637 5 $ 546 6 $ 388 Home equity 1 275 1 96 1 170 - - - - Construction & Land 1 118 1 31 1 479 1 34 - - Commercial real estate - - 1 29 - - 1 31 - - 4 364 Commercial business 1 28 1 228 - - 2 744 2 1,959 1 45 Consumer - - 1 6 1 9 - - - - - - --------------------------------------------------------------------------------------------------------------------------------- Total 3 $421 11 $ 953 5 $1,026 9 $1,446 7 $2,505 11 $ 797 ================================================================================================================================= 8 9 NON-PERFORMING ASSETS AND IMPAIRED LOANS. The following table sets forth information regarding non-accrual loans and REO. The bank's policy is to cease accruing interest on mortgage loans 90 days or more past due, cease accruing interest on consumer loans 60 days or more past due (unless the loan principal and interest are determined by management to be fully secured and in the process of collection), and to charge off any accrued and unpaid interest. At September 30, ------------------------------------------- 2004 2003 2002 2001 2000 ---------------------------------------------------------------------------------------------------------------- (Dollars in Thousands) Loans accounted for on a non-accrual basis Mortgage loans: Single-family $ 563 $ 637 $ 388 $ 340 $ 144 Home equity 96 - - - - Commercial real estate 29 31 21 36 50 Construction and Land 31 34 - 122 Commercial business 228 716 45 - - Consumer 6 - - 8 ----------------------------------------------------------------------------------------------------------------- Total non-accrual loans 953 1,418 454 506 194 Accruing loans which are contractually past due 90 days or more - 28 343 290 - ----------------------------------------------------------------------------------------------------------------- Total of non-accrual and 90 days past due loans 953 1,446 797 796 194 Foreclosed real estate, net - - - - 172 ----------------------------------------------------------------------------------------------------------------- Total non-performing assets $ 953 $1,446 $ 797 $ 796 $ 366 ================================================================================================================= Non-accrual loans as a percentage of loans 0.39% 0.59% 0.18% 0.31% 0.15% held for investment, net ================================================================================================================= Non-accrual and 90 days or more past due loans 0.39% 0.60% 0.32% 0.48% 0.15% as a percentage of loans held for investment, net ================================================================================================================= Non-accrual and 90 days or more past due loans 0.22% 0.29% 0.16% 0.21% 0.07% as a percentage of total assets ================================================================================================================= Non-performing assets as a percentage of total assets 0.22% 0.29% 0.16% 0.21% 0.12% ================================================================================================================= During the year ended September 30, 2004, the amount of additional interest income that would have been recognized on non-accrual loans if such loans had continued to perform in accordance with their contractual terms was $108,000. ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is established through a provision for loan losses based on management's evaluation of the risks inherent in its loan portfolio and the general economy. The allowance for loan losses is maintained at an amount management considers adequate to cover estimated losses in loans receivable which are deemed probable and estimable based on information currently known to management. The allowance is based upon a number of factors, including current economic conditions, actual loss experience and industry trends. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the bank's allowance for loan losses. Such agencies may require the bank to make additional provisions for estimated loan losses based upon their judgments about information available to them at the time of their examination. There can be no assurance that the bank will not sustain credit losses in future periods, which could be substantial in relation to the size of the allowance. As of September 30, 2004, the bank's allowance for loan losses amounted to $1.6 million or 0.62% of total loans. While the allowance for loan losses to total non-performing loans at September 30, 2004 is 167.89%, the allowance as a percentage of total loans remained the same when compared to September 30, 2003. A $209,000 provision for loan losses was recorded during the year ended September 30, 2004, compared to a provision of $855,000 during the year ended September 30, 2003. The decrease in non-performing assets from the year ago period was due to the non-performing status of one of the bank's commercial business loans. The decrease in provision was due primarily to a reduction in the required provision for that loan since the bank is in the process of liquidating that loan from the cash flow of the collateral securing the loan. 9 10 The following table sets forth activity in the bank's allowance for loan losses for the periods indicated. Where specific loan loss reserves have been established, any differences between the loss allowances and the amount of loss realized has been charged or credited to current operations. Year Ended September 30, ----------------------------------------------------------- 2004 2003 2002 2001 2000 ---------------------------------------------------------------------------------------------------------------------------- (Dollars in Thousands) Balance at beginning of period $ 1,550 $ 1,699 $ 810 $ 765 $ 590 Provisions 209 855 968 55 13 Dominion reserves - - - 100 225 Charge-offs: Mortgage loans: Single-family 20 162 64 66 61 Commercial real estate - 22 - - - Commercial business 177 828 7 53 - Consumer 3 8 27 12 2 ---------------------------------------------------------------------------------------------------------------------------- Total charge-offs 200 1,020 98 131 63 Recoveries: Mortgage loans: Single-family 29 6 12 21 - Commercial real estate - - - - - Commercial business 10 4 - - - Consumer 2 6 7 - - ---------------------------------------------------------------------------------------------------------------------------- Total recoveries 41 16 19 21 - Net charge-offs 159 1,005 79 110 63 ---------------------------------------------------------------------------------------------------------------------------- Balance at end of period $ 1,600 $1,550 $ 1,699 $ 810 $ 765 ============================================================================================================================ Ratio of net charge-offs during the period 0.06% 0.36% 0.03% 0.07% 0.06% to average loans outstanding during the period ============================================================================================================================ Allowance for loan losses to total non-performing loans at end of period 167.89% 109.31% 374.23% 160.08% 394.33% ============================================================================================================================ Allowance for loan losses to total loans 0.62% 0.62% 0.66% 0.46% 0.54% ============================================================================================================================ 10 11 The following table sets forth the bank's allowance for loan losses in each of the categories listed and the percentage of such amounts to the total allowance and the percentage of such amounts to total loans. Management believes that the allowance can be allocated by category only on an approximate basis. The allocation of the allowance to each category is not necessarily indicative of future losses and does not restrict the use of the allowance to absorb losses in any other categories. At September 30, ----------------------------------------------------------------------------------------------------- 2004 2003 2002 2001 2000 --------------------- -------------------- -------------------- ------------------- ----------------- Percent of Percent of Percent of Percent of Percent of Loans in Loans in Loans in Loans in Loans in Each Each Each Each Each Category Category Category Category Category to Total to Total to Total to Total to Total Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans - ------------------------------------------------------------------------------------------------------------------------------------ (Dollars in Thousands) Mortgage loans: Single-family $ 110 29.02% $ 141 38.20% $ 148 47.11% $ 95 47.84% $ 73 55.70% Multi-family 8 0.42 11 0.58 4 0.21 5 0.36 8 0.74 Construction 78 6.49 80 4.78 80 7.32 74 10.81 54 10.28 Commercial real estate 233 8.95 208 8.19 219 7.30 195 10.17 195 7.62 Land 175 8.04 132 6.88 72 3.84 53 3.07 39 2.23 - ------------------------------------------------------------------------------------------------------------------------------------ Total mortgage loans 604 52.92 572 58.63 523 65.78 422 72.25 369 76.57 - ------------------------------------------------------------------------------------------------------------------------------------ Commercial and Consumer: Commercial 515 18.53 770 15.57 1,005 11.14 263 6.61 168 7.94 Consumer: Home equity 213 28.32 159 25.47 151 22.58 88 20.00 50 14.23 Automobile 9 0.23 13 0.33 20 0.50 31 1.14 27 1.26 - ------------------------------------------------------------------------------------------------------------------------------------ Total commercial and consumer 737 47.08 942 41.37 1,176 34.22 382 27.75 245 23.43 - ------------------------------------------------------------------------------------------------------------------------------------ Unallocated 259 N/A 36 N/A - N/A 6 N/A 151 N/A - ------------------------------------------------------------------------------------------------------------------------------------ Total $1,600 100.00% $1,550 100.00% $1,699 100.00% $810 100.00% $765 100.00% ==================================================================================================================================== INVESTMENT ACTIVITIES The investment policy of the bank, as approved by the board of directors, requires management to maintain adequate liquidity and generate a favorable return on investments, to complement the bank's lending activities without incurring undue interest rate and credit risk. The bank primarily utilizes investments in securities for liquidity management, as a source of income and as a method of deploying excess funds not utilized for investment in loans. Securities bought and held principally for sale in the near term, generally within 90 days, are classified as trading. At September 30, 2004, the bank had invested $92.7 million in mortgage-backed securities, or 21.35% of total assets, of which $92.2 million were classified as available-for-sale and $482,000 were classified as held-to-maturity. Investments in mortgage-backed securities involve a risk that actual prepayments will be greater than estimated prepayments over the life of the security, which may require adjustments to the amortization of any premium or accretion of any discount relating to such instruments thereby changing the net yield on such securities. There is also reinvestment risk associated with the cash flows from such securities or in the event such securities are redeemed by the issuer. In addition, the market value of such securities may be adversely affected by changes in interest rates. 11 12 The following table sets forth information regarding the amortized cost and estimated market value of the bank's investment portfolio at the dates indicated. At September 30, ------------------------------------------------------------------------------- 2004 2003 2002 -------------------------- ------------------------- -------------------------- Estimated Estimated Estimated Amortized Market Amortized Market Amortized Market Cost Value Cost Value Cost Value --------------------------------------------------------------------------------------------------------------- (In Thousands) Available-for-sale: Corporate debt securities $ 3,923 $ 3,928 $ 2,892 $ 2,918 $ 1,902 $ 1,890 CMOs 9,812 9,823 8,805 8,792 12,582 12,578 U.S. Government SBA's 36,919 36,721 113,431 113,862 127,554 127,702 FHLMC MBS's 14,146 14,085 11,477 11,442 17,350 17,338 FNMA MBS's 61,195 60,302 70,684 70,355 25,268 25,211 GNMA MBS's 17,946 17,853 4,032 4,039 6,923 6,954 --------------------------------------------------------------------------------------------------------------- Total available-for-sale 143,941 142,712 211,321 211,408 191,579 191,673 --------------------------------------------------------------------------------------------------------------- Held-to-maturity: Corporate debt securities 1,003 1,065 1,012 1,094 1,020 933 U.S. Government SBA's 8,810 8,427 11,465 11,121 14,057 13,677 FHLMC MBS's 245 247 444 455 1,199 1,212 FNMA MBS's 237 235 455 468 1,410 1,437 --------------------------------------------------------------------------------------------------------------- Total held-to-maturity 10,295 9,974 13,376 13,138 17,686 17,259 --------------------------------------------------------------------------------------------------------------- Total investment securities $ 154,236 $152,686 $224,697 $224,546 $209,265 $208,932 =============================================================================================================== Investment securities with: Fixed rates $ 1,003 $ 1,065 $ 1,012 $ 1,122 $ 3,206 $ 3,180 Adjustable rates 59,464 58,899 136,593 136,665 153,909 153,600 Mortgage-backed securities with: Fixed rates 551 541 1,169 1,169 2,209 2,212 Adjustable rates 93,218 92,181 85,923 85,590 49,941 49,940 --------------------------------------------------------------------------------------------------------------- Total $154,236 $152,686 $224,697 $224,546 $209,265 $208,932 =============================================================================================================== As of September 30, 2004, the bank held investments in available for sale with unrealized holding losses totaling $1.4 million, consisting of the following: Less than 12 months 12 months or more Total -------------------------- -------------------------- ------------------------ Fair Unrealized Fair Unrealized Fair Unrealized Description of Securities Value Losses Value Losses Value Losses --------------------------------------------------------------------------------------------------------------- (In Thousands) Corporate debt securities $ 2,963 $ 37 $ - $ - $ 2,963 $ 37 CMOs 2,783 6 - - 2,783 6 U.S. Government securities SBA 23,775 282 - - 23,775 282 GNMA 17,853 93 - - 17,853 93 U.S. Government agency securities: FHLMC MBS's 5,959 71 - - 5,959 71 FNMA MBS's 58,808 887 487 10 59,295 897 --------------------------------------------------------------------------------------------------------------- Total $ 112,141 $ 1,376 $ 487 $ 10 $ 112,628 $ 1,386 =============================================================================================================== 12 13 The table below sets forth certain information regarding the carrying value, weighted average yields and contractual maturities of the bank's investment securities available-for-sale and mortgage-backed securities available-for-sale. At September 30, 2004 ------------------------------------------------------------------------------------------------------- More than One More than Five One Year or Less Year to Five Years Years to Ten Years More than Ten Years Total ------------------ -------------------- -------------------- --------------------- ------------------ Weighted Weighted Weighted Weighted Weighted Carrying Average Carrying Average Carrying Average Carrying Average Carrying Average Value Yield Value Yield Value Yield Value Yield Value Yield ------------------------------------------------------------------------------------------------------------------------------- (Dollars in Thousands) Investment securities available-for-sale: Adjustable-rate securities: CMO's $ - - % $ - - % $ - - % $ 9,823 2.46% $ 9,823 2.46% Corporate debt - - - - 2,963 4.00 965 1.71 3,928 3.44 U.S. Government SBA's - - 398 5.13 - - 36,323 4.49 36,721 4.50 ------------------------------------------------------------------------------------------------------------------------------- Total - - 398 5.13 2,963 4.00 47,111 4.01 50,472 4.02 ------------------------------------------------------------------------------------------------------------------------------- MBS's available-for-sale: Adjustable-rate securities: FHLMC - - - - - - 14,085 3.35 14,085 3.35 FNMA 63 3.41 - - - - 59,752 3.50 59,815 3.51 GNMA - - 70 4.63 - - 17,783 4.04 17,853 4.05 ------------------------------------------------------------------------------------------------------------------------------- Total 63 3.41 70 4.63 - - 91,620 3.59 91,753 3.59 ------------------------------------------------------------------------------------------------------------------------------- MBS'S fixed-rate: FNMA - - - - 487 9.00 - - 487 9.00 ------------------------------------------------------------------------------------------------------------------------------- Total - - - - 487 9.00 - - 487 9.00 ------------------------------------------------------------------------------------------------------------------------------- Total mortgage-backed securities available- for-sale 63 3.41 70 4.63 487 9.00 91,620 3.59 92,240 3.62 ------------------------------------------------------------------------------------------------------------------------------- Total investment portfolio $63 3.41% $468 5.05% $3,450 4.71% $138,731 3.73% $142,712 3.76% =============================================================================================================================== The table below sets forth certain information regarding the carrying value, weighted average yields and contractual maturities of the bank's investment securities held-to-maturity and mortgage-backed securities held to maturity. At September 30, 2004 ------------------------------------------------------------------------------------------------------- More than One More than Five One Year or Less Year to Five Years Years to Ten Years More than Ten Years Total ------------------ -------------------- -------------------- --------------------- ------------------ Weighted Weighted Weighted Weighted Weighted Carrying Average Carrying Average Carrying Average Carrying Average Carrying Average Value Yield Value Yield Value Yield Value Yield Value Yield - ----------------------------------------------------------------------------------------------------------------------------------- (Dollars in Thousands) Investment securities held-to-maturity: Adjustable-rate securities: U.S. Government SBA's $ - -% $ 596 5.10% $ - -% $8,214 3.76% $ 8,810 3.85% Fixed-rate: Corporate debt - - 1,003 7.15 - - - - 1,003 7.15 --------------------------------------------------------------------------------------------------------------------------------- Total investment securities - - 1,599 6.45 - - 8,214 3.76 9,813 4.19 held-to-maturity --------------------------------------------------------------------------------------------------------------------------------- Mortgage-backed securities held-to-maturity: Adjustable-rate securities: FHLMC - - - - - - 245 5.13 245 5.13 FNMA - - - - - - 183 5.24 183 5.24 ------------------------------------------------------------------------------------------------------------------------------- Total - - - - - - 428 5.17 428 5.17 ------------------------------------------------------------------------------------------------------------------------------- Fixed-rate: FNMA - - - - - - 54 6.50 54 6.50 --------------------------------------------------------------------------------------------------------------------------------- Total - - - - - - 54 6.50 54 6.50 --------------------------------------------------------------------------------------------------------------------------------- Total mortgage-backed securities held-to- maturity - - - - - - 482 5.32 482 5.32 --------------------------------------------------------------------------------------------------------------------------------- Total held-to-maturity investments $ - -% $1,599 6.45% $ - -% $8,696 3.85% $10,295 4.24% ================================================================================================================================= 13 14 SOURCES OF FUNDS GENERAL. Deposits, loan repayments and prepayments, cash flows generated from operations, Federal Home Loan Bank ("FHLB") advances and reverse repurchase agreements are the primary sources of the bank's funds for use in lending, investing and for other general purposes. DEPOSITS. Deposits are attracted from within the bank's market area by offering a broad selection of deposit instruments, including checking, savings, money market and time deposits. Deposit account terms vary, differentiated by the minimum balance required, the time periods that the funds must remain on deposit and the interest rate, among other factors. In determining the terms of its deposit accounts, the bank considers current interest rates, profitability to the bank, interest rate risk characteristics, competition and its customer preferences and concerns. The bank may pay above-market interest rates to attract or retain deposits when less expensive sources of funds are not available. The bank reviews its deposit composition and pricing weekly. At September 30, 2004, $105.1 million, or 57.72% of the bank's certificate of deposit accounts were to mature within one year. The following table sets forth the distribution and the rates paid on each category of the bank's deposits. At September 30, ------------------------------------------------------------------------------ 2004 2003 -------------------------------------- --------------------------------------- Percent of Percent of Total Rate Total Rate Balance Deposits Paid Balance Deposits Paid - -------------------------------------------------------------------------------------------------------------------- (Dollars in Thousands) Savings accounts $ 14,266 4.94% 0.98% $ 11,893 3.99% 0.98% Now and money market accounts 74,185 25.67 1.16 73,779 24.77 1.06 Certificates of deposit 182,056 63.01 2.60 197,961 66.46 2.46 Noninterest-bearing deposits: Demand deposits 18,449 6.38 - 14,243 4.78 - - -------------------------------------------------------------------------------------------------------------------- Total deposits $288,956 100.00% 1.98% $297,876 100.00% 1.94% ==================================================================================================================== The following table presents information concerning the amounts, the rates and the periods to maturity of the bank's certificate accounts outstanding. At September 30, 2004 ----------------------------- Amount Rate ------------------------------------------------------------------------------------------------ (Dollars in Thousands) Balance maturing: Three months or less $ 47,937 1.86% Three months to one year 57,153 2.23 One year to three years 62,535 3.24 Over three years 14,431 3.72 ------------------------------------------------------------------------------------------------ Total $182,056 2.60% ================================================================================================ 14 15 At September 30, 2004, the bank had $57.0 million in certificate accounts in amounts of $100,000 or more maturing as follows: Maturity Period Weighed Average Amount Rate -------------------------------------------------------------------------------------------- Three months or less $ 26,662 1.53% Over 3 through 6 months 10,427 1.88 Over 6 through 12 months 5,971 2.45 Over 12 months 13,979 3.38 -------------------------------------------------------------------------------------------- Total $57,039 2.14% ============================================================================================ The following table sets forth the deposit activity of the bank for the periods indicated. At or For the Year Ended September 30, ------------------------------------------- 2004 2003 2002 ------------------------------------------------------------------------------------------------ (In Thousands) Balance at beginning of period $297,876 $281,877 $229,982 Net deposits (withdrawals) before interest credited (13,627) 11,118 44,871 Interest credited 4,707 4,881 7,024 ------------------------------------------------------------------------------------------------ Net increase (decrease) in deposits (8,920) 15,999 51,895 ------------------------------------------------------------------------------------------------ Ending balance $288,956 $297,876 $281,877 ================================================================================================ BORROWINGS. At September 30, 2004, borrowings consisted of FHLB advances and reverse repurchase agreements totaling $116.1 million. FHLB advances amounted to $51.2 million at September 30, 2004, a decrease from the $86.8 million outstanding at September 30, 2003, and other borrowings (reverse repurchase agreements) amounted to $64.9 million, a decrease of $12.9 million compared to $77.8 million at September 30, 2003. During the fiscal year ended September 30, 2004, all reverse repurchase agreements represented agreements to repurchase the same securities. The following table sets forth information regarding the bank's borrowed funds: At or For the Year Ended September 30, ------------------------------------------ 2004 2003 2002 ----------------------------------------------------------------------------------------------------------------- FHLB Advances: Average balance outstanding $ 116,155 $ 102,868 $99,269 Maximum amount outstanding at any month-end during the period 142,250 124,150 123,500 Balance outstanding at end of period 51,200 86,800 96,500 Weighted average interest rate during the period 2.39% 2.58% 3.10% Weighted average interest rate at end of period 3.93% 2.72% 3.12% Reverse repurchase agreements: Average balance outstanding 89,734 86,225 68,577 Maximum amount outstanding at any month-end during the period 93,730 89,850 95,577 Balance outstanding at end of period 64,865 77,835 91,011 Weighted average interest rate during the period 4.26% 4.31% 3.43% Weighted average interest rate at end of period 1.98% 1.25% 1.97% 15 16 SUBSIDIARY ACTIVITIES We have two subsidiaries; the bank and Greater Atlantic Capital Trust I. We established the Trust in January 2002 to issue certain convertible preferred securities which we completed in March 2002. See discussion of the Trust in Note 20 to the financial statements. The bank has one wholly-owned subsidiary, Greater Atlantic Mortgage Corporation, and, in furtherance of our community banking focus, we have expanded the operations of Greater Atlantic Mortgage in order to diversify our revenue stream and support our growth. The strategy of Greater Atlantic Mortgage is to originate mortgage loans for sale in the secondary market and to develop profitable niche mortgage products, such as Federal Housing Administration ("FHA") streamline refinancings. Currently, the operations of Greater Atlantic Mortgage employ approximately 61 persons in Tysons Corner, Virginia and Rockville, Maryland. For the fiscal year ended September 30, 2004, Greater Atlantic Mortgage originated $403.0 million of single-family residential loans, respectively, the majority of which consisted of loans insured by the FHA or partially guaranteed by the Veterans Administration ("VA") which were pre-sold in the secondary market with servicing released. PERSONNEL As of September 30, 2004, we had 140 full-time employees and 15 part-time employees. The employees are not represented by a collective bargaining unit and the company considers its relationship with its employees to be good. 16 17 REGULATION AND SUPERVISION GENERAL As a savings and loan holding company, the Company is required by federal law to report to, and otherwise comply with the rules and regulations of, the Office of Thrift Supervision. The Bank is subject to extensive regulation, examination and supervision by the Office of Thrift Supervision, as its primary federal regulator, and the Federal Deposit Insurance Corporation, as the deposit insurer. The Bank is a member of the Federal Home Loan Bank System and, with respect to deposit insurance, of the Savings Association Insurance Fund managed by the Federal Deposit Insurance Corporation. The Bank must file reports with the Office of Thrift Supervision and the Federal Deposit Insurance Corporation concerning its activities and financial condition in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with, or acquisitions of, other savings institutions. The Office of Thrift Supervision and/or the Federal Deposit Insurance Corporation conduct periodic examinations to test the Bank's safety and soundness and compliance with various regulatory requirements. This regulation and supervision establishes a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection of the insurance fund 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 regulatory requirements and policies, whether by the Office of Thrift Supervision, the Federal Deposit Insurance Corporation or Congress, could have a material adverse impact on the Company, the Bank and their operations. Certain regulatory requirements applicable to the Bank and to the Company are referred to below or elsewhere herein. The description of statutory provisions and regulations applicable to savings institutions and their holding companies set forth below does not purport to be a complete description of such statutes and regulations and their effects on the Bank and the Company. HOLDING COMPANY REGULATION The Company is a nondiversified unitary savings and loan holding company within the meaning of federal law. Under prior law, a unitary savings and loan holding company, such as the Company, was not generally restricted as to the types of business activities in which it may engage, provided that the Bank continued to be a qualified thrift lender. See "FEDERAL SAVINGS INSTITUTION REGULATION - QTL TEST." The Gramm-Leach-Bliley Act of 1999 provides that no company may acquire control of a savings institution after May 4, 1999 unless it engages only in the financial activities permitted for financial holding companies under the law or for multiple savings and loan holding companies as described below. Further, the Gramm-Leach-Bliley Act specifies that existing savings and loan holding companies may only engage in such activities. The Gramm-Leach-Bliley Act, however, grandfathered the unrestricted authority for activities with respect to unitary savings and loan holding companies existing prior to May 4, 1999, so long as the holding company's savings institution subsidiary continues to comply with the QTL Test. The Company does not qualify for the grandfathering. Upon any non-supervisory acquisition by the Company of another savings institution or savings bank that meets the qualified thrift lender test and is deemed to be a savings institution by the Office of Thrift Supervision, the Company would become a multiple savings and loan holding company (if the acquired institution is held as a separate subsidiary) and would generally be limited to activities permissible for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act, subject to the prior approval of the Office of Thrift Supervision, and certain activities authorized by Office of Thrift Supervision regulation. However, the OTS has issued an interpretation concluding that multiple savings and loan holding companies may also engage in activities permitted for financial holding companies. A savings and loan holding company is prohibited from, directly or indirectly, acquiring more than 5% of the voting stock of another savings institution or savings and loan holding company, without prior written approval of the Office of Thrift Supervision and from acquiring or retaining control of a depository institution that is not insured by the Federal Deposit Insurance Corporation. In evaluating applications by holding companies to acquire savings institutions, the Office of Thrift Supervision considers the financial and managerial resources and future prospects of the Company and institution involved, the effect of the acquisition on the risk to the deposit insurance funds, the convenience and needs of the community and competitive factors. The Office of Thrift Supervision may not approve any acquisition that would result in a multiple savings and loan holding company controlling savings institutions in more than one state, subject to two exceptions: (i) the approval of interstate supervisory acquisitions by savings and loan holding companies and (ii) the acquisition of a savings institution in another state if the laws of the state of the target savings institution specifically permit such acquisitions. The states vary in the extent to which they permit interstate savings and loan holding company acquisitions. 17 18 Although savings and loan holding companies are not currently subject to specific capital requirements or specific restrictions on the payment of dividends or other capital distributions, federal regulations do prescribe such restrictions on subsidiary savings institutions as described below. The Bank must notify the Office of Thrift Supervision (30) days before declaring any dividend to the Company. In addition, the financial impact of a holding company on its subsidiary institution is a matter that is evaluated by the Office of Thrift Supervision and the agency has authority to order cessation of activities or divestiture of subsidiaries deemed to pose a threat to the safety and soundness of the institution. ACQUISITION OF THE COMPANY. Under the Federal Change in Bank Control Act, a notice must be submitted to the Office of Thrift Supervision if any person (including a company), or group acting in concert, seeks to acquire "control" of a savings and loan holding company. Under certain circumstances, a change of control may occur, and prior notice is required, upon the acquisition of 10% or more of the Company's outstanding voting stock, unless the Office of Thrift Supervision has found that the acquisition will not result in a change of control of the Company. Under the Change in Bank Control Act, the Office of Thrift Supervision has 60 days from the filing of a complete notice to act, taking into consideration certain factors, including the financial and managerial resources of the acquirer and the anti-trust effects of the acquisition. Any company that acquires control would then be subject to regulation as a savings and loan holding company. FEDERAL SAVINGS INSTITUTION REGULATION BUSINESS ACTIVITIES. The activities of federal savings banks are governed by federal law and regulations. These laws and regulations delineate the nature and extent of the activities in which federal savings banks may engage. In particular, certain lending authority for federal savings banks, E.G., commercial, non-residential real property loans and consumer loans, is limited to a specified percentage of the institution's capital or assets. CAPITAL REQUIREMENTS. The Office of Thrift Supervision capital regulations require savings institutions to meet three minimum capital standards: a 1.5% tangible capital to total assets ratio, a 4% leverage ratio (3% for institutions receiving the highest rating on the CAMELS examination rating system) and an 8% risk-based capital ratio. In addition, the prompt corrective action standards discussed below also establish, in effect, a minimum 2% tangible capital standard, a 4% leverage ratio (3% for institutions receiving the highest rating on the CAMELS system) and, together with the risk-based capital standard itself, a 4% Tier 1 risk-based capital standard. The Office of Thrift Supervision regulations also require that, in meeting the tangible, leverage and risk-based capital standards, institutions must generally deduct investments in and loans to subsidiaries engaged in activities as principal that are not permissible for a national bank. The risk-based capital standard for savings institutions requires the maintenance of Tier 1 (core) and total capital (which is defined as core capital and supplementary capital) to risk-weighted assets of at least 4% and 8%, respectively. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, recourse obligations, residual interests and direct credit substitutes, are multiplied by a risk-weight factor of 0% to 100%, assigned by the Office of Thrift Supervision capital regulation based on the risks believed inherent in the type of asset. Core (Tier 1) capital is defined as common stockholders' equity (including retained earnings), certain noncumulative perpetual preferred stock and related surplus, and minority interests in equity accounts of consolidated subsidiaries less intangibles other than certain mortgage servicing rights and credit card relationships. The components of supplementary capital currently include cumulative preferred stock, long-term perpetual preferred stock, mandatory convertible securities, subordinated debt and intermediate preferred stock, the allowance for loan and lease losses limited to a maximum of 1.25% of risk-weighted assets and up to 45% of unrealized gains on available-for-sale equity securities with readily determinable fair market values. Overall, the amount of supplementary capital included as part of total capital cannot exceed 100% of core capital. The Office of Thrift Supervision also has authority to establish individual minimum capital requirements in appropriate cases upon a determination that an institution's capital level is or may become inadequate in light of the particular circumstances. At September 30, 2004, the Bank met each of its capital requirements. The following table presents the bank's capital position at September 30, 2004. Capital Excess ---------------------------- Actual Required (Deficiency) Actual Required Capital Capital Amount Percent Percent --------------------------------------------------------------------------------------------------------------- (Dollars in Thousands) Tangible $25,335 $ 6,498 $18,837 5.85% 1.50% Core (Leverage) 25,335 17,329 8,006 5.85 4.00 Risk-based 26,843 19,790 7,053 10.85 8.00 18 19 PROMPT CORRECTIVE REGULATORY ACTION. The Office of Thrift Supervision is required to take certain supervisory actions against undercapitalized institutions, the severity of which depends upon the institution's degree of undercapitalization. Generally, a savings institution that has a ratio of total capital to risk weighted assets of less than 8%, a ratio of Tier 1 (core) capital to risk-weighted assets of less than 4% or a ratio of core capital to total assets of less than 4% (3% or less for institutions with the highest examination rating) is considered to be "undercapitalized." A savings institution that has a total risk-based capital ratio less than 6%, a Tier 1 capital ratio of less than 3% or a leverage ratio that is less than 3% is considered to be "significantly undercapitalized" and a savings institution that has a tangible capital to assets ratio equal to or less than 2% is deemed to be "critically undercapitalized." Subject to a narrow exception, the Office of Thrift Supervision is required to appoint a receiver or conservator within specified time frames for an institution that is "critically undercapitalized." The regulation also provides that a capital restoration plan must be filed with the Office of Thrift Supervision within 45 days of the date a savings institution receives notice that it is "undercapitalized," "significantly undercapitalized" or "critically undercapitalized." Compliance with the plan must be guaranteed by any parent holding company. In addition, numerous mandatory supervisory actions become immediately applicable to an undercapitalized institution, including, but not limited to, increased monitoring by regulators and restrictions on growth, capital distributions and expansion. The Office of Thrift Supervision could also take any one of a number of discretionary supervisory actions, including the issuance of a capital directive and the replacement of senior executive officers and directors. INSURANCE OF DEPOSIT ACCOUNTS. The Bank is a member of the Savings Association Insurance Fund. The Federal Deposit Insurance Corporation maintains a risk-based assessment system by which institutions are assigned to one of three categories based on their capitalization and one of three subcategories based on examination ratings and other supervisory information. An institution's assessment rate depends upon the categories to which it is assigned. Assessment rates for Savings Association Insurance Fund member institutions are determined semi-annually by the Federal Deposit Insurance Corporation and currently range from zero basis points for the healthiest institutions to 27 basis points of assessable deposits for the riskiest. In addition to the assessment for deposit insurance, institutions are required to make payments on bonds issued in the late 1980s by the Financing Corporation to recapitalize the predecessor to the Savings Association Insurance Fund. During fiscal 2004, Financing Corporation payments for Savings Association Insurance Fund members approximated 1.52 basis points of assessable deposits. The Bank's assessment rate for the fiscal year 2004 was 1.46 basis points and the total assessment paid for this period (including the FICO assessment) was $43,566. The Federal Deposit Insurance Corporation has authority to increase insurance assessments. A significant increase in Savings Association Insurance Fund insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank. Management cannot predict what insurance assessment rates will be in the future. Insurance of deposits may be terminated by the Federal Deposit Insurance Corporation 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 Federal Deposit Insurance Corporation or the Office of Thrift Supervision. The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance. LOANS TO ONE BORROWER. Federal law provides that savings institutions are generally subject to the limits on loans to one borrower applicable to national banks. A savings institution may not make a loan or extend credit to a single or related group of borrowers in excess of 15% of its unimpaired capital and surplus. An additional amount may be lent, equal to 10% of unimpaired capital and surplus, if secured by specified readily marketable collateral. At September 30, 2004, Greater Atlantic's limit on loans to one borrower was $4.0 million, and Greater Atlantic's largest aggregate outstanding loan to one borrower was $5.0 million. Of this loan, $1.0 million was sold in the form of a participation loan in December 2004. QTL TEST. The Home Owners' Loan Act requires savings institutions to meet a qualified thrift lender test. Under the test, a savings association is required to either qualify as a "domestic building and loan association" under the Internal Revenue Code or 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) in at least 9 months out of each 12 month period. A savings institution that fails the qualified thrift lender test is subject to certain operating restrictions and may be required to convert to a bank charter. As of September 30, 2004, Greater Atlantic maintained 85% of its portfolio assets in qualified thrift investments and, therefore, met the qualified thrift lender test. Recent legislation has expanded the extent to which education loans, credit card loans and small business loans may be considered "qualified thrift investments." 19 20 LIMITATION ON CAPITAL DISTRIBUTIONS. Office of Thrift Supervision regulations impose limitations upon all capital distributions by a savings institution, including cash dividends, payments to repurchase its shares and payments to stockholders of another institution in a cash-out merger. An application to and the prior approval of the Office of Thrift Supervision is required prior to any capital distribution if the institution does not meet the criteria for "expedited treatment" of applications under Office of Thrift Supervision regulations (I.E., generally, examination ratings in the two top categories), the total capital distributions for the calendar year exceed net income for that year plus the amount of retained net income for the preceding two years, the institution would be undercapitalized following the distribution or the distribution would otherwise be contrary to a statute, regulation or agreement with Office of Thrift Supervision. If an application is not required, the institution must still provide prior notice to Office of Thrift Supervision of the capital distribution if, like Greater Atlantic, it is a subsidiary of a holding company. In the event Greater Atlantic's capital fell below its regulatory requirements or the Office of Thrift Supervision notified it that it was in need of more than normal supervision, Greater Atlantic's ability to make capital distributions could be restricted. In addition, the Office of Thrift Supervision could prohibit a proposed capital distribution by any institution, which would otherwise be permitted by the regulation, if the Office of Thrift Supervision determines that such distribution would constitute an unsafe or unsound practice. ASSESSMENTS. Savings institutions are required to pay assessments to the Office of Thrift Supervision to fund the agency's operations. The general assessments, paid on a semi-annual basis, are computed based upon the savings institution's total assets, including consolidated subsidiaries, as reported in Greater Atlantic's latest quarterly thrift financial report. The assessments paid by Greater Atlantic for the fiscal year ended September 30, 2004, totaled $143,092. TRANSACTIONS WITH RELATED PARTIES. Greater Atlantic's authority to engage in transactions with "affiliates" (E.G., any company that controls or is under common control with an institution, including Greater Atlantic Financial and its non-savings institution subsidiaries) is limited by federal law. The aggregate amount of covered transactions with any individual affiliate is limited to 10% of the 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 capital and surplus. Certain 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 generally prohibited. The 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-affiliated companies. In addition, savings institutions are prohibited from lending to any affiliate that is engaged in activities that are not permissible for bank holding companies and no savings institution may purchase the securities of any affiliate other than a subsidiary. The recently enacted Sarbanes-Oxley Act generally prohibits loans by the Company to its executive officers and directors. However, that act contains a specific exception for loans by the Bank to its executive officers and directors in compliance with federal banking laws. Under such laws, the Bank's authority to extend credit to executive officers, directors and 10% shareholders ("insiders"), as well as entities such persons control, is limited. The law limits both the individual and aggregate amount of loans the Bank may make to insiders based, in part, on the Bank's capital position and requires certain board approval procedures to be followed. Such loans are required to be made on terms substantially the same as those offered to unaffiliated individuals and not involve more than the normal risk of repayment. There is an exception for loans made pursuant to a benefit or compensation program that is widely available to all employees of the institution and does not give preference to insiders over other employees. ENFORCEMENT. The Office of Thrift Supervision has primary enforcement responsibility over savings institutions and has the authority to bring actions against the institution and all institution-affiliated parties, including stockholders, and any attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution. Formal enforcement action may range from the issuance of a capital directive or cease and desist order to removal of officers and/or directors to institution of receivership, conservatorship or termination of deposit insurance. Civil penalties cover a wide range of violations and can amount to $25,000 per day, or even $1.0 million per day in especially egregious cases. The Federal Deposit Insurance Corporation has the authority to recommend to the Director of the Office of Thrift Supervision that enforcement action be taken with respect to a particular savings institution. If the Director does not take action, the Federal Deposit Insurance Corporation has authority to take such action under certain circumstances. Federal law also establishes criminal penalties for certain violations. STANDARDS FOR SAFETY AND SOUNDNESS. The federal banking agencies have adopted Interagency Guidelines prescribing Standards for Safety and Soundness. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If the Office of Thrift Supervision determines that a savings institution fails to meet any standard prescribed by the guidelines, the Office of Thrift Supervision may require the institution to submit an acceptable plan to achieve compliance with the standard. 20 21 FEDERAL HOME LOAN BANK SYSTEM Greater Atlantic is a member of the Federal Home Loan Bank System, which consists of 12 regional Federal Home Loan Banks. The Federal Home Loan Bank provides a central credit facility primarily for member institutions. Greater Atlantic, as a member of the Federal Home Loan Bank, is required to acquire and hold shares of capital stock in that Federal Home Loan Bank in an amount at least equal to 1.0% of the aggregate principal amount of its unpaid residential mortgage loans and similar obligations at the beginning of each year, or 1/20 of its advances (borrowings) from the Federal Home Loan Bank, whichever is greater. Greater Atlantic was in compliance with this requirement with an investment in Federal Home Loan Bank stock at September 30, 2004 of $4.1 million. The Federal Home Loan Banks are required to provide funds used for the resolution of insolvent thrifts in the late 1980s and to contribute funds for affordable housing programs. Those requirements could reduce the amount of dividends that the Federal Home Loan Banks pay to their members and could also result in the Federal Home Loan Banks imposing a higher rate of interest on advances to their members. If dividends were reduced, or interest on future Federal Home Loan Bank advances increased, Greater Atlantic's net interest income would likely also be reduced. FEDERAL RESERVE SYSTEM The Federal Reserve Board regulations require savings institutions to maintain non-interest earning reserves against their transaction accounts (primarily NOW and regular checking accounts). The regulations generally provide that reserves be maintained against aggregate transaction accounts as follows: a 3% reserve ratio is assessed on net transaction accounts up to and including $45.4 million; a 10% reserve ratio is applied above $45.4. The first $6.6 million of otherwise reservable balances (subject to adjustments by the Federal Reserve Board) are exempted from the reserve requirements. The amounts are adjusted annually. The Bank complies with the foregoing requirements. COMMUNITY REINVESTMENT ACT Under the Community Reinvestment Act, as implemented by Office of Thrift Supervision regulations, a savings association 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 Community Reinvestment Act 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, consistent with the Community Reinvestment Act. The Community Reinvestment Act requires the Office of Thrift Supervision, in connection with its examination of an institution, to assess the institution's record of meeting the credit needs of its community and to take such record into account in its evaluation of applications by such institution. The Community Reinvestment Act requires public disclosure of an institution's Community Reinvestment Act rating. Greater Atlantic's latest Community Reinvestment Act rating, received from the Office of Thrift Supervision was "Satisfactory." 21 22 FEDERAL AND STATE TAXATION GENERAL. The company and the bank report their income on a fiscal year basis using the accrual method of accounting and are subject to federal income taxation in the same manner as other corporations with some exceptions. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to the bank or the company. The bank has not been audited by the IRS or the Virginia Department of Taxation ("DOT") in the past five years. DISTRIBUTIONS. To the extent that the bank makes "non-dividend distributions" to the company that are considered as made (i) from the reserve for losses on qualifying real property loans, to the extent the reserve for such losses exceeds the amount that would have been allowed under the experience method, or (ii) from the supplemental reserve for losses on loans ("Excess Distributions"), then an amount based on the amount distributed will be included in the bank's taxable income. Non-dividend distributions include distributions in excess of the bank's current and accumulated earnings and profits, distributions in redemption of stock and distributions in partial or complete liquidation. However, dividends paid out of the bank's current or accumulated earnings and profits, as calculated for federal income tax purposes, will not be considered to result in a distribution from the bank's bad debt reserve. Thus, any dividends to the company that would reduce amounts appropriated to the bank's bad debt reserve and deducted for federal income tax purposes would create a tax liability for the bank. The amount of additional taxable income created by an Excess Distribution is an amount that, when reduced by the tax attributable to the income, is equal to the amount of the distribution. Thus, if, after the Conversion, the bank makes a "non-dividend distribution," then approximately one and one-half times the amount so used would be includable in gross income for federal income tax purposes, presumably taxed at a 34% corporate income tax rate (exclusive of state and local taxes). See "Regulation" and "Dividend Policy" for limits on the payment of dividends of the bank. The bank does not intend to pay dividends that would result in a recapture of any portion of its bad debt reserve. CORPORATE ALTERNATIVE MINIMUM TAX ("AMT"). The Code imposes a tax on alternative minimum taxable income ("AMTI") at a rate of 20%. Before 2002, only 90% of AMTI could be offset by net operating loss carryovers. Recently, the United States Congress passed legislation which increased the amount of AMTI which could be offset by existing net operating losses from 90% to 100%. Presently, elimination of the 90% ceiling on use of net operating losses to reduce or eliminate AMT exists for two years. Accordingly, the company, and the bank, do not expect to record a provision for income taxes in fiscal 2003. AMTI is increased by an amount equal to 75% of the amount by which the bank's adjusted current earnings exceeds its AMTI (determined without regard to this preference and prior to reduction for net operating losses). The bank does not expect to be subject to the AMT until at least fiscal 2005. DIVIDENDS RECEIVED DEDUCTION AND OTHER MATTERS. The company may exclude from its income 100% of dividends received from the bank as a member of the same affiliated group of corporations. The corporate dividends received deduction is generally 70% in the case of dividends received from unaffiliated corporations with which the company and the bank will not file a consolidated tax return, except that if the company or the bank owns more than 20% of the stock of a corporation distributing a dividend then 80% of any dividends received may be deducted. STATE AND LOCAL TAXATION COMMONWEALTH OF VIRGINIA. The Commonwealth of Virginia imposes a tax at the rate of 6.0% on the "Virginia taxable income" of the bank and the company. Virginia taxable income is equal to federal taxable income with certain adjustments. Significant modifications include the subtraction from federal taxable income of interest or dividends on obligations or securities of the United States that are exempt from state income taxes, and a recomputation of the bad debt reserve deduction on reduced modified taxable income. DELAWARE TAXATION. As a Delaware company not earning income in Delaware, the company is exempt from Delaware corporate income tax but is required to file an annual report with and pay an annual franchise tax to the State of Delaware. However, to the extent that the company conducts business outside of Delaware, the company may be considered doing business and subject to additional taxing jurisdictions outside of Delaware. 22 23 ITEM 2. PROPERTIES During fiscal year 2004, we conducted our business from nine full-service banking offices and our administrative office. The following table sets forth certain information concerning the bank's offices as of September 30, 2004. On November 19, 2004, the bank sold its office at 1025 Connecticut Avenue, N.W. Washington, D.C. Net Book Value of Property or Leasehold Original Improvements Year Date of at Leased or Leased or Lease September 30, Location Owned Acquired Expiration 2004 ------------------------------------------------------------------------------------------------------------------ (In Thousands) ADMINISTRATIVE OFFICES: 10700 Parkridge Boulevard Leased 1998 01-31-11 $ 146 Reston, Virginia 20191 BRANCH OFFICES: 11834 Rockville Pike Leased 1998 06-15-05 40 Rockville, Maryland 20852 8070 Ritchie Highway Leased 1998 08-31-08 28 Pasadena, Maryland 21122 1025 Connecticut Avenue, N.W. Leased 1998 07-31-08 122 Washington, D.C. 20036 10700 Parkridge Boulevard Leased 2004 01-31-11 576 Reston, Virginia 20191 46901 Cedar Lakes Plaza Leased 1999 02-28-19 289 Sterling, Virginia 20164 43086 Peacock Market Plaza Leased 2000 06-30-15 275 South Riding, Virginia 20152 1 South Royal Avenue Owned 1977 708 Front Royal, Virginia 22630 9484 Congress Street Owned 1989 433 New Market, Virginia 22844 2800 Valley Avenue Owned 1978 1,781 Winchester, Virginia 22601 LOAN OFFICE: 2200 Defense Highway Leased 2002 10-31-05 3 Crofton, Maryland 21114 GREATER ATLANTIC MORTGAGE OFFICES: 8230 Old Courthouse Road Leased 1995 12-31-05 13 Vienna, Virginia 22182 11300 Rockville Pike Leased 2001 01-31-06 4 Rockville, Maryland 20852 ------------------------------------------------------------------------------------------------------------------ Total $4,418 ================================================================================================================== The total net book value of the company's furniture, fixtures and equipment at September 30, 2004 was $7.3 million. The properties are considered by management to be in good condition. ITEM 3. LEGAL PROCEEDINGS The company is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Such routine legal proceedings, in the aggregate, are believed by management to be immaterial to the company's financial condition, results of operations or cash flows. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the stockholders during the fourth quarter of the fiscal year ended September 30, 2004, through the solicitation of proxies or otherwise. 23 24 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES MARKET INFORMATION. The company's stock trades on the NASDAQ Stock Market (ticker symbol GAFC). At September 30, 2004, there were approximately 493 stockholders of record. The following table sets forth market price information, based on closing prices, as reported by the NASDAQ for the common stock high and low closing prices for the periods indicated. First Quarter Second Fourth Quarter Ended Quarter Ended Third Quarter Ended December 31 March 31 Ended June 30 September 30 ------------------------------------------------------------------------------------------------- Fiscal Year 2004 High 8.30 8.20 7.70 6.53 Low 7.50 7.27 6.00 5.78 Fiscal Year 2003 High 6.68 7.95 7.43 7.95 Low 6.15 6.30 6.50 7.08 ------------------------------------------------------------------------------------------------- These market quotations reflect inter-dealer prices, without retail mark-up, mark-down, or commission and may not necessarily represent actual transactions. The company has not sold any unregistered securities and did not repurchase any of its equity securities in the fiscal year ended September 30, 2004. 24 25 ITEM 6. SELECTED FINANCIAL DATA You should read the following Selected Consolidated Financial Data in conjunction with our Consolidated Financial Statements and the notes thereto, the information contained in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other financial information included elsewhere in this Annual Report. -------------------------------------------------------------------------------------------------------------- At or For the Years Ended September 30, 2004 2003 2002 2001 2000 -------------------------------------------------------------------------------------------------------------- (In Thousands, Except Per Share Data) Consolidated Statements of Operations Data: Interest income $ 18,962 $ 20,987 $ 21,782 $ 23,623 $ 17,772 Interest expense 12,355 13,049 13,735 17,247 13,094 -------------------------------------------------------------------------------------------------------------- Net interest income 6,607 7,938 8,047 6,376 4,678 Provision for loan losses 209 855 968 55 13 -------------------------------------------------------------------------------------------------------------- Net interest income after provision for loan 6,398 7,083 7,079 6,321 4,665 losses Noninterest income 9,929 18,889 6,178 5,707 2,054 Noninterest expense 19,430 23,711 15,839 12,550 10,957 -------------------------------------------------------------------------------------------------------------- (Loss) income before taxes (3,103) 2,261 (2,582) (522) (4,238) Income tax provision (benefit) 89 - - - (600) -------------------------------------------------------------------------------------------------------------- Net (loss) income $ (3,192) $ 2,261 $ (2,582) $ (522) $ (3,638) ============================================================================================================== Per Share Data: Net income (loss): Basic $ (1.06) $ 0.75 $ (0.86) $ (0.17) $ (1.21) Diluted $ (1.06) $ 0.60 $ (0.86) $ (0.17) $ (1.21) Book value 5.65 7.08 6.33 7.04 6.94 Tangible book value 5.59 6.68 5.93 6.80 6.94 Weighted average shares outstanding: Basic 3,012,434 3,012,434 3,010,420 3,007,434 3,007,434 Diluted 3,012,434 4,413,462 3,010,420 3,007,434 3,007,434 Consolidated Statements of Financial Condition Data: Total assets $ 434,370 $ 499,354 $ 502,678 $ 370,604 $ 296,296 Total loans receivable, net 246,387 242,253 248,081 164,603 132,698 Allowance for loan losses 1,600 1,550 1,699 810 765 Mortgage-loans held for sale 5,528 6,554 14,553 14,683 5,599 Investment securities (1) 60,285 138,049 157,247 131,302 70,777 Mortgage-backed securities 92,722 86,735 52,112 39,115 66,169 Total deposits 288,956 297,876 281,877 229,982 188,387 FHLB advances 51,200 86,800 96,500 74,500 46,100 Other borrowings 64,865 77,835 91,010 43,323 36,736 Guaranteed convertible preferred securities of 9,369 9,359 9,346 - - subsidiary trust Total stockholders' equity 17,140 21,340 19,063 21,180 20,867 Tangible capital 16,825 20,126 17,865 20,365 20,295 25 26 SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA - (CONTINUED) -------------------------------------------------------------------------------------------------------------- At or For the Years Ended September 30, 2004 2003 2002 2001 2000 -------------------------------------------------------------------------------------------------------------- (In Thousands, Except Per Share Data) Average Consolidated Statements of Financial Condition Data Total assets $521,648 $510,684 $449,941 $343,226 $251,417 Investment securities(1) 123,198 161,161 155,350 118,320 75,808 Mortgage-backed securities(1) 111,016 51,046 39,320 46,225 59,489 Total loans 268,116 281,574 239,342 164,790 106,917 Allowance for loan losses 1,498 1,696 1,148 800 599 Total deposits 275,636 279,469 243,120 207,657 137,272 Total stockholders' equity 21,032 19,709 20,8958 21,045 24,067 Performance Ratios (2) Return on average assets (0.61)% 0.44% (0.57)% (0.15)% (1.45)% Return on average equity (15.18) 11.47 (12.36) (2.48) (15.12) Equity to assets 3.95 4.27 3.79 6.13 9.57 Net interest margin 1.32 1.61 1.85 1.94 1.93 Efficiency ratio(3) 117.50 88.38 111.35 103.86 162.76 Asset Quality Data: Non-performing assets to total assets, at 0.22 0.28 0.09 0.14 0.12 period end Non-performing loans to total loans, at period 0.37 0.57 0.18 0.29 0.14 end Net charge-offs to average total loans 0.06 0.36 0.03 0.07 0.06 Allowance for loan losses to: Total loans 0.62% 0.62% 0.66% 0.46% 0.54% Non-performing loans 167.89 109.31 374.23 160.08 394.33 Non-performing loans $ 953 $ 1,418 $ 454 $ 506 $ 194 Non-performing assets 953 1,446 797 796 366 Allowance for loan losses 1,600 1,550 1,699 810 765 Capital Ratios of the Bank: Leverage ratio 5.85% 5.85% 5.01% 5.51% 6.85% Tier 1 risk-based capital ratio 10.24 12.42 11.20 10.94 13.71 Total risk-based capital ratio 10.85 13.03 11.95 11.36 14.23 (1) Consists of securities classified as available-for-sale, held-to-maturity and for trading. (2) Ratios are presented on an annualized basis where appropriate. (3) Efficiency ratio consists of noninterest expense divided by net interest income and noninterest income 26 27 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION FORWARD-LOOKING STATEMENTS When used in this Annual Report on Form 10-K and in future filings by the company with the Securities and Exchange Commission (the "SEC"), in the company's press releases or other public or shareholder communications, and in oral statements made with the approval of an authorized executive officer, the words or phrases "will likely result," "are expected to," "will continue," "is anticipated," "estimate," "project" or similar expressions are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to certain risks and uncertainties, including, among other things, changes in economic conditions in the company's market area, changes in policies by regulatory agencies, fluctuations in interest rates, demand for loans in the company's market area and competition, that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. The company wishes to advise readers that the factors listed above could affect the company's financial performance and could cause the company's actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any current statements. The company does not undertake and specifically declines any obligation to publicly release the results of any revisions which may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events. GENERAL The profitability of the company and, more specifically, the profitability of its primary subsidiary, the bank, depends primarily on its net interest income. Net interest income is the difference between the interest income it earns on its loans and investment portfolio, and the interest it pays on interest-bearing liabilities, which consists mainly of interest paid on deposits and borrowings. Our profitability is also affected by the level of its non-interest income and operating expenses. Non-interest income consists primarily of gains on sales of loans and available-for-sale investments, service charge fees and commissions earned by non-bank subsidiaries. Operating expenses consist primarily of salaries and employee benefits, occupancy-related expenses, equipment and technology-related expenses and other general operating expenses. The operations of the bank, and banking institutions in general, are significantly influenced by general economic conditions and related monetary and fiscal policies of regulatory agencies. Deposit flows and the cost of deposits and borrowings are influenced by interest rates on competing investments and general market rates of interest. Lending activities are affected by the demand for financing real estate and other types of loans, which in turn are affected by the interest rates at which such financing may be offered and other factors affecting loan demand and the availability of funds. CRITICAL ACCOUNTING POLICIES, ESTIMATES AND JUDGEMENTS The company's financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses as well as the disclosure of contingent liabilities. Management continually evaluates its estimates and judgments including those related to the allowance for loan losses and income taxes. Management bases its estimates and judgments on historical experience and other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. The company believes that of its significant accounting policies, the following may involve a higher degree of judgment or complexity. ALLOWANCE FOR LOAN LOSSES The company maintains an allowance for loan losses based on management's evaluation of the risks inherent in its loan portfolio and the general economy. Management classifies loans as substandard, doubtful or loss as required by federal regulations. Management provides a 100% reserve for all assets classified as loss. Further, management bases its estimates of the allowance on current economic conditions, actual loss experience and industry trends. Also, the company discontinues recognizing interest income on loans with principal and/or interest past due 90 days. INCOME TAXES The provision (or benefit) for income taxes is based on taxable income, tax credits and available net operating losses. The company records deferred tax assets and liabilities using enacted tax rates for the effect of temporary differences between the book and tax bases of assets and liabilities. If enacted tax rates changed, the company would adjust the deferred tax assets and liabilities, through the provision for income taxes in the period of change, to reflect the enacted tax rate expected to be in effect when the deferred tax items reverse. The company records a valuation allowance on deferred tax assets to reflect the expected 27 28 future tax benefits expected to be realized. In determining the appropriate valuation allowance, the company considers the expected level of future taxable income and available tax planning strategies. At September 30, 2004, the company had deferred tax assets of $2.0 million, which included a valuation allowance of $3.0 million. 2004 COMPARED TO 2003 NET INCOME. For the fiscal year ended September 30, 2004, the company sustained net losses of $3.2 million or $1.06 per diluted share, compared to net earnings of $2.3 million or $0.60 per diluted share for fiscal year 2003. The $5.5 million decrease in net earnings was primarily due to decreases in non-interest income and net interest income, which were only partially offset by a decrease in non-interest expense. A decline in the FHA Streamline refinancing market, which appears to have peaked in fiscal 2003, led to a decline in loan originations and sales at the bank's mortgage banking subsidiary and contributed to the decline in net earnings. NET INTEREST INCOME. An important source of our earnings is net interest income, which is the difference between income earned on interest-earning assets, such as loans, investment securities and mortgage-backed securities, and interest paid on interest-bearing liabilities such as deposits and borrowings. The level of net interest income is determined primarily by the relative average balances of interest-earning assets and interest-bearing liabilities in combination with the yields earned and rates paid upon them. The correlation between the repricing of interest rates on assets and on liabilities also influences net interest income. The following table presents a comparison of the components of interest income and expense and net interest income. Years ended September 30, Difference ------------------------------- ------------------------------- 2004 2003 Amount % - ------------------------------------------------------------------------------------------------------------ (Dollars in thousands) Interest income: Loans $ 13,506 $ 14,369 $ (863) (6.01)% Investments 5,456 6,618 (1,162) (17.56) - ------------------------------------------------------------------------------------------------------------ Total 18,962 20,987 (2,025) (9.65) - ------------------------------------------------------------------------------------------------------------ Interest expense: Deposits 5,751 6,673 (922) (13.82) Borrowings 6,604 6,376 228 3.58 - ------------------------------------------------------------------------------------------------------------ Total 12,355 13,049 (694) (5.32) - ------------------------------------------------------------------------------------------------------------ Net interest income $ 6,607 $ 7,938 $ (1,331) (16.77)% ============================================================================================================ Our decline in net interest income for fiscal year 2004 resulted primarily from a 29 basis point decrease in net interest margin (net interest income divided by average interest-earning assets) from 1.61% for fiscal year ended September 30, 2003 to 1.32% for fiscal year ended September 30, 2004, offset in part by an $8.5 million increase in the bank's interest-earning assets. The decrease in net interest margin resulted from a charge of $2.7 million, representing payments made on certain interest rate swap and cap agreements, that took effect during fiscal year 2004, and payment on the company's trust preferred securities compared to a charge of $2.5 million in fiscal year 2003. That decrease was coupled with increases in average interest bearing liabilities exceeding increases in average interest earning assets by $4.4 million and by the average yield on interest earning assets declining 27 basis points more than the average cost on interest bearing liabilities. INTEREST INCOME. Interest income for the fiscal year ended September 30, 2004 decreased $2.0 million compared to fiscal year 2003, primarily as a result of a 48 basis point decrease in the average yield earned on interest earning assets. That decrease was partially offset by an increase of $8.5 million in the average outstanding balances of loans and investment securities. INTEREST EXPENSE. The $694,000 decrease in interest expense for fiscal year 2004 compared to fiscal year 2003 was principally the result of a 21 basis point decrease in the cost of funds on average deposits and borrowed funds. That decrease was offset by a $13.0 million increase in average deposits and borrowed funds. The decrease in interest expense on deposits was primarily due to a 30 basis point decrease in rates paid on average certificates of deposit, savings and NOW and money market accounts and was coupled with a $3.9 million or 1.37% decrease in certificates, savings and NOW and money market accounts, from $279.5 million for fiscal 2003 to $275.6 million for fiscal 2004. The increase in borrowing expense was primarily attributable to average borrowings increasing by $16.8 million. That increase was offset by a decline of 21 basis points in the average cost of borrowings resulting in an overall increase of $228,000 in the average borrowing expense. 28 29 COMPARATIVE AVERAGE BALANCES AND INTEREST INCOME ANALYSIS. The following table presents the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and annualized rates. No tax-equivalent adjustments were made and all average balances are average daily balances. Non-accruing loans have been included in the tables as loans carrying a zero yield. Year Ended September 30, ------------------------------------------------------------------------------------------------- 2004 2003 2002 ------------------------------------------------------------------------------------------------- Interest Average Interest Average Interest Average Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate Balance Expense Rate --------- -------- ------- ------- -------- -------- -------- -------- ------- (Dollars in Thousands) Interest-earning assets: Real estate loans $152,999 $ 8,582 5.61% $185,270 $10,194 5.50% $165,933 $10,217 6.16% Consumer loans 68,268 2,566 3.76 63,548 2,539 4.00 49,861 2,305 4.62 Commercial business loans 46,849 2,358 5.03 32,756 1,636 4.99 23,548 1,517 6.44 --------- ------- ----- -------- ------- ----- -------- ------- ----- Total loans 268,116 13,506 5.04 281,574 14,369 5.10 239,342 14,039 5.87 Investment securities 123,198 3,077 2.50 161,161 4,899 3.04 155,350 5,796 3.73 Mortgage-backed securities 111,016 2,379 2.14 51,046 1,719 3.37 39,320 1,947 4.95 --------- ------- ----- -------- ------- ----- -------- ------- ----- Total interest- earning assets 502,330 18,962 3.77 493,781 20,987 4.25 434,012 21,782 5.02 Non-earning assets 19,318 ------- ----- 16,903 ------- ----- 15,929 ------- ----- --------- -------- -------- Total assets $521,648 $510,684 $449,941 ========= ======== ======== Liabilities and Stockholders' Equity: Interest-bearing liabilities: Savings accounts $ 11,978 113 0.94 $ 9,686 122 1.26 $ 5,852 118 2.02 Now and money market accounts 77,981 852 1.09 76,744 1,050 1.37 73,505 1,621 2.21 Certificates of deposit 185,677 4,786 2.58 193,039 5,501 2.85 163,763 6,569 4.01 --------- ------- ----- -------- ------- ----- -------- ------- ----- Total deposits 275,636 5,751 2.09 279,469 6,673 2.39 243,120 8,308 3.42 FHLB advances 116,155 2,779 2.39 102,868 2,657 2.58 99,269 3,074 3.10 Other borrowings 89,734 3,825 4.26 86,225 3,719 4.31 68,577 2,353 3.43 --------- ------- ----- -------- ------- ----- -------- ------- ----- Total interest-bearing liabilities 481,525 12,355 2.57 468,562 13,049 2.78 410,966 13,735 3.34 ------- ----- ------- ----- ------- ----- Noninterest-bearing liabilities: Noninterest-bearing demand deposits 15,243 17,130 15,291 Other liabilities 3,848 5,283 2,789 --------- -------- -------- Total liabilities 500,616 490,975 429,046 Stockholders' equity 21,032 19,709 20,895 --------- -------- -------- Total liabilities and stockholders' equity $521,648 $510,684 $449,941 ========= ======== ======== Net interest income $ 6,607 $ 7,938 $ 8,047 ======= ======= ======= Interest rate spread 1.21% 1.47% 1.68% ===== ===== ===== Net interest margin 1.32% 1.61% 1.85% ===== ===== ===== 29 30 RATE/VOLUME ANALYSIS. The following table presents certain information regarding changes in interest income and interest expense attributable to changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities for the periods indicated. The change in interest attributable to both rate and volume has been allocated to the changes in rate and volume on a pro rata basis. Year Ended September 30, 2004 Year Ended September 30, 2003 Compared to Year Compared to Year Ended September 30, 2003 Ended September 30, 2002 Change Attributable to Change Attributable to ------------------------------- --------------------------------- Volume Rate Total Volume Rate Total - -------------------------------------------------------------------------------------------------------- (In Thousands) Real estate loans $(1,776) $ 164 $(1,612) $1,191 $(1,214) $ (23) Consumer loans 189 (162) 27 633 (399) 234 Commercial business loans 704 18 722 593 (474) 119 - -------------------------------------------------------------------------------------------------------- Total loans (883) 20 (863) 2,417 (2,087) 330 Investments (1,154) (668) (1,822) 217 (1,114) (897) Mortgage-backed securities 2,020 (1,360) 660 581 (809) (228) - -------------------------------------------------------------------------------------------------------- Total interest-earning assets $ (17) $(2,008) $(2,025) $3,215 $(4,010) $ (795) ======================================================================================================== Savings accounts $ 29 $ (38) $ (9) $ 77 $ (73) $ 4 Now and money market accounts 17 (215) (198) 71 (642) (571) Certificates of deposit (210) (505) (715) 1,174 (2,242) (1,068) - ----------------------------------------------------------------------------------------------------------- Total deposits (164) (758) (922) 1,322 (2,957) (1,635) FHLB advances 343 (221) 122 111 (528) (417) Other borrowings 151 (45) 106 606 760 1,366 - ----------------------------------------------------------------------------------------------------------- Total interest-bearing liabilities $ 330 $(1,024) $ (694) $2,039 $(2,725) $ (686) =========================================================================================================== Change in net interest income $ (347) $ (984) $(1,331) $1,176 $(1,285) $ (109) =========================================================================================================== PROVISION FOR LOAN LOSSES. The allowance for loan losses, which is established through provisions for losses charged to expense, is increased by recoveries on loans previously charged off and is reduced by charge-offs on loans. Determining the proper reserve level or allowance involves management's judgment based upon a review of factors, including the company's internal review process, which segments the loan portfolio into groups based on loan type. Management then looks at its classified assets, which are loans 30 days or more delinquent, and classifies those loans as special mention, substandard or doubtful, based on the performance of the loans. Those classified loans are then individually evaluated for impairment. Since the historical three-year loss experience for the bank is new, those loans that are not classified are not individually evaluated. Those loans are then segmented by type and assigned a reserve percentage that reflects the industry loss experience. The loans individually evaluated for impairment are measured by either the present value of expected future cash flows, the loans observable market price, or the fair value of the collateral. Although management utilizes its best judgment in providing for probable losses, there can be no assurance that the bank will not have to increase its provisions for loan losses in the future. An increase in provision may result from an adverse market for real estate and economic conditions generally in the company's primary market area, future increases in non-performing assets or for other reasons which would adversely affect the company's results of operations. Non-performing assets were $953,000 or 0.22% of total assets at September 30, 2004, compared to $1.4 million at September 30, 2003, with $1.1 million classified as substandard and $66,000 classified as doubtful. Non-performing assets decreased $465,000 from the comparable period one year ago, the provision for loan losses decreased $647,000. The decrease in non-performing assets from the year ago period was due to the non-performing status of one of the bank's commercial business loans. The decrease in provision was due primarily to a reduction in the required provision for that loan since the bank is in the process of liquidating that loan from the cash flow of the collateral securing the loan. NONINTEREST INCOME. Noninterest income decreased $9.0 million during fiscal 2004 over fiscal 2003. That decrease was primarily the result of the decrease in gain on sale of loans along with decreases in service charges on deposits and loans, gains on sale of investment securities and gains on derivatives. Those decreases were offset by a $34,000 increase in gain on sale of real estate owned and other operating income. The level of gains on sale of loans during fiscal 2004 resulted from lower than anticipated loan origination and sales volumes at the bank's mortgage banking subsidiary and lower margins than those obtained in fiscal year 2003. During fiscal year 2004, disbursements on loans originated for sale amounted to $403.0 million compared to $722.1 million during fiscal year 2003. The $319.1 million decrease in loans originated and disbursed was largely attributable to 30 31 increases in market interest rates which resulted in decreased home mortgage refinancings. During the year, substantially all loans originated were sold in the secondary market, in most cases with servicing released. Proceeds from the sale of loans for fiscal 2004 amounted to $413.2 million compared to $747.4 million during fiscal year 2003. Sales of loans resulted in gains of $9.2 million and $17.4 million for fiscal 2004 and fiscal 2003, respectively. The following table presents a comparison of the components of non-interest income. Years Ended September 30, Difference ------------------------------ ------------------------------ 2004 2003 Amount % - -------------------------------------------------------------------------------------------------------------- (Dollars in Thousands) Noninterest income: Gain on sale of loans $ 9,191 $ 17,373 $ (8,182) (47.10)% Service fees on loans 237 706 (469) (66.43) Service fees on deposits 755 769 (14) (1.82) Gain on sale of investment securities (58) 35 (93) (265.71) Gain (loss) on derivatives (227) 9 (236) (2,622.22) Loss on sale of real estate owned - (24) 24 100.00 Other operating income 31 21 10 47.62 - --------------------------------------------------------------------------------------------------------------- Total noninterest income $ 9,929 $ 18,889 $ (8,960) (47.44)% =============================================================================================================== NONINTEREST EXPENSE. Noninterest expense for fiscal 2004 amounted to $19.4 million, a decrease of $4.3 million or 18.05% from the $23.7 million incurred in fiscal 2003. The decrease was primarily attributable to a $4.6 million decrease in the mortgage banking subsidiary's noninterest expense as a result of decreased loan origination and sales activity. That decrease was primarily in compensation of $5.8 million, professional services and other operating expenses of $568,000. The increase in the bank's noninterest expense of $356,000 was primarily in compensation, occupancy and data processing. Those increases were offset by decreases in professional services, advertising, depreciation expense on furniture fixtures and equipment, and other operating expense. The decrease in compensation at the mortgage subsidiary resulted from a decrease in commissions to loan officers, due to decreased loan production and the related employee benefit costs associated with the decrease in their compensation. The following table presents a comparison of the components of noninterest expense. Years Ended September 30, Difference ------------------------------- --------------------------- 2004 2003 Amount % - ------------------------------------------------------------------------------------------------------------- (Dollars in Thousands) Noninterest expense: Compensation and employee benefits $ 8,401 $ 13,706 $ (5,305) (38.71)% Occupancy 2,161 1,963 198 10.09 Professional services 917 1,329 (412) (31.00) Advertising 2,563 1,072 1,491 139.09 Deposit insurance premium 44 46 (2) (4.35) Furniture, fixtures and equipment 1,139 1,069 70 6.55 Data processing 1,465 1,317 148 11.24 Real estate owned expense - 5 (5) (100.00) Other operating expense 2,740 3,204 (464) (14.48) - ------------------------------------------------------------------------------------------------------------- Total noninterest expense $ 19,430 $ 23,711 $ (4,281) (18.05)% ============================================================================================================= INCOME TAXES. The company files a consolidated federal income tax return with its subsidiaries and computes its income tax provision or benefit on a consolidated basis. The company believes that it will generate future taxable income to assure utilization of the existing net operating losses. Management has provided a valuation allowance for net deferred tax assets of $3.0 million, due to the timing of the generation of future taxable income. At September 30, 2004, the company had net operating loss carryforwards totaling approximately $10.0 million, which expire in years 2006 to 2021. As a result of the change in ownership of the bank, approximately $1.5 million of the total net operating loss carryforwards are subject to an annual usage limitation of approximately $114,000. 31 32 CONTRACTUAL COMMITMENTS AND OBLIGATIONS The following summarizes the company's contractual cash obligations and commercial commitments, including maturing certificates of deposit, as of September 30, 2004 and the effect such obligations may have on liquidity and cash flow in future periods. Less Than Two-Three Four-Five After Five Total One Year Years Years Years - ----------------------------------------------------------------------------------------------------------- (In Thousands) FHLB Advances (1) $ 51,200 $ 13,200 $ 8,000 $ - $ 30,000 Reverse repurchase agreements 64,865 64,865 - - - Operating leases: 8,615 1,338 2,364 2,072 2,841 - ----------------------------------------------------------------------------------------------------------- Total obligations $ 124,680 $ 79,403 $10,364 $ 2,072 $ 32,841 =========================================================================================================== (1) The company expects to refinance these short and medium-term obligations under substantially the same terms and conditions. OTHER COMMERCIAL COMMITMENTS Less Than Two-Three Four-Five After Five Total One Year Years Years Years - ----------------------------------------------------------------------------------------------------------- (In Thousands) Certificates of deposit maturities (1) $ 182,056 $ 105,090 $ 62,535 $ 14,431 $ - Loan originations 63,300 63,300 - - - Unfunded lines of credit 98,300 98,300 - - - Standby letter of credit 500 500 - - - - ----------------------------------------------------------------------------------------------------------- Total $ 344,156 $ 267,190 $ 62,535 $ 14,431 $ - =========================================================================================================== (1) The company expects to retain maturing deposits or replace amounts maturing with comparable certificates of deposits based on current market interest rates. ASSET-LIABILITY MANAGEMENT The primary objective of asset/liability management is to ensure the steady growth of the company's primary earnings component, net interest income, and the maintenance of reasonable levels of capital independent of fluctuating interest rates. Interest rate risk can be defined as the vulnerability of an institution's financial condition and/or results of operations to movements in interest rates. Interest rate risk, or sensitivity, arises when the maturity or repricing characteristics of assets differ significantly from the maturity or repricing characteristics of liabilities. Management endeavors to structure the balance sheet so that repricing opportunities exist for both assets and liabilities in roughly equivalent amounts at approximately the same time intervals to maintain interest rate risk at an acceptable level. Management oversees the asset/liability management function and meets periodically to monitor and manage the structure of the balance sheet, control interest rate exposure, and evaluate pricing strategies for the company. The asset mix of the balance sheet is continually evaluated in terms of several variables: yield, credit quality, appropriate funding sources and liquidity. Management of the liability mix of the balance sheet focuses on expanding the company's various funding sources. At times, depending on the level of general interest rates, the relationship between long- and short-term interest rates, market conditions and competitive factors, the bank may determine to increase our interest rate risk position in order to increase our net interest margin. The bank manages its exposure to interest rates by structuring the balance sheet in the ordinary course of business. The bank currently emphasizes adjustable rate loans and/or loans that mature in a relatively short period when compared to single-family residential loans. In addition, to the extent possible, the bank attempts to attract longer-term deposits. While the bank has entered into interest rate swaps and caps to assist in managing interest rate risk, it has not entered into instruments such as leveraged derivatives, structured notes, financial options, financial futures contracts or forward delivery contracts. One of the ways the bank monitors interest rate risk is through an analysis of the relationship between interest-earning assets and interest-bearing liabilities to measure the impact that future changes in interest rates will have on net interest income. An interest rate sensitive asset or liability is one that, within a defined time period, either matures or experiences an interest rate change in line with general market interest rates. The management of interest rate risk is performed by analyzing the maturity and repricing relationships between interest-earning assets and interest-bearing liabilities at specific points in time ("GAP") and 32 33 by analyzing the effects of interest rate changes on net interest income over specific periods of time by projecting the performance of the mix of assets and liabilities in varied interest rate environments. The table below illustrates the maturities or repricing of the company's assets and liabilities, including noninterest-bearing sources of funds to specific periods, at September 30, 2004. Estimates and assumptions concerning prepayment rates of major asset categories are based on information obtained from Farin and Associates on projected prepayment levels on mortgage-backed and related securities and decay rates on savings, NOW and money market accounts. The bank believes that such information is consistent with our current experience. - ----------------------------------------------------------------------------------------------------------------------- Three 91 Days 181 Days One Year Years to Five 90 Days to 180 to One to Three Five Years or Maturing or Repricing Periods or Less Days Year Years Years More Total - ----------------------------------------------------------------------------------------------------------------------- (Dollars in Thousands) Interest-earning assets Loans: Adjustable and balloon $ 31,751 $ 3,652 $11,052 $21,096 $ 4,187 $ 711 $ 72,449 Fixed-rate 28,867 688 7,966 3,539 3,627 12,209 56,896 Commercial business 36,758 2,463 1,901 2,489 1,718 2,954 48,283 Consumer 72,987 94 144 269 85 54 73,633 Investment securities 63,893 - - 1,000 - 4,085 68,978 Mortgage-backed securities 21,308 24,078 24,949 20,981 24 6 91,346 - ------------------------------------------------------------------------------------------------------------------- Total 255,564 30,975 46,012 49,374 9,641 20,019 411,585 - ------------------------------------------------------------------------------------------------------------------- Interest-bearing liabilities: Deposits: Savings accounts 4,096 2,920 2,098 1,356 1,755 2,041 14,266 NOW accounts 6,729 5,190 5,104 3,292 4,129 4,968 29,412 Money market accounts 14,287 9,728 7,543 4,466 4,906 3,842 44,772 Certificates of deposit 47,904 26,235 30,917 62,436 14,239 193 181,924 Borrowings: FHLB advances 15,200 - 3,000 8,000 - 25,000 51,200 Other borrowings 64,865 - - - - 9,369 74,234 Derivatives matched against liabilities (72,000) 5,000 33,000 23,000 5,000 6,000 - - ------------------------------------------------------------------------------------------------------------------- Total 81,081 49,073 81,662 102,550 30,029 51,413 395,808 - ------------------------------------------------------------------------------------------------------------------- GAP $174,483 $(18,098) $(35,650) $(53,176) $(20,388) $(31,394) $ 15,777 =================================================================================================================== Cumulative GAP $174,483 $156,385 $120,735 $ 67,559 $ 47,171 $ 15,777 ======================================================================================================= Ratio of Cumulative GAP to total interest earning assets 42.39% 38.00% 29.33% 16.41% 11.46% 3.83% ======================================================================================================= As indicated in the interest rate sensitivity table, the twelve-month cumulative gap, representing the total net assets and liabilities that are projected to re-price over the next twelve months, was asset sensitive in the amount of $120.7 million at September 30, 2004. While the GAP position is a useful tool in measuring interest rate risk and contributes toward effective asset and liability management, it is difficult to predict the effect of changing interest rates solely on the measure, without accounting for alterations in the maturity or repricing characteristics of the balance sheet that occur during changes in market interest rates. The GAP position reflects only the prepayment assumptions pertaining to the current rate environment, and assets tend to prepay more rapidly during periods of declining interest rates than during periods of rising interest rates. Management uses two other analyses to manage interest rate risk: (1) an earnings-at-risk analysis to develop an estimate of the direction and magnitude of the change in net interest income if rates move up or down 100 to 300 basis points; and (2) a value-at-risk analysis to estimate the direction and magnitude of the change in net portfolio value if rates move up or down 100 to 200 basis points. Currently the bank uses a sensitivity of net interest income analysis prepared by Farin and Associates to measure earnings-at-risk and the OTS Interest Rate Risk Exposure Report to measure value-at-risk. 33 34 The following table sets forth the earnings at risk analysis that measures the sensitivity of net interest income to changes in interest rates at September 30, 2004: Net Interest Income Sensitivity Analysis ------------------------------------------------------------------ Basis Point Percent Changes in Rate Net Interest Change Change From by Basis Point Margin From Base Base ----------------- ------------ ------------- ------------- +300 2.24% (0.10)% (4.27)% +200 2.30% (0.04)% (1.71)% +100 2.34% (0.00)% (0.00)% +0 2.34% - - -100 2.24% (0.10)% (4.27)% -200 2.10% (0.24)% (10.26)% -300 1.88% (0.46)% (19.66)% In a declining rate scenario the bank is not within the established limits set by the board of directors. It is currently believed that a declining rate market is unlikely at this time but will be monitored for any changes in interest rate policy. The table indicates that, based on an immediate and sustained 200 basis point increase in market interest rates, net interest margin, as measured as a percent of total assets, would decrease by 4 basis points or 1.71% and if interest rates decrease 200 basis points net interest margin, as a percent of total assets, would decrease by 24 basis points or 10.26%. The net interest income sensitivity analysis does not represent a forecast and should not be relied upon as being indicative of expected operating results. The estimates used are based upon the assumption as to the nature and timing of interest rate levels including the shape of the yield curve. These estimates have been developed based upon current economic conditions; the company cannot make any assurances as to the predictive nature of these assumptions including how customer preferences or competitor influences might change. Presented below, as of September 30, 2004, is an analysis of our interest rate risk as measured by changes in net portfolio value for parallel shifts of up 200 and down 100 basis points in market interest rates: Net Portfolio Value as a Percent of Net Portfolio Value the Present Value of Assets ---------------------------- ------------------------------------ Changes in Rates Dollar Percent Net Portfolio Change in (bp) Change Change Value Ratio NPV Ratio ------------------------------------------------------------------------------------------- (Dollars in thousands) +200 $2,662 9.02% 7.42% 0.71% +100 1,905 6.45 7.19 0.48 +0 - - 6.71 - -100 (3,685) (12.49) 5.86 (0.85) While in the down 100 basis point scenario puts our net portfolio value percentage below the board of directors established limit of 6.25% given that interest rates are rising no action is being taken at this time. Management will monitor the situation over the next several quarters to see if any changes should be made in our position. The improvement in net portfolio value of $7.2 million or 25.13% in the event of a 200 basis point increase in rates is a result of the current amount of adjustable rate loans and investments held by the bank as of September 30, 2004. The foregoing increase in net portfolio value, in the event of an increase in interest rates of 200 basis points, currently exceeds the company's internal board guidelines. In addition to the strategies set forth above, in 2002, the bank began using derivative financial instruments, such as interest rate swaps, to help manage interest rate risk. The bank does not use derivative financial instruments for trading or speculative purposes. All derivative financial instruments are used in accordance with board approved risk management policies. The bank enters into interest rate swap agreements principally to manage its exposure to the impact of rising short-term interest rates on its earnings and cash flows. Since short-term interest rates have declined from inception of the interest rate swap agreements, the change in fair value of the interest rate swap agreements has resulted in a loss of approximately $654,000 for fiscal 2004. The bank does not foresee any significant changes in the strategies used to manage interest rate risk in the near future. 34 35 2003 COMPARED TO 2002 NET INCOME. For the fiscal year ended September 30, 2003, the company had net earnings of $2.3 million or $0.60 per diluted share, compared to net losses of $2.6 million or $0.86 per diluted share for fiscal year 2002. The $4.9 million increase in net earnings over the comparable period one-year ago was primarily due to $3.5 million in derivative losses in 2002 compared to a gain of $9,000 in 2003. In addition, the increase in non-interest income exceeded an increase in non-interest expense. The reduction in interest rates and the resultant increase in loan originations and sales at the Bank's mortgage banking subsidiary along with the continued growth of the bank contributed to the improvement in earnings. NET INTEREST INCOME. An important source of our earnings is net interest income, which is the difference between income earned on interest-earning assets, such as loans, investment securities and mortgage-backed securities, and interest paid on interest-bearing liabilities such as deposits and borrowings. The level of net interest income is determined primarily by the relative average balances of interest-earning assets and interest-bearing liabilities in combination with the yields earned and rates paid upon them. The correlation between the repricing of interest rates on assets and on liabilities also influences net interest income. The following table presents a comparison of the components of interest income and expense and net interest income. Years ended September 30, Difference ------------------------------- ------------------------------- 2003 2002 Amount % - ------------------------------------------------------------------------------------------------------------ (Dollars in Thousands) Interest income: Loans $14,369 $14,039 $ 330 2.35% Investments 6,618 7,743 (1,125) (14.53) - ------------------------------------------------------------------------------------------------------------ Total 20,987 21,782 (795) (3.65) - ------------------------------------------------------------------------------------------------------------ Interest expense: Deposits 6,673 8,308 (1,635) (19.68) Borrowings 6,376 5,427 949 17.49 - ------------------------------------------------------------------------------------------------------------ Total 13,049 13,735 (686) (4.99) - ------------------------------------------------------------------------------------------------------------ Net interest income $ 7,938 $ 8,047 $ (109) (1.35)% ============================================================================================================ Our decline in net interest income for fiscal year 2003 resulted primarily from a 24 basis point decrease in net interest margin (net interest income divided by average interest-earning assets) from 1.85% for fiscal year ended September 30, 2002 to 1.61% for fiscal year ended September 30, 2003, offset in part by a $59.8 million increase in the bank's interest-earning assets. The decrease in net interest margin resulted from a charge of $2.5 million, representing payments made on certain interest rate swap and cap agreements, that took effect during fiscal year 2003, and payment on the company's trust preferred securities compared to a charge of $1.0 million in fiscal year 2002. That decrease was offset by increases in average interest earning assets exceeding increases in average interest bearing liabilities by $2.2 million and was offset in part by the average yield on interest earning assets declining 21 basis points more than the average cost on interest bearing liabilities. INTEREST INCOME. Interest income for the fiscal year ended September 30, 2003 decreased $795,000 compared to fiscal year 2002, primarily as a result of a 77 basis point decrease of in the average yield earned on interest earning assets. That decrease was partially offset by an increase of $59.8 million in the average outstanding balances of loans and investment securities. INTEREST EXPENSE. The $686,000 decrease in interest expense for fiscal year 2003 compared to fiscal year 2002 was principally the result of a 56 basis point decrease in the cost of funds on average deposits and borrowed funds. That decrease was offset by a $57.6 million increase in average deposits and borrowed funds. The decrease in interest expense on deposits was primarily due to a 103 basis point decrease in rates paid on average certificates of deposit, savings and NOW and money market accounts. That decrease was offset by a $36.4 million or 14.95% increase in certificates, savings and NOW and money market accounts, from $243.1 million for fiscal 2002 to $279.5 million for fiscal 2003. 35 36 COMPARATIVE AVERAGE BALANCES AND INTEREST INCOME ANALYSIS. The following table presents the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and annualized rates. No tax-equivalent adjustments were made and all average balances are average daily balances. Non-accruing loans have been included in the tables as loans carrying a zero yield. Year Ended September 30, --------------------------------------------------------------------------------------------------- 2003 2002 2001 ------------------------------- ------------------------------- ------------------------------- Interest Average Interest Average Interest Average Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate Balance Expense Rate --------- -------- ------- -------- -------- ------- -------- -------- ------- (Dollars in Thousands) Interest-earning assets: Real estate loans $185,270 $10,194 5.50% $165,933 $10,217 6.16% $124,646 $ 9,298 7.46% Consumer loans 63,548 2,539 4.00 49,861 2,305 4.62 29,106 2,287 7.86 Commercial business loans 32,756 1,636 4.99 23,548 1,517 6.44 11,038 1,073 9.72 -------- ------- ------ -------- ------- ----- -------- ------- ------ Total loans 281,574 14,369 5.10 239,342 14,039 5.87 164,790 12,658 7.68 Investment securities 161,161 4,899 3.04 155,350 5,796 3.73 118,320 7,897 6.67 Mortgage-backed securities 51,046 1,719 3.37 39,320 1,947 4.95 46,225 3,068 6.64 -------- ------- ------ -------- ------- ----- -------- ------- ------ Total interest-earning assets 493,781 20,987 4.25 434,012 21,782 5.02 329,335 23,623 7.17 ------- ------ -------- ------- ----- -------- ------- ------ Non-earning assets 16,903 15,929 13,891 -------- -------- -------- Total assets $510,684 $449,941 $343,226 ======== ======== ======== Liabilities and Stockholders' Equity: Interest-bearing liabilities: Savings accounts $ 9,686 122 1.26 $ 5,852 118 2.02 $ 4,089 136 3.33 Now and money market accounts 76,744 1,050 1.37 73,505 1,621 2.21 59,783 2,744 4.59 Certificates of deposit 193,039 5,501 2.85 163,763 6,569 4.01 143,785 8,749 6.08 -------- ------- ------ -------- ------- ----- -------- ------- ------ Total deposits 279,469 6,673 2.39 243,120 8,308 3.42 207,657 11,629 5.60 FHLB advances 102,868 2,657 2.58 99,269 3,074 3.10 60,784 3,396 5.59 Other borrowings 86,225 3,719 4.31 68,577 2,353 3.43 43,217 2,222 5.14 -------- ------- ------ -------- ------- ----- -------- ------- ------ Total interest-bearing liabilities 468,562 13,049 2.78 410,966 13,735 3.34 311,658 17,247 5.53 ------- ------ ------- ----- ------- ------ Noninterest-bearing liabilities: Noninterest-bearing demand deposits 17,130 15,291 8,767 Other liabilities 5,283 2,789 1,756 -------- -------- -------- Total liabilities 490,975 429,046 322,181 Stockholders' equity 19,709 20,895 21,045 -------- -------- --------- Total liabilities and stockholders' equity $510,684 $449,941 $343,226 ======== ======== ======== Net interest income $ 7,938 $ 8,047 $ 6,376 ======= ======= ======= Interest rate spread 1.47% 1.68% 1.64% ====== ===== ====== Net interest margin 1.61% 1.85% 1.94% ====== ===== ====== 36 37 RATE/VOLUME ANALYSIS. The following table presents certain information regarding changes in interest income and interest expense attributable to changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities for the periods indicated. The change in interest attributable to both rate and volume has been allocated to the changes in rate and volume on a pro rata basis. Year Ended September 30, 2003 Year Ended September 30, 2002 Compared to Year Compared to Year Ended September 30, 2002 Ended September 30, 2001 Change Attributable to Change Attributable to --------------------------------- ----------------------------------- Volume Rate Total Volume Rate Total - ----------------------------------------------------------------------------------------------------------- (In Thousands) Real estate loans $ 1,191 (1,214) $ (23) $ 3,080 $(2,161) $ 919 Consumer loans 633 (399) 234 1,631 (1,613) 18 Commercial business loans 593 (474) 119 1,216 (772) 444 - ----------------------------------------------------------------------------------------------------------- Total loans 2,417 (2,087) 330 5,927 (4,546) 1,381 Investments 217 (1,114) (897) 2,471 (4,572) (2,101) Mortgage-backed securities 581 (809) (228) (458) (663) (1,121) - ----------------------------------------------------------------------------------------------------------- Total interest-earning assets $ 3,215 $(4,010) $ (795) $ 7,940 $(9,781) $(1,841) =========================================================================================================== Savings accounts $ 77 $ (73) $ 4 $ 59 $ (77) $ (18) Now and money market accounts 71 (642) (571) 630 (1,753) (1,123) Certificates of deposit 1,174 (2,242) (1,068) 1,216 (3,396) (2,180) - ----------------------------------------------------------------------------------------------------------- Total deposits 1,322 (2,957) (1,635) 1,905 (5,226) (3,321) FHLB advances 111 (528) (417) 2,150 (2,472) (322) Other borrowings 606 760 1,366 1,304 (1,173) 131 - ----------------------------------------------------------------------------------------------------------- Total interest-bearing liabilities $ 2,039 $(2,725) $ (686) $ 5,359 $(8,871) $(3,512) =========================================================================================================== Change in net interest income $ 1,176 $(1,285) $ (109) $ 2,581 $ (910) $ 1,671 =========================================================================================================== PROVISION FOR LOAN LOSSES. The allowance for loan losses, which is established through provisions for losses charged to expense, is increased by recoveries on loans previously charged off and is reduced by charge-offs on loans. Determining the proper reserve level or allowance involves management's judgment based upon a review of factors, including the company's internal review process, which segments the loan portfolio into groups based on loan type. Management then looks at its classified assets, which are loans 30 days or more delinquent, and classifies those loans as special mention, substandard or doubtful, based on the performance of the loans. Those classified loans are then individually evaluated for impairment. Since the historical three-year loss experience for the bank is new, those loans that are not classified are not individually evaluated. Those loans are then segmented by type and assigned a reserve percentage that reflects the industry loss experience. The loans individually evaluated for impairment are measured by either the present value of expected future cash flows, the loans observable market price, or the fair value of the collateral. Although management utilizes its best judgment in providing for probable losses, there can be no assurance that the bank will not have to increase its provisions for loan losses in the future. An increase in provision may result from an adverse market for real estate and economic conditions generally in the company's primary market area, future increases in non-performing assets or for other reasons which would adversely affect the company's results of operations. Non-performing assets were $1.4 million or 0.28% of total assets at September 30, 2003, compared to $454,000 at September 30, 2002, with $1.0 million classified as substandard and $372,000 classified as doubtful. While non-performing assets increased $965,000 from the comparable period one year ago, the provision for loan losses decreased $113,000. The increase in non-performing assets from the year ago period was due to the non-performing status of one of the bank's commercial business loans. The decrease in provision was due primarily to a reduction in the required provision for that loan since the bank is in the process of liquidating that loan from the cash flow of the collateral securing the loan. NONINTEREST INCOME. Noninterest income increased $12.7 million during fiscal 2003 over fiscal 2002. That increase was primarily the result of the increase in gain on sale of loans, gain on derivatives (compared to a prior year loss) and service charges on deposits and loans, offset by a $163,000 decrease in gain on sales of investment securities. The significant level of gains during fiscal 2003 resulted from the company taking advantage of increased loan origination volume coupled with home loan refinancing and a favorable interest rate environment enabling the company to sell loans at a gain through Greater Atlantic Mortgage. During fiscal year 2003, disbursements on loans originated for sale amounted to $722.1 million compared to $425.4 million during fiscal year 2002. The $296.7 million increase in loans originated and disbursed was largely attributable to 37 38 decreases in market interest rates which resulted in increased home mortgage refinancings. During the year, substantially all loans originated were sold in the secondary market, in most cases with servicing released. Proceeds from the sale of loans for fiscal 2003 amounted to $747.4 million compared to $434.7 million during fiscal year 2002. Sales of loans resulted in gains of $17.4 million and $8.4 million for fiscal 2003 and fiscal 2002, respectively. The following table presents a comparison of the components of non-interest income. Years Ended September 30, Difference ------------------------------ ------------------------------ 2003 2002 Amount % - ------------------------------------------------------------------------------------------------------------- (Dollars in Thousands) Noninterest income: Gain on sale of loans $ 17,373 $ 8,432 $ 8,941 106.04% Service fees on loans 706 484 222 45.87 Service fees on deposits 769 512 257 50.20 Gain on sale of investment securities 35 198 (163) (82.32) Gain (loss on derivatives 9 (3,512) 3,521 100.26 Loss on sale of real estate owned (24) - (24) n/a Other operating income 21 64 (43) (67.19) - ------------------------------------------------------------------------------------------------------------- Total noninterest income $ 18,889 $ 6,178 $ 12,711 205.75% ============================================================================================================= NONINTEREST EXPENSE. Noninterest expense for fiscal 2003 amounted to $23.7 million, an increase of $7.9 million or 49.70% from the $15.8 million incurred in fiscal 2002. The increase was primarily attributable to a $6.9 million increase in the mortgage banking subsidiary's noninterest expense. That increase was primarily in compensation of $5.7 million, advertising of $260,000 and other operating expenses of $516,000. The increase in the bank's noninterest expense of $1.0 million was primarily in compensation, professional services, depreciation expense on furniture fixtures and equipment, data processing, occupancy and other operating expense, attributable to the continued expansion and growth of the bank. The increase in compensation at the mortgage subsidiary resulted from an increase in commissions to loan officers, due to increased loan production and the related employee benefit costs associated with the increase in their compensation. The following table presents a comparison of the components of noninterest expense. Years Ended September 30, Difference ------------------------------ ------------------------------ 2003 2002 Amount % - --------------------------------------------------------------------------------------------------------------- (Dollars in Thousands) Noninterest expense: Compensation and employee benefits $13,706 $ 7,898 $5,808 73.54% Occupancy 1,963 1,788 175 9.79 Professional services 1,329 782 547 69.95 Advertising 1,072 779 293 37.61 Deposit insurance premium 46 43 3 6.98 Furniture, fixtures and equipment 1,069 875 194 22.17 Data processing 1,317 1,134 183 16.14 Real estate owned expense 5 - 5 n/a Other operating expense 3,204 2,540 664 26.14 - --------------------------------------------------------------------------------------------------------------- Total noninterest expense $23,711 $15,839 $7,872 49.70% =============================================================================================================== INCOME TAXES. The company files a consolidated federal income tax return with its subsidiaries and computes its income tax provision or benefit on a consolidated basis. The company expects to offset all taxable income in fiscal 2003 with existing net operating losses carried forward from prior years. 38 39 LIQUIDITY AND CAPITAL RESOURCES LIQUIDITY. The bank's primary sources of funds are deposits, principal and interest payments on loans, mortgage-backed and investment securities and borrowings. While maturities and scheduled amortization of loans are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition. The bank has continued to maintain the levels of liquid assets as previously required by OTS regulations. The bank manages its liquidity position and demands for funding primarily by investing excess funds in short-term investments and utilizing FHLB advance and reverse repurchase agreements in periods when the bank's demands for liquidity exceed funding from deposit inflows. The bank's most liquid assets are cash and cash equivalents, interest bearing deposits and securities available-for-sale. The levels of those assets are dependent on the bank's operating, financing, lending and investing activities during any given period. At September 30, 2004, cash and cash equivalents, interest bearing deposits and securities available-for-sale totaled $153.3 million, or 35.30% of total assets. The primary investing activities of the bank are the origination of residential one- to four-family loans, commercial real estate loans, real estate construction and development loans, commercial business and consumer loans and the purchase of United States Treasury and agency securities, mortgage-backed and mortgage-related securities and other investment securities. During the year ended September 30, 2004, the bank's loan originations and purchases totaled $145.8 million. Purchases of United States Treasury and agency securities, mortgage-backed and mortgage related securities and other investment securities totaled $88.8 million for the year ended September 30, 2004. The bank has other sources of liquidity if a need for additional funds arises. At September 30, 2004, the bank had $51.2 million in advances outstanding from the FHLB and had an additional overall borrowing capacity from the FHLB of $111.3 million at that date. Depending on market conditions, the pricing of deposit products and FHLB advances, the bank may continue to rely on FHLB borrowings to fund asset growth. At September 30, 2004, the bank had commitments to fund loans and unused outstanding lines of credit, unused standby letters of credit and undisbursed proceeds of construction mortgages totaling $162.1 million. The bank anticipates that it will have sufficient funds available to meet its current loan origination commitments. Certificate accounts, including IRA and Keogh accounts, which are scheduled to mature in less than one year from September 30, 2004, totaled $105.1 million. Based upon experience, management believes the majority of maturing certificates of deposit will remain with the bank. In addition, management of the bank believes that it can adjust the rates offered on certificates of deposit to retain deposits in changing interest rate environments. In the event that a significant portion of these deposits are not retained by the bank, the bank would be able to utilize FHLB advances and reverse repurchase agreements to fund deposit withdrawals, which would result in an increase in interest expense to the extent that the average rate paid on such borrowings exceeds the average rate paid on deposits of similar duration. CAPITAL RESOURCES. At September 30, 2004, the bank exceeded all minimum regulatory capital requirements with a tangible capital level of $25.3 million, or 5.85% of total adjusted assets, which exceeds the required level of $6.5 million, or 1.50%; core capital of $25.3 million, or 5.85% of total adjusted assets, which exceeds the required level of $17.3 million, or 4.00%; and risk-based capital of $26.8 million, or 10.85% of risk-weighted assets, which exceeds the required level of $19.8 million, or 8.00%. On March 20, 2002, Greater Atlantic Capital Trust I (the, "Trust"), a Delaware statutory business trust and a wholly owned Trust subsidiary of the company, issued $9.6 million aggregate liquidation amount (963,038 shares) of 6.50% cumulative preferred securities maturing on December 31, 2031, retaining an option to call the securities on or after December 31, 2003. Conversion of the preferred securities into the company's common stock may occur at any time on or after 60 days after the closing of the offering. The company may redeem the preferred securities, in whole or in part, at any time on or after December 31, 2003. Distributions on the preferred securities are payable quarterly on March 31, June 30, September 30 and December 31 of each year beginning on June 30, 2002. The Trust also issued 29,762 common securities to the company for $297,620. The proceeds from the sale of the preferred securities and the proceeds from the sale of the trust's common securities were utilized to purchase from the company junior subordinated debt securities of $9,928,000 bearing interest of 6.50% and maturing December 31, 2031. All intercompany interest and equity were eliminated in consolidation. The Trust was formed for the sole purpose of investing the proceeds from the sale of the convertible preferred securities in the corresponding convertible debentures. The company has fully and unconditionally guaranteed the preferred securities along with all obligations of the trust related thereto. The sale of the preferred securities yielded $9.2 million after deducting offering expenses. The company retained approximately $1.5 million of the proceeds for general corporate purposes, investing the retained funds in short-term investments. The remaining $8.0 million of the proceeds was invested in the bank to increase its capital position. 39 40 CHANGES IN LEVELS OF INTEREST RATES MAY ADVERSELY AFFECT US. In general, market risk is the sensitivity of income to variations in interest rates and other relevant market rates or prices. The company's market rate sensitive instruments include interest-earning assets and interest-bearing liabilities. The company enters into market rate sensitive instruments in connection with its various business operations, particularly its mortgage banking activities. Loans originated, and the related commitments to originate loans that will be sold, represent market risk that is realized in a short period of time, generally two or three months. The company's primary source of market risk exposure arises from changes in United States interest rates and the effects thereof on mortgage prepayment and closing behavior, as well as depositors' choices ("interest rate risk"). Changes in these interest rates will result in changes in the company's earnings and the market value of its assets and liabilities. We expect to continue to realize income from the differential or "spread" between the interest earned on loans, securities and other interest-earning assets, and the interest paid on deposits, borrowings and other interest-bearing liabilities. That spread is affected by the difference between the maturities and re-pricing characteristics of interest-earnings assets and interest-bearing liabilities. Loan volume and yields are affected by market interest rates on loans, and rising interest rates generally are associated with fewer loan originations. Management expects that a substantial portion of our assets will continue to be indexed to changes in market interest rates and we intend to attract a greater proportion of short-term liabilities, which will help address our interest rate risk. The lag in implementation of re-pricing terms on our adjustable-rate assets may result in a decline in net interest income in a rising interest rate environment. There can be no assurance that our interest rate risk will be minimized or eliminated. Further, an increase in the general level of interest rates may adversely affect the ability of certain borrowers to pay the interest on and principal of their obligations. Accordingly, changes in levels of market interest rates, (primarily increases in market interest rates), could materially adversely affect our interest rate spread, asset quality, loan origination volume and overall financial condition and results of operations. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk is the risk of loss from adverse changes in market prices and rates. The company's market risk arises primarily from interest rate risk inherent in its lending and deposit taking activities. The company has little or no risk related to trading accounts, commodities or foreign exchange. To mitigate the impact of changes in market interest rates on our interest-earning assets and interest-bearing liabilities, we actively manage the amounts and maturities of these assets and liabilities. A key component of this strategy is the origination and retention of short-term and adjustable-rate assets and the origination and sale of fixed-rate loans. We retain short-term and adjustable-rate assets because they have re-pricing characteristics that more closely match the re-pricing characteristics of our liabilities. To further mitigate the risk of timing differences in the re-pricing of assets and liabilities, our interest-earning assets are matched with interest-bearing liabilities that have similar re-pricing characteristics. For example, the interest rate risk of holding fixed-rate loans is managed with long-term deposits and borrowings, and the risk of holding ARMs is managed with short-term deposits and borrowings. Periodically, mismatches are identified and managed by adjusting the re-pricing characteristics of our interest-bearing liabilities with derivatives, such as interest rate caps and interest rate swaps. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION Please refer to the index on page 50 for the Consolidated Financial Statements of Greater Atlantic Financial Corp. and subsidiary, together with the report thereon by BDO Seidman, LLP. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There have been no disagreements with the Registrant's accountants on any matters of accounting principles or practices or financial statement disclosures. ITEM 9A. CONTROLS AND PROCEDURES (a) Evaluation of disclosure controls and procedures. The Company ------------------------------------------------ maintains controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. Based upon their evaluation of those controls and procedures performed within the period, the chief executive and chief financial officers of the Company concluded that the Company's disclosure controls and procedures were adequate. (b) Changes in internal controls. The company made no significant ---------------------------- changes in its internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation of those controls by the Chief Executive and Chief Financial Officers. 40 41 ITEM 9B. OTHER INFORMATION During the quarter ended September 30, 2004, the Company filed a Current Report on Form 8-K for all information required to be disclosed in a report on Form 8-K. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. MANAGEMENT OF THE COMPANY DIRECTORS The following table sets forth information regarding the board of directors of the company. Each of the directors of the company is also a director of the bank. Director Term Name Age Position(s) Held With the Company Since Expires ------------------------------ -------- -------------------------------------------------- ---------- -------- Carroll E. Amos 57 Director, President and Chief Executive Officer 1997 2005 Sidney M. Bresler 50 Director 2003 2007 Charles W. Calomiris 47 Director, Chairman of the Board of Directors 2001 2005 Paul J. Cinquegrana 63 Director 1997 2006 Jeffrey M. Gitelman 60 Director 1997 2007 Jeffrey W. Ochsman 52 Director 1999 2006 James B. Vito 79 Director 1998 2005 EXECUTIVE OFFICERS WHO ARE NOT DIRECTORS The following table sets forth information regarding the executive officers of the company and the bank who are not also directors. Name Age Position(s) Held With the Company ----------------------------- ------- ------------------------------------------------------------------------------- Edward C. Allen 56 Senior Vice President and Chief Operating Officer, of the Bank Jeremiah D. Behan 55 Senior Vice President, Construction Lending, of the Bank Justin R. Golden 54 Senior Vice President, Consumer Lending, of the Bank Gary L. Hobert 55 Senior Vice President, Commercial Business Lending, of the Bank Patsy J. Mays 58 Senior Vice President, Small Business Lending and Retail Banking, of the Bank Robert W. Neff 57 Senior Vice President, Commercial Real Estate Lending, of the Bank Laurel L. Mitchell 46 Corporate Secretary, of the Company and the Bank David E. Ritter 54 Senior Vice President and Chief Financial Officer, of the Company and the Bank Each of the executive officers of the company and the bank holds his or her office until his or her successor is elected and qualified or until removed or replaced. Officers are subject to re-election by the board of directors annually. 41 42 BIOGRAPHICAL INFORMATION DIRECTORS Charles W. Calomiris, Chairman of the Board of Directors of the company and the bank. Mr. Calomiris is currently the Henry Kaufman Professor of Finance and Economics at the Columbia University Graduate School of Business and a professor at the School of International and Public Affairs at Columbia. During the last five years he has served as a consultant to the Federal Reserve Board as well as to Federal Reserve Banks and the World Bank, to the governments of states and foreign countries and to major U. S. corporations. Carroll E. Amos is President and Chief Executive Officer of the company and of the bank. He is a private investor who until 1996 served as President and Chief Executive Officer of 1st Washington Bancorp and Washington Federal Saving Bank. Sidney M. Bresler is Chief Executive Officer and Chief Operating Officer of Bresler & Reiner, Inc. engaged in residential land development and construction and rental property ownership and management. Paul J. Cinquegrana is a Principal of Washington Securities Corporation, a stock and bond brokerage firm. Jeffrey M. Gitelman, D.D.S., is an Oral Surgeon and the owner of Jeffrey M. Gitelman D.D.S., P.C. Jeffrey W. Ochsman, is a partner in the law firm of Friedlander, Misler, Sloan, Kletzkin & Ochsman, PLLC, Washington, D.C. James B. Vito is a managing general partner of James Properties, engaged in the sale and management of property. EXECUTIVE OFFICERS WHO ARE NOT DIRECTORS Edward C. Allen joined the bank as a Senior Vice President and Chief Financial Officer in mid 1996 and became Chief Operating Officer in 1997. Prior to joining the bank, Mr. Allen was the Chief Financial Officer of Servus Financial Corp. from 1994 to 1996 and Senior Vice President of NVR Savings Bank from 1992 to 1994. Jeremiah D. Behan joined the bank in 1998 as a Senior Vice President with primary responsibility for the bank's Construction Lending Department. From 1997 until joining the bank, Mr. Behan was the Senior Servicing Officer for Virginia Asset Financing Corporation. From 1986 until 1996, he served as Senior Vice President of Construction Administration and Servicing at Washington Federal Savings Bank. Justin R. Golden joined the bank as Senior Vice President of the Consumer Lending Department in 1998. From 1984 until 1997 he served in various capacities at Citizens Bank, most recently having responsibility for reorganizing and operating that bank's home equity lending function. Gary L. Hobert joined the bank as Senior Vice President of the Commercial Business Lending Department in 2001. From 2000 until joining the bank, Mr. Hobert was the Senior Vice President of Adams National Bank. From 1998 until 2000 he served as Executive Vice President and Senior Loan Officer for Grandbank. Patsy J. Mays joined the bank in 1998 as a Senior Vice President, primarily responsible for Small Business Lending and Retail Banking. Prior to joining the bank, Ms. Mays served as an Assistant Vice President at Wachovia Bank of South Carolina responsible for sales production and branch operations from 1995 to 1996. From 1993 until 1995 she served as Vice President for Branch Administration at Ameribanc Savings Bank. Laurel L. Mitchell joined the bank and the company as Corporate Secretary in 1999 after three years as Executive Assistant to the Executive Director of Collier, Shannon, Rill and Scott, PLLC. Ms. Mitchell had previously been employed with America's Community Bankers from 1993 to 1997. Robert W. Neff joined the bank in 1997 as Senior Vice President, Commercial Real Estate Lending. Prior to joining the bank, Mr. Neff served as a Consultant on commercial real estate loan brokerage with the First Financial Group of Washington after serving from 1984 until 1996 as an Executive Vice President for Commercial Real Estate Lending at Washington Federal Savings Bank. David E. Ritter joined the bank and the company as a Senior Vice President and Chief Financial Officer in 1998. From 1996 to 1997, Mr. Ritter was a Senior Financial Consultant with Peterson Consulting. From 1988 until 1996, he was the Executive Vice President and Chief Financial Officer of Washington Federal Savings Bank. 42 43 COMPLIANCE WITH SECTION 16 (A) OF THE EXCHANGE ACT Section 16(a) of the Securities and Exchange Act requires the company's executive officers and directors, and persons who own more than ten percent of a registered class of the company's equity securities, to file reports of ownership and changes in ownership with the Securities and Exchange Commission and the National Association of Securities Dealers, Inc., and to furnish the company with copies of all Section 16(a) forms they file. Based solely on its review of the copies of such forms received by it, or written representations from certain reporting persons that no Forms 5 were required for those persons, the company believes that all filing requirements applicable to its executive officers and directors were met during fiscal 2004. CODE OF ETHICS AND BUSINESS CONDUCT The Company has adopted a Code of Ethics and Business Conduct applicable to all employees, officers and directors of the Company and its subsidiaries. A copy of the Code of Ethics and Business Conduct will be furnished without charge to stockholders of record upon written request to Greater Atlantic Financial Corp., Ms. Laurel L. Mitchell, Corporate Secretary, 10700 Parkridge Boulevard, Suite P50, Reston, Virginia 20191. AUDIT COMMITTEE FINANCIAL EXPERT No current member of the Audit Committee qualifies as an "audit committee financial expert" as defined in the rules of the Securities and Exchange Commission. The Company is currently seeking an additional director who will qualify as an "audit committee financial expert," but has not found a qualified candidate who is willing to serve in that capacity. ITEM 11. EXECUTIVE COMPENSATION SUMMARY COMPENSATION TABLE. The following table sets forth the cash compensation paid by the company for services rendered in all capacities during the fiscal years ended September 30, 2004, 2003 and 2002, to the Chief Executive Officer, the only executive officer of the company who received salary and bonus in excess of $100,000 ("Named Executive Officers"). Securities Name and Principal Underlying Position Fiscal Year Salary Bonus Options --------------------------- ------------ ------------ ------------ ------------ Carroll E. Amos, 2004 $182,000 $ - 75,000 President and Chief 2003 $177,850 $ - 65,000 Executive Officer 2002 $162,950 $ - 65,000 For 2004, 2003 and 2002, there were no (a) perquisites over the lesser of $50,000 or 10% of the Chief Executive Officer's total salary and bonus for the year; (b) payments of above-market preferential earnings on deferred compensation; (c) payments of earnings with respect to long-term incentive plans prior to settlement or maturation; (d) tax payment reimbursements; or (e) preferential discounts on stock. EMPLOYMENT AGREEMENT. The Company has entered into an employment agreement with Mr. Carroll E. Amos. The Employment Agreement is intended to ensure that the Bank and the Company will be able to maintain a stable and competent management base. The continued success of the Bank and the Company depends to a significant degree on the skills and competence of its executive officers, particularly the Chief Executive Officer. The Employment Agreement provides for a three-year term for Mr. Amos and provides that commencing on the first anniversary date and continuing each anniversary date thereafter the board of directors may extend the Employment Agreement for an additional year so that the remaining term shall be three years, unless written notice of non-renewal is given by the board of directors after conducting a performance evaluation of Mr. Amos. The Employment Agreement provides that Mr. Amos's base salary will be reviewed annually. The base salary provided for in the Employment Agreement for Mr. Amos was increased to $165,400 at the fourth anniversary date and to $182,000 on January 1, 2003. In addition to the base salary, the Employment Agreement provides for, among other things, participation in various employee benefit plans and stock-based compensation programs, as well as furnishing fringe benefits available to similarly situated executive personnel. The Employment Agreement provides for termination by the Bank for cause (as defined in the Employment Agreement) at any time. In the event the Bank chooses to terminate Mr. Amos's employment for reasons other than for cause or, in the event of Mr. Amos's resignation from the Bank upon: (i) failure to re-elect Mr. Amos to his current office; (ii) a material change in Mr. Amos's functions, duties or responsibilities; (iii) a relocation of Mr. Amos's principal place of employment by more than 30 miles; (iv) liquidation or dissolution of the Bank or the Company; or (v) a breach of the Employment Agreement by the Bank, Mr. Amos or, in the event of death, Mr. Amos's beneficiary would be entitled to receive 43 44 an amount generally equal to the remaining base salary and bonus payments that would have been paid to Mr. Amos during the remaining term of the Employment Agreement. The Bank would also continue and pay for Mr. Amos's life, health and disability coverage for the remaining term of the Employment Agreement. Upon any termination of Mr. Amos's employment, Mr. Amos is subject to a covenant not to compete with the Bank for one year. Under the Employment Agreement, if involuntary termination or voluntary termination follows a change in control of the Bank or the Company, Mr. Amos or, in the event of his death, his beneficiary, would receive a severance payment generally equal to the greater of: (i) the payments due for the remaining terms of the agreement, including the value of stock-based incentives previously awarded to Mr. Amos; or (ii) three times the average of the three preceding taxable years' annual compensation. The Bank would also continue Mr. Amos's life, health, and disability coverage for thirty-six months. In the event of a change in control of the Bank, the total amount of payment due under the Employment Agreement, based solely on the base salary paid to Mr. Amos, and excluding any benefits under any employee benefit plan which may otherwise become payable, would equal approximately $546,000. All reasonable costs and legal fees paid or incurred by Mr. Amos pursuant to any dispute or question of interpretation relating to the Employment Agreement is to be paid by the Bank, if he is successful on the merits pursuant to a legal judgment, arbitration or settlement. The Employment Agreement also provides that the Bank will indemnify Mr. Amos to the fullest extent allowable under federal law. DIRECTORS' COMPENSATION FEES. Since the formation of the Company, the executive officers, directors and other personnel have been compensated for services by the Bank and have not received additional remuneration from the Company. Beginning on October 1, 1998, the Chairman was made a salaried officer of the Bank and the Company and in those capacities received compensation at the rate of $3,000 per month. Since January 1, 2003, each outside directors of the Bank has received $750 for each Board meeting and $350 for each committee meeting attended. STOCK OPTION AND WARRANT PLANS Under the Greater Atlantic Financial Corp. 1997 Stock Option and Warrant Plan (the "Option Plan"), which was ratified by shareholders in 1997 and amended in 2000 and 2002, options are granted to employees at the discretion of a committee comprised of disinterested directors who administer the plan. There were no options granted to the Chief Executive Officer in fiscal year 2004. The following table provides certain information with respect to the number of shares of Common Stock represented by outstanding stock options held by the Chief Executive Officer as of September 30, 2004. Also reported are the values for "in-the-money" options which represent the positive spread between the exercise price of any such existing stock options and the price of the Common Stock as of the end of the fiscal year on September 30, 2004. Fiscal Year-End Options/SAR Values -------------------------------------------------------------- Number of Securities Underlying Unexercised Options at Fiscal Year Value of Unexercised Shares Value End (#) In-the-Money Options at Fiscal Acquired on Realized Exercisable/ Year End ($) Name Exercise (#) ($) Unexercisable Exercisable/Unexercisable -------------------- ---------------- ------------ --------------------------- ---------------------------------- Carroll E. Amos 0 0 75,000 $20,482 (1) Value of unexercised in-the-money stock options equals the market value of shares covered by in-the-money options on September 30, 2004 less the option exercise price. Options are in-the-money if the market value of shares covered by the options is greater than the exercise price. 44 45 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS Persons and groups owning in excess of five percent of the Company's Common Stock are required to file certain reports regarding such ownership with the Company and with the Securities and Exchange Commission ("SEC"), in accordance with the Securities Exchange Act of 1934 (the "Exchange Act"). The following table sets forth information regarding persons known to be beneficial owners of more than five percent of the Company's outstanding Common Stock as of December 17, 2004. Amount and Nature of Name and Address Beneficial Percent Title of Class of Beneficial Owner Ownership of Class - ------------------------- ------------------------------------ -------------------------- ------------------- Common Stock Charles W. Calomiris 251 Fox Meadow Road Scarsdale, New York 10583 176,807 shares(1)(2) 5.87% Common Stock Robert I. Schattner, DDS 121 Congressional Lane Rockville, MD 20852 427,396 shares(1)(3) 14.19% Common Stock The Ochsman Children Trust 1650 Tysons Boulevard McLean, VA 22102 238,597 shares(1)(4) 7.92% Common Stock George W. Calomiris 4848 Upton Street, N.W. 199,715 shares(5) 6.43% Washington, DC 20016 Common Stock Jenifer Calomiris 4919 Upton Street, N.W. 190,438 shares(6) 6.14% Washington, D.C. 20016 Common Stock Katherine Calomiris Tompros 5100 Van Ness Street, N.W. Washington, D.C. 20016 190,638 shares(7) 6.15% - ----------------- (1) Does not include presently exercisable warrants to purchase 9,166, 20,000 and 13,334 shares held, respectively, by Charles W. Calomiris, Dr. Schattner, and The Ochsman Children Trust under the Greater Atlantic Financial Corp. 1997 Stock Option Plan, or shares of preferred securities presently convertible into 114,841, 330,099 and 69,545 shares of common stock held, respectively, by Charles W. Calomiris Dr. Schattner and the Ochsman Children Trust. (2) The information furnished is derived from a Schedule 13D filed by Charles W. Calomiris on July 25, 2003, and a Form 4 filed on July 24, 2003. (3) The information furnished is derived from a Schedule 13D and a Form 4 filed by Robert I Schattner filed on December 10, 2002. (4) The information furnished is derived from a Schedule 13D filed by The Ochsman Children Trust on April 9, 2002. (5) Includes presently exercisable warrants to purchase 9,167 shares and shares of preferred securities presently convertible into 85,754 shares of common stock held by George W. Calomiris. The information furnished is derived from a Schedule 13D filed by George Calomiris on December 7, 2004. (6) Includes presently exercisable warrants to purchase 9,167 shares and shares of preferred securities presently convertible into 79,747 shares of common stock held by Jenifer Calomiris. The information furnished is derived from a Schedule 13D filed by Jenifer Calomiris on March 21, 2003. (7) Includes presently exercisable warrants to purchase 9,167 shares and shares of preferred securities presently convertible into 79,747 shares of common stock held by Katherine Calomiris Tompros. The information furnished is derived from a Schedule 13D filed by Katherine Calomiris Tompros on March 21, 2003. 45 46 INFORMATION WITH RESPECT TO DIRECTORS AND EXECUTIVE OFFICERS The following table sets forth, as of December 17, 2004, the names of the directors, and executive officers of the Company as well as their ages; a brief description of their recent business experience, including present occupations and employment; certain directorships held by each; the year in which each became a director of the Company and the year in which his term as director of the Company expires. This table also sets forth the amount of Common Stock and the percent thereof beneficially owned as of the December 17, 2004 by each director and all directors and executive officers as a group as of the December 17, 2004. Expiration Shares of Name and Principal of Common Stock Ownership as a Occupation at Present Director Term as Beneficially Percent of and for Past Five Years Age Since(1) Director Owned(1) Class - ------------------------------------------------ -------- ----------- ----------- ------------- ---------------- Charles W. Calomiris, Chairman of the 47 2001 2005 176,807(2)(3) 5.87% Board of the Company, is the Henry Kaufman Professor of Finance and Economics at the Columbia University Graduate School of Business. Carroll E. Amos, President and Chief 57 1997 2005 44,060(4) 1.46% Executive Officer of the Company, is a private investor who until 1996 served as President and Chief Executive Officer of 1st Washington Bancorp and Washington Federal Savings Bank. James B. Vito is Managing General 79 1998 2005 76,942(2) 2.32% Partner, James Properties, engaged in the sale and management of property. Paul J. Cinquegrana is a Principal of 63 1997 2006 52,134(2) 1.73% Washington Securities Corporation, stock and bond brokerage firm. Jeffrey W. Ochsman is an attorney and 52 1999 2006 500 * partner of the law firm of Friedlander, Misler, Sloan, Kletzkin & Ochsman, PLLC. Jeffrey M. Gitelman, D.D.S., is an Oral 60 1997 2007 84,913(2) 2.82% Surgeon and the owner of Jeffrey M. Gitelman - D.D.S., P.C. Sidney M. Bresler is a Director, Chief 50 2003 2007 500 * Executive Officer and Chief Operating Officer of Bresler & Reiner, Inc. engaged in residential land development and construction and rental property ownership and management. 46 47 Shares of Name and Principal Common Stock Occupation at Present Beneficially Ownership as A and for Past Five Years Age Owned(1) Percent of Class - --------------------------------------------------------- -------- -------------- ------------------- EXECUTIVE OFFICERS WHO ARE NOT DIRECTORS David E. Ritter joined the Bank and the Company as 54 300(4) * a Senior Vice President and Chief Financial Officer in 1998. Laurel L. Mitchell joined the Bank and Company as 46 Corporate Secretary in October, 1999, after two years as an Executive Assistant with Collier, Shannon, Rill & Scott, PLLC, a Washington, D.C. law firm. All directors and executive officers as a group (eight 436,156 14.48% persons)(3) (1) Each person effectively exercises sole voting or dispositive power as to shares reported. (2) Does not include presently exercisable warrants to purchase 9,166, 3,334, 3,334, and 2,000 shares, respectively, held by Messrs. Calomiris, Gitelman, Cinquegrana, and Vito under the Greater Atlantic Financial Corp. 1997 Stock Option Plan, or shares of preferred securities presently convertible into 114,841, 33,874, 23,500, 17,387, and 6,431 shares of common stock held, respectively, by Messrs. Calomiris, Vito, Cinquegrana, Gitelman and Amos. (3) Includes 128,727 shares held directly, 10,000 shares held by his spouse and 38,080 shares held as custodian for minor children. (4) Does not include presently exercisable options to purchase 75,000 shares granted to Mr. Amos or 18,000 granted to Mr. Ritter under the Greater Atlantic Financial Corp. 1997 Stock Option and Warrant Plan. * Does not exceed 1.0% of the Company's Common Stock. The following table summarizes share and exercise price information about the Company's equity compensation plans as of September 30, 2004. Number of securities remaining available for Number of securities to be future issuance under equity issued upon exercise of Weighted-average exercise compensation plans outstanding options, warrants price of outstanding options, (excluding securities Plan category and rights warrants and rights reflected in column (a)) - ------------------------------------------------------------------------------------------------------------------------------- Equity compensation plans approved by security holders: 1997 Stock Option and Warrant Plan 444,685 $6.99 124,000 Equity compensation plans not approved by security holders N/A N/A N/A - ------------------------------------------------------------------------------------------------------------------------------- Total 444,685 $6.99 124,000 =============================================================================================================================== 47 48 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Federal regulations require that all loans or extensions of credit to executive officers and directors must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with the general public and must not involve more than the normal risk of repayment or present other unfavorable features. In addition, loans made to a director or executive officer in excess of the greater of $25,000 or 5% of the bank's capital and surplus (up to a maximum of $500,000) must be approved in advance by a majority of the disinterested members of the board of directors. The Bank currently makes loans to its executive officers and directors on the same terms and conditions offered to the general public. The Bank's policy provides that all loans made by the Bank to its executive officers and directors be made in the ordinary course of business, on substantially the same terms, including collateral, as those prevailing at the time for comparable transactions with other persons and may not involve more than the normal risk of collectibility or present other unfavorable features. As of September 30, 2004, one of the Bank's directors had loans with the bank which had outstanding balances totaling $389,000. Such loans were made by the bank in the ordinary course of business, with no favorable terms and do not involve more than the normal risk of collectibility or present unfavorable features. The Company's policy is that all transactions between the Company and its executive officers, directors, holders of 10% or more of the shares of any class of its common stock and affiliates thereof, will contain terms no less favorable to the Company than could have been obtained by it in arm's length negotiations with unaffiliated persons and will be approved by a majority of independent outside directors of the Company not having any interest in the transaction. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES AUDIT FEES BDO Seidman, LLP billed the Company aggregate fees of $181,907 and $158,976 for professional services rendered for the audit of the Company's annual consolidated financial statements and for the reviews of the condensed consolidated financial statements included in the Company's Forms 10-Q for the fiscal year ended September 30, 2004 and 2003, respectively. The audit committee has not adopted pre-approved policies and procedures. Before the company or any subsidiary engages an accountant, the company's audit committee approves the engagement. AUDIT-RELATED FEES BDO Seidman, LLP did not provide any such services to the Company for the fiscal year ended September 30, 2004 or 2003. TAX FEES BDO Seidman billed the Company $17,824 and $19,745 for tax services for the fiscal year ended September 30, 2004 and 2003, respectively. Tax fees represented 8.92% of the fees paid to BDO Seidman, LLP in fiscal year 2004 and 11.05% in fiscal year 2003. PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) 1. FINANCIAL STATEMENTS See Index to Consolidated Financial Statements on page 50 2. FINANCIAL STATEMENT SCHEDULES All schedules are omitted because they are not required or applicable, or the required information is shown in the consolidated financial statements or the notes thereto. (b) EXHIBITS 23.1 Consent of BDO Seidman, LLP 31.1 Certification of Chief Executive Officer 31.2 Certification of Chief Financial Officer 32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350 32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350 48 49 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. GREATER ATLANTIC FINANCIAL CORP. By: /s/ Carroll E. Amos -------------------------------------- Carroll E. Amos Chief Executive Officer and President and Director Dated: December 27, 2004 Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed by the following persons of the registrant and in the capacities and on the dates indicated. Name Title Date ---- ----- ---- /s/ Charles W. Calomiris ------------------------ Charles W. Calomiris Chairman of the Board December 27, 2004 /s/ Carroll E. Amos Chief Executive Officer, ------------------- and President and Director December 27, 2004 Carroll E. Amos --------------------- Sidney M. Bresler Director /s/ Paul J. Cinquegrana ----------------------- Paul J. Cinquegrana Director December 27, 2004 /s/ Jeffrey M. Gitelman ----------------------- Jeffrey M. Gitelman Director December 27, 2004 /s/ Jeffrey W. Ochsman ---------------------- Jeffrey W. Ochsman Director December 27, 2004 /s/ James B. Vito ----------------- James B. Vito Director December 27, 2004 /s/ David E. Ritter Senior Vice President and ------------------- Chief Financial Officer December 27, 2004 David E. Ritter 49 50 CONSOLIDATED FINANCIAL STATEMENTS OF GREATER ATLANTIC FINANCIAL CORP. INDEX Page ---- Report of Independent Registered Public Accounting Firm 51 Consolidated Statements of Financial Condition as of September 30, 2004 and 2003 52 Consolidated Statements of Operations for the Years Ended September 30, 2004, 2003 and 2002 53 Consolidated Statements of Comprehensive Income (Loss) for the Years Ended September 30, 2004, 2003 and 2002 54 Consolidated Statements of Stockholders' Equity for the Years Ended September 30, 2004, 2003 and 2002 54 Consolidated Statements of Cash Flows for the Years Ended September 30, 2004, 2003 and 2002 55 Notes to Consolidated Financial Statements 57 50 51 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Stockholders Greater Atlantic Financial Corp. Reston, Virginia We have audited the accompanying consolidated statements of financial condition of Greater Atlantic Financial Corp. and Subsidiaries as of September 30, 2004 and 2003, and the related consolidated statements of operations, comprehensive income (loss), stockholders' equity, and cash flows for each of the three years in the period ended September 30, 2004. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Greater Atlantic Financial Corp. and Subsidiaries at September 30, 2004 and 2003 and the results of their operations and their cash flows for each of the three years in the period ended September 30, 2004 in conformity with accounting principles generally accepted in the United States of America. /s/ BDO Seidman, LLP Richmond, Virginia November 19, 2004 51 52 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION September 30, --------------------------------- 2004 2003 ---------------------------------------------------------------------------------------------------------------------- (Dollars in Thousands) Assets Cash and cash equivalents $ 2,532 $ 2,029 Interest bearing deposits 8,071 4,114 Investment securities Available-for-sale 142,712 211,408 Held-to-maturity 10,295 13,376 Loans held for sale 5,528 6,554 Loans receivable, net 246,387 242,253 Accrued interest and dividends receivable 1,940 2,299 Deferred income taxes 2,034 1,520 Federal Home Loan Bank stock, at cost 4,085 4,340 Premises and equipment, net 7,275 7,948 Goodwill 1,284 1,284 Prepaid expenses and other assets 2,227 2,229 ---------------------------------------------------------------------------------------------------------------------- Total Assets $ 434,370 $ 499,354 ====================================================================================================================== Liabilities and stockholders' equity Liabilities Deposits $ 288,956 $ 297,876 Advance payments from borrowers for taxes and insurance 305 225 Accrued expenses and other liabilities 2,535 5,919 Advances from the FHLB and other borrowings 116,065 164,635 Junior subordinated debt securities 9,369 9,359 ---------------------------------------------------------------------------------------------------------------------- Total liabilities 417,230 478,014 ---------------------------------------------------------------------------------------------------------------------- Commitments and contingencies ---------------------------------------------------------------------------------------------------------------------- Stockholders' Equity Preferred stock $.01 par value - 2,500,000 shares authorized, none outstanding - - Common stock, $.01 par value - 10,000,000 shares authorized; 3,012,434 shares outstanding 30 30 Additional paid-in capital 25,152 25,152 Accumulated deficit (6,963) (3,771) Accumulated other comprehensive loss (1,079) (71) ---------------------------------------------------------------------------------------------------------------------- Total stockholders' equity 17,140 21,340 ---------------------------------------------------------------------------------------------------------------------- Total liabilities and stockholders' equity $ 434,370 $ 499,354 ====================================================================================================================== See accompanying notes to consolidated financial statements. 52 53 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS Year Ended September 30, ------------------------------------------------- 2004 2003 2002 - -------------------------------------------------------------------------------------------------------------------------- (Dollars in Thousands, Except Per Share Data) Interest income Loans $ 13,506 $ 14,369 $ 14,039 Investments 5,456 6,618 7,743 - -------------------------------------------------------------------------------------------------------------------------- Total interest income 18,962 20,987 21,782 - -------------------------------------------------------------------------------------------------------------------------- Interest expense Deposits 5,751 6,673 8,308 Borrowed money 6,604 6,376 5,427 - -------------------------------------------------------------------------------------------------------------------------- Total interest expense 12,355 13,049 13,735 - -------------------------------------------------------------------------------------------------------------------------- Net interest income 6,607 7,938 8,047 Provision for loan losses 209 855 968 - -------------------------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses 6,398 7,083 7,079 - -------------------------------------------------------------------------------------------------------------------------- Noninterest income Fees and service charges 992 1,475 996 Gain on sale of loans 9,191 17,373 8,432 Gain (loss)on sale of investment securities (58) 35 198 Gain (loss) on derivatives (227) 9 (3,512) Loss on sale of real estate owned - (24) - Other operating income 31 21 64 - -------------------------------------------------------------------------------------------------------------------------- Total noninterest income 9,929 18,889 6,178 - -------------------------------------------------------------------------------------------------------------------------- Noninterest expense Compensation and employee benefits 8,401 13,706 7,898 Occupancy 2,161 1,963 1,788 Professional services 917 1,329 782 Advertising 2,563 1,072 779 Deposit insurance premium 44 46 43 Furniture, fixtures and equipment 1,139 1,069 875 Data processing 1,465 1,317 1,134 Other real estate owned expenses - 5 - Other operating expenses 2,740 3,204 2,540 - -------------------------------------------------------------------------------------------------------------------------- Total noninterest expense 19,430 23,711 15,839 - -------------------------------------------------------------------------------------------------------------------------- Net income (loss) before income tax provision (3,103) 2,261 (2,582) Income tax provision 89 - - ========================================================================================================================== Net income (loss) $ (3,192) $ 2,261 $ (2,582) ========================================================================================================================== Basic earnings (loss) per share $ (1.06) $ 0.75 $ (0.86) ========================================================================================================================== Diluted earnings (loss) per share $ (1.06) $ 0.60 $ (0.86) ========================================================================================================================== See accompanying notes to consolidated financial statements. 53 54 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) Year Ended September 30, --------------------------------------------- 2004 2003 2002 ----------------------------------------------------------------------------------------------------- (In Thousands) Net (loss) income $ (3,192) $ 2,261 $ (2,582) ----------------------------------------------------------------------------------------------------- Other comprehensive (loss) income, net of tax: Unrealized (loss) income on securities (1,008) 16 445 ----------------------------------------------------------------------------------------------------- Other comprehensive (loss) income (1,008) 16 445 ----------------------------------------------------------------------------------------------------- Comprehensive (loss) income $ (4,200) $ 2,277 $ (2,137) ===================================================================================================== See accompanying notes to consolidated financial statements GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY - ------------------------------------------------------------------------------------------------------------------------ Accumulated Additional Accumulated Other Total Preferred Common Paid-in Earnings Comprehensive Stockholders' Stock Stock Capital (Deficit) Income (Loss) Equity - ------------------------------------------------------------------------------------------------------------------------ (DOLLARS IN THOUSANDS) Balance at September 30, 2001 $ - $ 30 $ 25,132 $ (3,450) $ (532) $ 21,180 Options exercised - - 20 - - 20 Other comprehensive income - - - - 445 445 Net loss for the period - - - (2,582) - (2,582) - ------------------------------------------------------------------------------------------------------------------------ Balance at September 30, 2002 - 30 25,152 (6,032) (87) 19,063 Other comprehensive income - - - - 16 16 Net income for the period - - - 2,261 - 2,261 - ------------------------------------------------------------------------------------------------------------------------ Balance at September 30, 2003 - 30 25,152 (3,771) (71) 21,340 Other comprehensive loss - - - - (1,008) (1,008) Net loss for the period - - - (3,192) - (3,192) - ------------------------------------------------------------------------------------------------------------------------ Balance at September 30, 2004 $ - $30 $ 25,152 $ (6,963) $(1,079) $ 17,140 ======================================================================================================================== See accompanying notes to consolidated financial statements 54 55 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended September 30, ------------------------------------------------ 2004 2003 2002 ----------------------------------------------------------------------------------------------------------------------------- (In Thousands) Cash flow from operating activities Net income (loss) $ (3,192) $ 2,261 $ (2,582) Adjustments to reconcile net income (loss) to net cash Provided (used) by operating activities Provision for loan losses 209 855 968 Amortization of deposit acquisition adjustment - 23 92 Amortization of loan acquisition adjustment (27) (18) (27) Depreciation and amortization 986 864 714 Proceeds from sale of trading securities - - 1,129 Proceeds from repayments of trading securities - - 183 Amortization of trading security premiums - - 8 Realized loss (gain) on trading securities 135 38 (9) Realized gain on sale of investments (77) (73) (125) Realized gain on sale of mortgaged-backed securities - - (64) Loss (gain) on derivatives 227 (9) 3,512 Amortization of investment security premiums 1,573 1,837 2,736 Amortization of mortgage-backed security premiums 1,453 740 515 Amortization of deferred fees (563) (396) (312) Discount accretion net of premium amortization 628 710 328 Loss on disposal of fixed assets - 11 - Loss on sale of foreclosed real estate - 24 - Gain on sale of loans held for sale (9,191) (17,373) (8,432) (Increase) decrease in assets Disbursements for origination of loans (402,988) (722,121) (424,730) Proceeds from sales of loans 413,204 747,398 433,292 Accrued interest and dividend receivable 359 560 (82) Prepaid expenses and other assets (261) 425 (1,736) Deferred loan fees collected, net of deferred costs incurred 436 231 1,439 Increase (decrease) in liabilities Accrued expenses and other liabilities (3,382) 1,055 686 ----------------------------------------------------------------------------------------------------------------------------- Net cash provided (used) by operating activities $ (471) $ 17,042 $ 7,503 ============================================================================================================================= (Continued) 55 56 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS - (CONTINUED) Year Ended September 30, -------------------------------------- 2004 2003 2002 ----------------------------------------------------------------------------------------------------------------------------- (In Thousands) Cash flow from investing activities Net decrease (increase) in loans $ (4,817) $ 4,414 $ (85,875) Purchases of premises and equipment (312) (1,034) (2,153) Proceeds from sales of foreclosed real estate - 104 - Purchases of investment securities (25,748) (31,113) (66,447) Proceeds from sale of investment securities 67,843 1,035 16,423 Proceeds from repayments of investment securities 33,235 47,808 21,873 Purchases of mortgage-backed securities (63,056) (61,851) (38,341) Proceeds from sale of mortgage-backed securities - - 5,601 Proceeds from repayments of mortgage-backed securities 54,932 26,171 18,020 Purchases of FHLB stock (15,875) (14,488) (3,475) Proceeds from sale of FHLB stock 16,130 15,638 1,895 ----------------------------------------------------------------------------------------------------------------------------- Net cash provided (used) in investing activities 62,332 (13,316) (132,479) ----------------------------------------------------------------------------------------------------------------------------- Cash flow from financing activities Net (decrease) increase in deposits (8,920) 15,976 51,804 Net (repayments) advances from FHLB (35,600) (9,700) 22,000 Net borrowings (repayments) on reverse repurchase agreements and other borrowings (12,971) (13,175) 47,688 Increase (decrease) in advance payments by borrowers for taxes and insurance 81 (55) 58 Issuance of convertible preferred securities - - 9,346 Amortization of convertible preferred stock costs 9 13 - Exercise of stock options - - 20 ----------------------------------------------------------------------------------------------------------------------------- Net cash (used) provided by financing activities (57,401) (6,941) 130,916 ----------------------------------------------------------------------------------------------------------------------------- Increase (decrease) in cash and cash equivalents 4,460 (3,215) 5,940 ----------------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents, at beginning of period 6,143 9,358 3,418 ----------------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents, at end of period $ 10,603 $ 6,143 $ 9,358 ============================================================================================================================= See accompanying notes to consolidated financial statements. 56 57 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES NATURE OF OPERATIONS Greater Atlantic Financial Corp. (GAFC or the "Company") is a bank holding company whose principal activity is the ownership and management of Greater Atlantic Bank (GAB or "the Bank"), and its wholly owned subsidiary, Greater Atlantic Mortgage Corporation (GAMC). The Bank originates commercial, mortgage and consumer loans and receives deposits from customers located primarily in Virginia, Washington, D.C. and Maryland. The Bank operates under a federal bank charter and provides full banking services. GAMC was incorporated as a separate entity on June 11, 1998 and began independent operations on September 1, 1998. GAMC is involved primarily in the origination and sale of single-family mortgage loans and, to a lesser extent, multi-family residential and second mortgage loans. GAMC also originates loans for the Bank's portfolio. In January 2002, GAFC established Greater Atlantic Capital Trust I to issue certain convertible preferred securities (see Note 20). PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of GAFC and its wholly owned subsidiaries, GAB, GAMC and Greater Atlantic Capital Trust I. All significant intercompany accounts and transactions have been eliminated in consolidation. RISK AND UNCERTAINTIES In its normal course of business, the Company encounters two significant types of risk: economic and regulatory. There are three main components of economic risk: interest rate risk, credit risk and market risk. The Company is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice more rapidly, or on a different basis, than its interest-earning assets. Credit risk is the risk of default on the Company's loan portfolio that results from the borrowers' inability or unwillingness to make contractually required payments. Market risk reflects changes in the value of collateral underlying loans receivable and the valuation of real estate held by the Company. The determination of the allowance for loan losses and the valuation of real estate are based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions. Management believes that, as of September 30, 2004 and September 30, 2003, the allowance for loan losses and valuation of real estate are adequate based on information currently available. A worsening or protracted economic decline would increase the likelihood of losses due to credit and market risks and could create the need for substantial additional loan loss reserves. See discussion of regulatory matters in Note 12. CONCENTRATION OF CREDIT RISK The Company's primary business activity is with customers located in Maryland, Virginia and the District of Columbia. The Company primarily originates residential loans to customers throughout these areas, most of who are residents local to the Company's business locations. The Company has a diversified loan portfolio consisting of residential, commercial and consumer loans. Commercial and consumer loans generally provide for higher interest rates and shorter terms, however such loans have a higher degree of credit risk. Management monitors all loans, including, when possible, making inspections of the properties, maintaining current operating statements, and performing net realizable value calculations, with allowances for losses established as necessary to properly reflect the value of the properties. Management believes the current loss allowances are sufficient to cover the credit risk estimated to exist at September 30, 2004. 57 58 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS INVESTMENT SECURITIES Investment securities, which the Company has the intent and ability to hold to maturity, are carried at amortized cost. The amortization of premiums and accretion of discounts are recorded on the level yield (interest) method, over the period from the date of purchase to maturity. When sales do occur, gains and losses are recognized at the time of sale and the determination of cost of securities sold is based upon the specific identification method. Investment securities which the Company intends to hold for indefinite periods of time, use for asset/liability management or that are to be sold in response to changes in interest rates, prepayment risk, the need to increase regulatory capital or other similar factors are classified as available-for-sale and carried at fair value with unrealized gains and losses excluded from earnings and reported in a separate component of stockholders' equity. If a sale does occur, gains and losses are recognized as a component of earnings at the time of the sale. The amortization of premiums and accretion of discounts are recorded on the level yield (interest) method. Investment securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings. LOANS AND ALLOWANCE FOR LOAN LOSSES Loans receivable are stated at unpaid principal balances, net of unearned discounts resulting from add-on interest, participation or whole-loan interests owned by others, undisbursed loans in process, deferred loan fees, and allowances for loan losses. Loans are placed on non-accrual status when the principal or interest is past due more than 90 days or when, in management's opinion, collection of principal and interest is not likely to be made in accordance with a loan's contractual terms. The allowance for loan losses provides for the risk of losses inherent in the lending process. The allowance for loan losses is based on periodic reviews and analyses of the loan portfolio which include consideration of such factors as the risk rating of individual credits, the size and diversity of the portfolio, economic conditions, prior loss experience and results of periodic credit reviews of the portfolio. The allowance for loan losses is increased by provisions for loan losses charged against income and reduced by charge-offs, net of recoveries. In management's judgment, the allowance for loan losses is considered adequate to absorb losses inherent in the loan portfolio at September 30, 2004. The Company considers a loan to be impaired if it is probable that they will be unable to collect all amounts due (both principal and interest) according to the contractual terms of the loan agreement. When a loan is deemed impaired, the Company computes the present value of the loan's future cash flows, discounted at the effective interest rate. As an expedient, creditors may account for impaired loans at the fair value of the collateral or at the observable market price of the loan if one exists. If the present value is less than the carrying value of the loan, a valuation allowance is recorded. For collateral dependent loans, the Company uses the fair value of the collateral, less estimated costs to sell, on a discounted basis, to measure impairment. Mortgage loans originated and intended for sale are carried at the lower of cost or estimated market value in the aggregate. Net unrealized losses are recognized in a valuation allowance by charges to income. DERIVATIVE FINANCIAL INSTRUMENTS The Company uses derivative financial instruments to mitigate market risk from changes in interest rates. Our derivative financial instruments are contracted in the over-the-counter market and include interest rate swaps. Derivative financial instruments are accounted for in accordance with Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133), which requires that all derivative instruments be recorded on the balance sheet at fair value. Changes in the fair value of derivatives are recorded each period either in current results of operations or other comprehensive income (loss). For a derivative designated as part of a hedge transaction, where it is recorded is dependent on whether it is a fair value hedge or a cash flow hedge. For a derivative designated as a fair value hedge, the gain or loss of the derivative in the period of change and the offsetting loss or gain of the hedged item attributed to the hedged risk are recognized in results of operations. For a derivative designated as a cash flow hedge, the effective portion of the derivative's gain or loss is initially reported as a component of other comprehensive income (loss) and subsequently reclassified into results of operations when the hedged exposure affects results of operations. The ineffective portion of the gain or loss of a cash flow hedge is recognized currently in results of operations. For a derivative not designated as a hedging instrument, the gain or loss is recognized currently in results of operations. 58 59 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MORTGAGE LOAN INCOME, DISCOUNTS AND PREMIUMS Interest income on loans is recorded on the accrual method. Discounts and premiums relating to mortgage loans purchased are deferred and amortized against or accreted into income over the estimated lives of the loans using the level yield (interest) method. Accrual of interest is discontinued and an allowance for uncollected interest is established and charged to interest income for the full amount of accrued interest receivable on loans, which are delinquent for a period of 90 days or more. LOAN ORIGINATION AND COMMITMENT FEES Loan origination and commitment fees and certain incremental direct loan origination costs are being deferred with the net amount being amortized as an adjustment of the related loan's yield. The Company is amortizing those amounts over the contractual life of the related loans as adjusted for anticipated prepayments using current and past payment trends. MORTGAGE LOAN SALES AND SERVICING The Company originates and sells loans and participating interest in loans generally without retaining servicing rights. Loans are sold to provide the Company with additional funds and to generate gains from mortgage banking operations. Loans originated for sale are carried at the lower of cost or market. When a loan and the related servicing are sold the Company recognizes any gain or loss at the time of sale. When servicing is retained on a loan that is sold, the Company recognizes a gain or loss based on the present value of the difference between the average constant rate of interest it receives, adjusted for a normal servicing fee, and the yield it must pay to the purchaser of the loan over the estimated remaining life of the loan. Any resulting net premium is deferred and amortized over the estimated life of the loan using a method approximating the level yield (interest) method. There were no loans sold with servicing rights retained during the years ended September 30, 2004 and September 30, 2003. The Company also sells participation interests in loans that it services. PREMISES AND EQUIPMENT Premises and equipment are recorded at cost. Depreciation is computed on the straight-line method over useful lives ranging from five to ten years. Leasehold improvements are capitalized and amortized using the straight-line method over the life of the related lease. FORECLOSED REAL ESTATE Real estate acquired through foreclosure is recorded at the lower of cost or fair value less estimated selling costs. Subsequent to the date of foreclosure, valuation adjustments are made, if required, to the lower of cost or fair value less estimated selling costs. Costs related to holding the real estate, net of related income, are reflected in operations when incurred. Recognition of gains on sale of real estate is dependent upon the transaction meeting certain criteria relating to the nature of the property sold and the terms of the sale. GUARANTEED CONVERTIBLE PREFERRED SECURITIES On July 1, 2003, the Company adopted Statement of Financial Accounting Standards No. 150, "Accounting for Mandatorily Redeemable Securities" ("SFAS 150"). SFAS 150 requires that the Company classify redeemable securities with a mandatory redemption date as liabilities in its balance sheet and classify distributions related to such securities as interest expense. Also, SFAS 150 requires that the redeemable securities be reflected at fair market value when reclassified as a liability. Accordingly, the guaranteed convertible preferred securities have been reclassified as a liability at September 30, 2003. The Company has consistently accounted for distributions related to these securities as interest expense, and since the Company sold the securities in a public offering, there was no fair market value adjustment necessary. 59 60 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS INCOME TAXES Income taxes are calculated using the liability method specified by Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". The net deferred tax asset is reduced, if necessary, by a valuation allowance for the amount of any tax benefits that, based on available evidence, are not expected to be realized (See Note 10). CASH AND CASH EQUIVALENTS The Company considers cash and interest bearing deposits in other banks as cash and cash equivalents for purposes of preparing the statement of cash flows. USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. COMPREHENSIVE INCOME Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"), establishes standards for the reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income is defined to include all changes in equity except those resulting from investments by owners and distributions to owners. Among other disclosures, SFAS 130 requires that all items that are required to be recognized under current accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. Presently, the Company's comprehensive income and loss is from unrealized gains and losses on certain investment securities. STOCK-BASED COMPENSATION The Company has adopted the disclosure only provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), but it continues to measure compensation cost for the stock options using the intrinsic value method prescribed by APB Opinion No. 25. As allowable under SFAS 123, the Company used the Black-Sholes method to measure the compensation cost of stock options granted in 2004 with the following assumptions: risk-free interest rate of 4.41%, a dividend payout rate of zero, and an expected option life of ten years. The volatility is 66%. Using these assumptions, the fair value of stock options granted during fiscal 2004 was $5.75. There were no adjustments made in calculating the fair value to account for vesting provisions, for non-transferability or risk of forfeiture. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. If the Company had elected to recognize compensation cost based on the value at the grant dates with the method prescribed by SFAS 123, net income and earnings per share would have been changed to the pro forma amounts indicated in the following table: 60 61 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Year Ended September 30, ------------------------------------------- 2004 2003 2002 - ----------------------------------------------------------------------------------------------------------- (In Thousands, Except Per Share Data) Net (loss) income as reported $ (3,192) $ 2,261 $ (2,582) Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (128) - (165) - ----------------------------------------------------------------------------------------------------------- Pro Forma net income (loss) $ (3,320) $ 2,261 $ (2,747) =========================================================================================================== Basic income (loss) per common share: As reported $ (1.06) $ 0.75 $ (0.86) Pro Forma (1.10) 0.75 (0.91) - ----------------------------------------------------------------------------------------------------------- Diluted income (loss) per common share: As reported $ (1.06) $ 0.60 $ (0.86) Pro Forma (1.10) 0.60 (0.91) - ----------------------------------------------------------------------------------------------------------- RECLASSIFICATIONS Certain prior year amounts have been reclassified to conform to the current method of presentation. These reclassifications have no effect on the results of operations previously reported. 61 62 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Investments Available-for-Sale, September 30, 2004 - ------------------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Market Cost Gains Losses Value - ------------------------------------------------------------------------------------------------------------------- (In Thousands) Investment securities SBA notes $ 36,919 $ 84 $ 282 $ 36,721 CMOs 9,812 17 6 9,823 Corporate debt securities 3,923 42 37 3,928 - ------------------------------------------------------------------------------------------------------------------- 50,654 143 325 50,472 - ------------------------------------------------------------------------------------------------------------------- Mortgage-backed securities FNMA notes 61,195 4 897 60,302 GNMA notes 17,946 - 93 17,853 FHLMC notes 14,146 10 71 14,085 - ------------------------------------------------------------------------------------------------------------------- 93,287 14 1,061 92,240 - ------------------------------------------------------------------------------------------------------------------- $ 143,941 $157 $ 1,386 $ 142,712 =================================================================================================================== Held-to-Maturity, September 30, 2004 - -------------------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Market Cost Gains Losses Value - -------------------------------------------------------------------------------------------------------------------- (In Thousands) Investment securities SBA notes $ 8,810 $ - $ 383 $ 8,427 Corporate debt securities 1,003 62 - 1,065 - -------------------------------------------------------------------------------------------------------------------- 9,813 62 383 9,492 - -------------------------------------------------------------------------------------------------------------------- Mortgage-backed securities FNMA notes 237 - 2 235 FHLMC notes 245 2 - 247 - -------------------------------------------------------------------------------------------------------------------- 482 2 2 482 - -------------------------------------------------------------------------------------------------------------------- $ 10,295 $ 64 $ 385 $ 9,974 ==================================================================================================================== 62 63 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Available-for-Sale, September 30, 2003 - -------------------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Market Cost Gains Losses Value - -------------------------------------------------------------------------------------------------------------------- (In Thousands) Investment securities SBA notes $ 113,431 $ 998 $ 567 $ 113,862 CMOs 8,805 24 37 8,792 Corporate debt securities 2,892 26 - 2,918 - -------------------------------------------------------------------------------------------------------------------- 125,128 1,048 604 125,572 - -------------------------------------------------------------------------------------------------------------------- Mortgage-backed securities FNMA notes 70,684 41 370 70,355 GNMA notes 4,032 10 3 4,039 FHLMC notes 11,477 17 52 11,442 - -------------------------------------------------------------------------------------------------------------------- 86,193 68 425 85,836 - -------------------------------------------------------------------------------------------------------------------- $ 211,321 $ 1,116 $ 1,029 $ 211,408 ==================================================================================================================== Held-to-Maturity, September 30, 2003 - -------------------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Market Cost Gains Losses Value - -------------------------------------------------------------------------------------------------------------------- (In Thousands) Investment securities SBA notes $ 11,465 $ 12 $ 356 $ 11,121 Corporate notes 1,012 82 - 1,094 - -------------------------------------------------------------------------------------------------------------------- 12,477 94 356 12,215 - -------------------------------------------------------------------------------------------------------------------- Mortgage-backed securities FNMA notes 455 13 - 468 FHLMC notes 444 11 - 455 - -------------------------------------------------------------------------------------------------------------------- 899 24 - 923 - -------------------------------------------------------------------------------------------------------------------- $ 13,376 $ 118 $ 356 $ 13,138 ==================================================================================================================== The weighted average interest rate on investments was 3.70% and 4.10% for the years ended September 30, 2004 and 2003, respectively. TRADING ACTIVITIES The net gains (losses) on trading activities included in earnings are as follows: Year Ended September 30, ------------------------------------- 2004 2003 2002 - ----------------------------------------------------------------------------- (In Thousands) FHLB notes $ - $ - $ - Mortgage-backed securities (135) (38) 9 - ----------------------------------------------------------------------------- $(135) $ (38) $ 9 ============================================================================= 63 64 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Proceeds from the sale of available for sale securities were $67.8 million, $1.0 million and $16.4 million for the years ended September 30, 2004, 2003 and 2002, respectively. Gross realized gains were $77,000, $73,000 and $125,000 for the year ended September 30, 2004, 2003 and 2002, respectively. As of September 30, 2004, the bank held investments in available for sale with unrealized holding losses totaling $1.0 million, consisting of the following: Less than 12 months 12 months or more Total -------------------------- -------------------------- ------------------------- Fair Unrealized Fair Unrealized Fair Unrealized Description of Securities Value Losses Value Losses Value Losses - --------------------------------------------------------------------------------------------------------------- (In Thousands) Corporate debt securities $ 2,963 $ 37 $ - $ - $ 2,963 $ 37 CMOs 2,783 6 - - 2,783 6 U.S. Government securities SBA 23,775 282 - - 23,775 282 GNMA 17,853 93 - - 17,853 93 U.S. Government agency securities: FHLMC MBS's 5,959 71 - - 5,959 71 FNMA MBS's 58,808 887 487 10 59,295 897 - --------------------------------------------------------------------------------------------------------------- Total $112,141 $ 1,376 $ 487 $ 10 $ 112,628 $ 1,386 =============================================================================================================== Such unrealized holding losses are the result of an increase in market interest rates during fiscal 2004 and are not the result of credit or principal risk. Based on the nature of the investments and other considerations discussed above, management concluded that such unrealized losses were not other than temporary as of September 30, 2004 The amortized cost and estimated fair value of securities at September 30, 2004 and 2003, by contractual maturity, are as follows: September 30, 2004 September 30, 2003 --------------------------------------------------------- Amortized Fair Amortized Fair Cost Value Cost Value ----------------------------------------------------------------------------------------------------------- (In Thousands) Available-for-sale: One year or less $ - $ - $ - $ - After one year through five years 411 398 611 600 After five years through ten years 3,000 2,963 - - After ten years 47,243 47,111 124,517 124,972 Mortgage-backed securities 93,287 92,240 86,193 85,836 ----------------------------------------------------------------------------------------------------------- 143,941 142,712 211,321 211,408 ----------------------------------------------------------------------------------------------------------- Held-to-maturity: After one year through five years 1,599 1,624 1,840 1,857 After five years through ten years - - - - After ten years 8,214 7,868 10,637 10,358 Mortgage-backed securities 482 482 899 923 ----------------------------------------------------------------------------------------------------------- 10,295 9,974 13,376 13,138 ----------------------------------------------------------------------------------------------------------- Total investment securities $154,236 $152,686 $224,697 $224,546 =========================================================================================================== Actual maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. 64 65 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. LOANS RECEIVABLE Loans receivable consists of the following: September 30, ----------------------------------- 2004 2003 ---------------------------------------------------------------------------------------------------- (In Thousands) Mortgage loans: Single-family $ 80,083 $ 102,247 Multi-family 1,074 1,445 Construction 16,696 11,996 Commercial real estate 23,023 20,533 Land loans 20,668 17,258 ---------------------------------------------------------------------------------------------------- Total mortgage loans 141,544 153,479 Commercial loans 47,654 39,043 Consumer loans 73,400 64,725 ---------------------------------------------------------------------------------------------------- Total loans 262,598 257,247 Less: Due borrowers on loans-in process (10,453) (8,394) Deferred loan fees 625 816 Allowance for loan losses (1,600) (1,550) Unearned (discounts) premium 745 688 ---------------------------------------------------------------------------------------------------- $ 251,915 $ 248,807 ==================================================================================================== Loans held for sale $ 5,528 $ 6,554 Loans receivable, net 246,387 242,253 ---------------------------------------------------------------------------------------------------- $ 251,915 $ 248,807 ==================================================================================================== Loans held for sale are all single-family mortgage loans. The activity in allowance for loan losses is summarized as follows: Year Ended September 30, ---------------------------------------------------- 2004 2003 2002 - -------------------------------------------------------------------------------------------------------------------- (In Thousands) Balance, beginning $ 1,550 $ 1,699 $ 810 Provision for loan losses 209 855 968 Charge-offs (200) (1,020) (98) Recoveries 41 16 19 - -------------------------------------------------------------------------------------------------------------------- Balance, ending $ 1,600 $ 1,550 $ 1,699 ==================================================================================================================== The amount of loans serviced for others totaled $16.9 million and $11.7 million as of September 30, 2004 and September 30, 2003, respectively. The allowance for uncollected interest, established for mortgage loans which are delinquent for a period of 90 days or more, amounted to $108,000, $106,000 and $19,000 as of September 30, 2004, 2003 and September 30, 2002, respectively. This is the entire amount of interest income that would have been recorded in these periods under the contractual terms of such loans. Principal balances of non-performing loans related to reserves for uncollected interest totaled $953,000, $1.4 million and $454,000 as of September 30, 2004, 2003, and September 30, 2002, respectively. 65 66 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. ACCRUED INTEREST AND DIVIDENDS RECEIVABLE Accrued interest and dividends receivable consist of the following: September 30, ------------------------- 2004 2003 ------------------------------------------------------------------------------- (In Thousands) Investments $ 810 $ 1,210 Loans receivable 1,090 1,046 Accrued dividends on FHLB stock 40 43 ------------------------------------------------------------------------------- $ 1,940 $ 2,299 =============================================================================== 5. PREMISES AND EQUIPMENT Premises and equipment consists of the following: September 30, ------------------------- 2004 2003 - -------------------------------------------------------------------------------- (In Thousands) Furniture, fixtures and equipment $ 5,626 $ 4,938 Leasehold improvements 4,996 4,592 Land 694 1,573 - -------------------------------------------------------------------------------- 11,316 11,103 Less: Allowances for depreciation and amortization 4,041 3,155 - -------------------------------------------------------------------------------- $ 7,275 $ 7,948 ================================================================================ 66 67 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. FORECLOSED REAL ESTATE There was no foreclosed real estate as of September 30, 2004 or 2003. The cost of operations for foreclosed real consists of the following: Year Ended September 30, -------------------------------------------- 2004 2003 2002 --------------------------------------------------------------------------------------------------- (In Thousands) INCOME: Gain on sale $ - $ - $ - --------------------------------------------------------------------------------------------------- EXPENSE: Loss on sale - 24 - Provision for (recovery of) loss - - - Operating expenses - 5 - --------------------------------------------------------------------------------------------------- - 29 - --------------------------------------------------------------------------------------------------- Loss $ - $ 29 $ - =================================================================================================== There was no activity in the allowance for losses on foreclosed real estate in fiscal 2004, 2003 or 2002. 7. DEPOSITS Deposits are summarized as follows: September 30, 2004 -------------------------------------------------------------------------------------------------------- Ranges of Contractual % Amount Interest Rates of Total -------------------------------------------------------------------------------------------------------- (In Thousands) Savings accounts $ 14,266 0.00 - 1.09% 4.9% NOW/money market accounts 74,185 0.00 - 1.68% 25.7 Certificates of deposit 182,056 0.99 - 9.00% 63.0 Non-interest bearing demand deposits 18,449 0.00% 6.4 -------------------------------------------------------------------------------------------------------- $ 288,956 100.0% ======================================================================================================== September 30, 2003 -------------------------------------------------------------------------------------------------------- Ranges of Contractual % Amount Interest Rates of Total -------------------------------------------------------------------------------------------------------- (In Thousands) Savings accounts $ 11,893 0.00 - 1.09% 4.0% NOW/money market accounts 73,779 0.00 - 1.34% 24.8 Certificates of deposit 197,961 0.99 - 9.00% 66.4 Non-interest bearing demand deposits 14,243 0.00% 4.8 -------------------------------------------------------------------------------------------------------- $ 297,876 100.0% ======================================================================================================== 67 68 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Certificates of deposit as of September 30, 2004 mature as follows: Year ending September 30, Amount --------------------------------------------------------------------------------------------- (In Thousands) Thousands 2005 $ 105,090 2006 43,200 2007 19,335 2008 9,249 2009 and after 5,182 --------------------------------------------------------------------------------------------- $ 182,056 ============================================================================================= Interest expense on deposit accounts consists of the following: Year Ended September 30, -------------------------------------------- 2004 2003 2002 ------------------------------------------------------------------------------------------------------------ (In Thousands) NOW/money market accounts $ 852 $ 1,050 $ 1,621 Savings accounts 113 122 118 Certificates of deposit 4,786 5,501 6,569 ------------------------------------------------------------------------------------------------------------ $ 5,751 $ 6,673 $ 8,308 ============================================================================================================ Deposits, including certificates of deposit, with balances in excess of $100,000 totaled $94.9 million and $101.1 million at September 30, 2004, and September 30, 2003, respectively. 8. DEFERRED COMPENSATION PLAN On October 30, 1997, the Company adopted a deferred compensation plan. Under the deferred compensation plan, an employee may elect to participate by directing that all or part of his or her compensation be credited to a deferral account. The election must be made prior to the beginning of the calendar year. The deferral account bears interest at 6% per year. The amounts credited to the deferral account are payable in preferred stock or cash at the election of the Board of Directors on the date the Company announces a change in control or the date three years from the date the participant elects to participate in the deferred compensation plan. The liability associated with the plan was zero at September 30, 2004 and 2003, respectively. 68 69 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. ADVANCES FROM FEDERAL HOME LOAN BANK AND OTHER BORROWINGS The Bank has $162.5 million credit availability as of September 30, 2004 from the Federal Home Loan Bank of Atlanta (FHLB), which it uses to fund loans originated by Greater Atlantic Mortgage Corporation. Any advances in excess of $10 million are required to be collateralized with eligible securities. The credit availability is at the discretion of the FHLB. The following table sets forth information regarding the Bank's borrowed funds: At or For the Year Ended September 30, -------------------------------------------------- 2004 2003 2002 ---------------------------------------------------------------------------------------------------------------------- (Dollars in Thousands) FHLB advances: Average balance outstanding $ 116,155 $ 102,868 $ 99,269 Maximum amount outstanding at any month-end during the period 142,250 124,150 123,500 Balance outstanding at end of period 51,200 86,800 96,500 Weighted average interest rate during the period 2.39% 2.58% 3.10% Weighted average interest rate at end of period 3.93% 2.72% 3.12% Reverse repurchase agreements: Average balance outstanding 89,734 86,225 68,577 Maximum amount outstanding at any month-end during the period 93,730 89,850 95,577 Balance outstanding at end of period 64,865 77,835 91,011 Weighted average interest rate during the period 4.26% 4.31% 3.43% Weighted average interest rate at end of period 1.98% 1.25% 1.97% The Bank has pledged certain investments with carrying values of $71.1 million at September 30, 2004, to collateralize advances from the FHLB. First mortgage loans in the amount of $55.8 million and HELOC's in the amount of $35.6 million are also available to be pledged as collateral for the advances at September 30, 2004. 10. INCOME TAXES The company had no income tax provision in 2003 and 2002 as its pretax income was offset by existing net operating losses. The provision for income taxes differs from the amount of income tax determined by applying the applicable U.S. statutory federal income tax rate to pre-tax income (loss) as a result of the following differences: Year Ended September 30, -------------------------------------------- 2004 2003 2002 ---------------------------------------------------------------------------------------------------------- (In Thousands) Federal tax provision (benefit) $ (1,055) $ 776 $ (876) State tax provision (benefit) (121) 89 (103) (Increase) decrease in provision resulting from: Valuation changes 1,259 (871) 973 Permanent differences 6 6 6 ---------------------------------------------------------------------------------------------------------- Income tax provision $ 89 $ - $ - ========================================================================================================== 69 70 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Significant components of the Company's deferred tax assets and liabilities are as follows: September 30, -------------------------------- 2004 2003 --------------------------------------------------------------------------------------------- (In Thousands) Deferred tax assets Net operating loss carryforwards $ 3,810 $ 2,746 Unrealized losses on derivatives 249 734 Allowance for loan losses 532 553 Available for sale securities 589 - Core deposit intangible 65 65 Deferred loan fees 289 239 Other 87 79 --------------------------------------------------------------------------------------------- Total deferred tax assets 5,621 4,416 --------------------------------------------------------------------------------------------- Deferred tax liabilities FHLB stock dividends - 53 Tax over book depreciation 518 436 Other 106 109 --------------------------------------------------------------------------------------------- Total deferred tax liabilities 624 598 --------------------------------------------------------------------------------------------- Net deferred tax assets 4,997 3,818 Less: Valuation allowance 2,963 2,298 --------------------------------------------------------------------------------------------- Total $ 2,034 $ 1,520 ============================================================================================= Management has provided a valuation allowance for net deferred tax assets, due to the timing of the generation of future taxable income. At September 30, 2004, the Company has net operating loss carryforwards for federal income tax purposes of approximately $10.0 million, which expire in the years 2006 to 2021. As a result of the change in ownership of the Bank, approximately $1.5 million of the total net operating loss carryforwards are subject to an annual usage limitation of approximately $114,000. 70 71 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. COMMITMENTS AND CONTINGENCIES The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit, standby letters of credit, and financial guarantees. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. At September 30, 2004, the Company had outstanding commitments to originate and purchase loans and undisbursed construction mortgages aggregating approximately $63.3 million. Fixed rate commitments are at market rates as of the commitment dates and generally expire within 60 days. In addition, the Company was contingently liable under unfunded lines of credit for approximately $98.3 million and standby letters of credit for approximately $511,000. RENTAL COMMITMENTS The Company has entered into lease agreements for the rental of certain properties expiring on various dates through February 28, 2019. The future minimum rental commitments as of September 30, 2004, for all noncancellable lease agreements, are as follows: Years ending Rental September 30, Commitments ------------------------------------------------------- (In Thousands) 2005 $ 1,338 2006 1,196 2007 1,168 2008 1,150 2009 922 Thereafter 2,841 ------------------------------------------------------- Total $ 8,615 ======================================================= Net rent expense for the years ended September 30, 2004, 2003 and September 30, 2002 was $ 1.7 million, $1.6 million and $1.5 million, respectively. 71 72 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. REGULATORY MATTERS Generally, annual dividends to shareholders are limited to the amount of current year net income, plus the total net income for the preceding two years, adjusted for any prior year distributions. Under certain circumstances, regulatory approval would be required before making a capital distribution. The Bank did not pay any cash dividends during the year ended September 30, 2004, 2003 or 2002. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) created five categories of financial institutions based on the adequacy of their regulatory capital level: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. Under FDICIA, a well-capitalized financial institution is one with Tier 1 leverage capital of 5%, Tier 1 risk-based capital of 6% and total risk-based capital of 10%. At September 30, 2004 and September 30, 2003, the Bank was classified as a well capitalized financial institution. As part of FDICIA, the minimum capital requirements that the Bank is subject to are as follows: 1) tangible capital equal to at least 1.5% of adjusted total assets, 2) core capital equal to at least 4% of adjusted total assets and 3) total risk-based capital equal to at least 8% of risk-based assets. The following presents the Bank's capital position at September 30, 2004 and September 30, 2003: ------------------------------------------------------------------------------------------------------------- Required Required Actual Actual At September 30, 2004 Balance Percent Balance Percent Surplus ------------------------------------------------------------------------------------------------------------- (Dollars in Thousands) Tangible $ 6,498 1.50% $ 25,335 5.85% $ 18,837 Core $ 17,329 4.00% $ 25,335 5.85% $ 8,006 Risk-based $ 19,790 8.00% $ 26,843 10.85% $ 7,053 ============================================================================================================= ------------------------------------------------------------------------------------------------------------- Required Required Actual Actual At September 30, 2003 Balance Percent Balance Percent Surplus ------------------------------------------------------------------------------------------------------------- (Dollars in Thousands) Tangible $ 7,476 1.50% $ 29,176 5.85% $ 21,700 Core $ 19,936 4.00% $ 29,176 5.85% $ 9,240 Risk-based $ 18,792 8.00% $ 30,613 13.03% $ 11,821 ============================================================================================================= 72 73 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following is a reconciliation of the Bank's net worth as reported to the OTS on GAAP capital as presented in the accompanying financial statements. September 30, ------------------------------ 2004 2003 -------------------------------------------------------------------------------------------------- (In Thousands) GAAP capital $ 18,480 $ 22,410 Guaranteed convertible preferred securities 8,000 8,000 Unrealized losses on available for sale securities 1,079 50 Excluded deferred tax asset (940) - Goodwill (1,284) (1,284) -------------------------------------------------------------------------------------------------- Tangible capital 25,335 29,176 Adjustments - - -------------------------------------------------------------------------------------------------- Core capital 25,335 29,176 Allowance for general loss reserves 1,600 1,550 Adjustments to arrive at Risk-Weighted Assets (92) (113) -------------------------------------------------------------------------------------------------- Risk-based capital $ 26,843 $ 30,613 ================================================================================================== Failure to meet any of the three capital requirements causes savings institutions to be subject to certain regulatory restrictions and limitations including a limit on asset growth, and the requirement to obtain regulatory approval before certain transactions or activities are entered into. 13. STOCKHOLDERS' EQUITY Effective November 14, 1998, the Company established the 1997 Stock Option and Warrant Plan (the "Plan"). The Plan reserves options for 76,667 shares to employees and warrants for 94,685 shares to stockholders. The Plan was amended effective March 14, 2000, to increase the number of options available for grant from 76,667 to 225,000 shares to employees and amended again effective March 15, 2002, to increase the number of options available for grant from 225,000 to 350,000 shares to employees and to limit its application to officers and employees. The stock options and warrants vest immediately upon issuance and carry a maximum term of 10 years. The exercise price for the stock options and warrants is the fair market value at grant date. As of September 30, 2004, 94,685 warrants were issued. The following summary represents the activity under the Plan: ------------------------------------------------------------------------------------------------------------ Number Exercise Expiration of Shares Price Date ------------------------------------------------------------------------------------------------------------ Balance outstanding at September 30, 2001 139,000 Options granted 10,000 $ 5.31 12-14-2010 Options granted 26,000 $ 7.00 1-1-2012 Options granted 20,000 $ 9.00 1-1-2012 Options exercised (5,000) $ 4.00 ------------------------------------------------------------------------------------------------------------ Balance outstanding and exercisable at September 30, 2002 190,000 Options granted - $ - ------------------------------------------------------------------------------------------------------------ Balance outstanding and exercisable at September 30, 2003 190,000 Options granted 36,000 $ 8.50 10-20-13 ------------------------------------------------------------------------------------------------------------ Balance outstanding and exercisable at September 30, 2004 226,000 ============================================================================================================ 73 74 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A summary of the stock options outstanding and exercisable as of September 30, 2004 is as follows: ------------------------------------------------------------------------------------------------------------------- Options Outstanding Options Exercisable ----------------------------------------------------------- ---------------------------------------------------- Weighted Weighted Weighted Average Average Average Exercise Number Remaining Life Exercise Number Exercise Prices Outstanding (years) Price Exercisable Price ----------------- --------------------- ------------------- ------------- -------------------- ------------------- $7.50 16,667 3.2 $7.50 16,667 $7.50 $8.38 41,667 4.2 $8.38 41,667 $8.38 $6.00 17,500 5.2 $6.00 17,500 $6.00 $4.00 58,166 6.2 $4.00 58,166 $4.00 $5.31 10,000 6.2 $5.31 10,000 $5.31 $7.00 26,000 7.3 $7.00 26,000 $7.00 $9.00 20,000 7.3 $9.00 20,000 $9.00 $8.50 36,000 9.1 $8.50 36,000 $8.50 ----------------- --------------------- ------------------- ------------- -------------------- ------------------- 14. EARNINGS (LOSS) PER SHARE OF COMMON STOCK The Company reports earning per share in accordance with Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS 128"). SFAS 128 requires two presentations of earning per share - "basic" and "diluted." Basic earnings per share are computed by dividing income available to common stockholders (the numerator) for the period by the weighted average number of shares of common stock outstanding during the year (the denominator). The computation of diluted earnings per share is similar to basic earnings per share, except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potentially dilutive common shares had been issued. The following table presents a reconciliation between the basic and diluted earnings (loss) per share for the year ended September 30, 2004, 2003 and 2002: For the Year Ended September 30, ----------------------------------------------------------------------------------------------- 2004 2003 2002 ----------------------------- ----------------------------- ----------------------------- Per Per Per Share Share Share Income Shares Amount Income Shares Amount Income Shares Amount - ------------------------------------------------------------------------------------------------------------------------------- (Dollars in Thousands, Except Per Share Data) Basic earnings per share $(3,192) 3,012,434 $(1.06) $2,261 3,012,434 $0.75 $(2,582) 3,010,420 $(0.86) Effect of conversion of preferred securities 409 1,371,428 Effect of dilutive stock options - 29,600 - ------------------------------------------------------------------------------------------------------------------------------- Diluted $(3,192) 3,012,434 $(1.06) $2,670 4,413,462 $0.60 $(2,582) 3,010,420 $(0.86) =============================================================================================================================== The effect of the conversion of preferred securities and stock options were excluded in 2002 and 2004 as they would have been anti-dilutive. 15. RELATED PARTY TRANSACTIONS The Bank offers loans to its officers, directors, employees and related parties of such persons. These loans are made in the ordinary course of business and, in the opinion of management, do not involve more than the normal risk of collectibility, or present other unfavorable features. Such loans are made on the same terms as those prevailing at the time for comparable transactions with non-affiliated persons. The aggregate balance of loans to directors, officers and other related parties is $916,000 and $903,000 as of September 30, 2004 and September 30, 2003, respectively. 74 75 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 16. MARKET VALUE DISCLOSURE OF FINANCIAL INSTRUMENTS The fair value information for financial instruments, which is provided below, is based on the requirements of Financial Accounting Standard Board Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," and does not represent the aggregate net fair value of the Bank. Much of the information used to determine fair value is subjective and judgmental in nature; therefore, fair value estimates, especially for less marketable securities, may vary. The amounts actually realized or paid upon settlement or maturity could be significantly different. The following methods and assumptions were used to estimate the fair value of each class of financial instrument for which it is reasonable to estimate that value: A. Cash and interest-bearing deposits - Fair value is estimated to be carrying value. B. Investment securities - Fair value is estimated using quoted market prices or market estimates. C. Loans receivable - For residential mortgage loans, fair value is estimated by discounting future cash flows using the current rate for similar loans. D. Deposits - For passbook savings, checking and money market accounts, fair value is estimated at carrying value. For fixed maturity certificates of deposit, fair value is estimated by discounting future cash flows at the currently offered rates for deposits of similar remaining maturities. E. Advances from the FHLB of Atlanta and reverse repurchase agreements - - Fair value is estimated by discounting future cash flows at the currently offered rates for advances of similar remaining maturities. F. Off-balance sheet instruments - The fair value of commitments is determined by discounting future cash flows using the current rate for similar loans. Commitments to extend credit for other types of loans and standby letters of credit were determined by discounting future cash flows using current rates. The carrying value and estimated fair value of financial instruments is summarized as follows: For the Year Ended September 30, ----------------------------------------------------------- 2004 2003 ----------------------------- ---------------------------- Carrying Estimated Carrying Estimated value fair value value fair value ---------------------------------------------------------------------------------------------------------- (In Thousands) Assets: Cash and interest bearing deposits $ 10,603 $ 10,603 $ 6,143 $ 6,143 Investment securities 153,007 152,686 224,784 224,546 Loans receivable 251,915 251,988 248,807 249,017 ---------------------------------------------------------------------------------------------------------- Liabilities: Deposits 288,956 289,803 297,876 301,211 Borrowings 116,065 118,713 164,635 168,114 ---------------------------------------------------------------------------------------------------------- Off-balance sheet instruments: Commitments to extend credit - 821 - 1,466 ---------------------------------------------------------------------------------------------------------- 17. EMPLOYEE BENEFIT PLANS The Company operates a 401(k) Retirement Plan covering all full-time employees meeting the minimum age and service requirements. Contributions to the Retirement Plan are at the discretion of the Company. The Company made no contributions for the years ended September 30, 2004 and 2003. 75 76 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 18. SUPPLEMENTAL CASH FLOW INFORMATION Year Ended September 30, ------------------------------ 2004 2003 ----------------------------------------------------------------------------------------------------- (In Thousands) Cash paid during period for interest on deposits and borrowings $7,777 $8,307 ===================================================================================================== 19. SEGMENT REPORTING The Company has two reportable segments, banking and mortgage banking. The Bank operates retail deposit branches throughout the greater Washington, D.C./Baltimore metropolitan area. The banking segment provides retail consumer and small businesses with deposit products such as demand, transaction, savings accounts and certificates of deposit and lending products, such as residential and commercial real estate, construction and development, consumer and commercial business loans. Further, the banking segment invests in residential real estate loans purchased from GAMC and others, and also invests in mortgage-backed and other securities. The mortgage banking segment activities, which are conducted principally through GAMC, include the origination of residential real estate loans either for the Bank's portfolio or for sale into the secondary market with servicing released. The accounting policies of the segments are the same as those described in Note 1. The Company evaluates performance based on net interest income, noninterest income, and noninterest expense. The total of these three items is the reportable segment's net contribution. The Company's reportable segments are strategic business units that offer different services in different geographic areas. They are managed separately because each segment appeals to different markets and, accordingly, requires different technology and marketing strategies. Since the Company derives a significant portion of its revenue from interest income and interest expense, the segments are reported below using net interest income. Because the Company also evaluates performance based on noninterest income and noninterest expense, these measures of segment profit and loss are also presented. ------------------------------------------------------------------------------------------------------------ Total Total Mortgage Reportable Intersegment Operating Banking Banking Segments Eliminations Earnings ------------------------------------------------------------------------------------------------------------ (In Thousands) Net interest income (1) 2004 $ 5,905 $ 493 $ 6,398 $ - $ 6,398 2003 $ 6,294 $ 789 $ 7,083 $ - $ 7,083 Noninterest income: 2004 $ 562 $ 9,398 $ 9,960 $ (31) $ 9,929 2003 $ 780 $18,142 $ 18,922 $ (33) $ 18,889 Noninterest expense: 2004 $ 10,384 $ 9,077 $ 19,461 $ (31) $ 19,430 2003 $ 10,029 $13,715 $ 23,744 $ (33) $ 23,711 Net income: 2004 $ (3,917) $ 725 $ (3,192) $ - $ (3,192) 2003 $ (2,955) $ 5,216 $ 2,261 $ - $ 2,261 Segment assets: 2004 $439,491 $ 7,869 $ 447,360 $(12,990) $434,370 2003 $503,241 $ 8,284 $ 511,525 $(12,171) $499,354 (1) Segment net interest income reflects income after provision for loan losses. 76 77 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 20. JUNIOR SUBORDINATED DEBT SECURITIES On March 20, 2002, Greater Atlantic Capital Trust I (the, "Trust"), a Delaware statutory business trust and a wholly owned Trust subsidiary of the Company issued $9.6 million aggregate liquidation amount (963,038 shares) of 6.50% cumulative preferred securities maturing on December 31, 2031, with an option to call on or after December 31, 2003. Conversion of the preferred securities into the Company's common stock may occur at any time on or after 60 days after the closing of the offering. The Company may redeem the preferred securities, in whole or in part, at any time on or after December 31, 2003. Distributions on the preferred securities are payable quarterly on March 31, June 30, September 30 and December 31 of each year beginning on June 30, 2002. The Trust also issued 29,762 common securities to the Company for $297,620. The Company purchased all the shares of the common stock. The proceeds from the sale of the preferred securities and the proceeds from the sale of the trust's common securities were utilized to purchase from the Company junior subordinated debt securities of $9,928,000 bearing interest of 6.50% and maturing December 31, 2031. All intercompany interest and equity were eliminated in consolidation. The Trust was formed for the sole purpose of investing the proceeds from the sale of the convertible preferred securities in the corresponding convertible debentures. The Company has fully and unconditionally guaranteed the preferred securities along with all obligations of the trust related thereto. The sale of the preferred securities yielded $9.3 million after deducting offering expenses. The Company currently retained approximately $1.3 million of the proceeds for general corporate purposes. The remaining $8.0 million of the proceeds was invested in Greater Atlantic Bank to increase its capital position. To comply with FIN46, the trust preferred subsidiary was deconsolidated in 2004, and the related securities have been presented as obligations of the Company and titled "Junior Subordinated Debt Securities" in the financial statements. 21. DERIVATIVE FINANCIAL INSTRUMENTS Beginning in fiscal 2002, the Bank utilized derivative financial instruments to hedge its interest rate risk. Beginning in 2002, the Bank adopted statement of Financial Accounting Standard No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133") which requires that an entity recognize all derivatives as either assets or liabilities and measure those instruments at fair value. The Bank bases the estimated fair values of these agreements on the cost of interest-rate exchange agreements with similar terms at available market prices, excluding accrued interest receivable and payable. However, active markets do not exist for many types of financial instruments. Consequently, fair values for these instruments must be estimated using techniques such as discounted cash flow analysis and comparisons to similar instruments. Estimates developed using these methods are highly subjective and require judgments regarding significant matters such as the amount and timing of future cash flows and the selection of discount rates that appropriately reflect market and credit risks. Changes in these judgments often have a material effect on the fair value estimates. Since those estimates are made as of a specific time, they are susceptible to material near term changes. The Bank entered into various interest-rate swaps during fiscal year 2003 and 2002 that total $72 million in notional principal. The swaps pay a fixed rate with the Bank receiving payments based upon one-to three-month floating rate LIBOR. The capped range is between 1.31% - 4.53%, and expires between 2 and 7 years. The Bank also entered into various interest rate caps during fiscal year 2003 and 2002 that total $30 million in notional principal with terms between four and ten years that limit the float between a floor of 2.00%, and capped between 5.00% - 8.00%. The Bank accounts for these derivatives, under the guidelines of SFAS 133. The Company's derivatives do not meet hedge accounting requirements under SFAS 133, and therefore, the Company carries the derivatives at their fair value on the balance sheet, recognizing changes in their fair value in current-period earnings. The Company recognized a loss of $227,000 in fiscal 2004, a gain of $9,000 in fiscal 2003 and a loss of $3.5 million in fiscal 2002 related to its derivatives. 77 78 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 22. RECENT ACCOUNTING STANDARDS In April 2003, the FASB issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. We adopted the use of this accounting statement in July 2003. In December 2003, the FASB issued FIN No. 46R, "Consolidation of Variable Interest Entities," an interpretation of Accounting Research Bulletin No. 51. FIN No. 46R requires that variable interest entities be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity's activities or is entitled to receive a majority of the entity's residual returns or both. FIN 46R also requires disclosure about variable interest entities that companies are not required to consolidate but in which a company has a significant variable interest. The consolidation requirements must be adopted no later than the beginning of the first fiscal year or interim period beginning after March 15, 2004. The adoption of FIN No. 46R is not expected to have a material impact on the Corporation's results of operations, financial position or cash flows. 23. PARENT COMPANY - ONLY FINANCIAL STATEMENTS Parent Company - Only Condensed Statements of Financial Condition September 30, ----------------------------------- 2004 2003 ------------------------------------------------------------------------------------------ (In Thousands) Assets Cash and cash equivalents $ 14 $ 565 Loans receivable - - Investment in subsidiary 27,832 30,765 Prepaid expenses and other assets 304 20 ------------------------------------------------------------------------------------------ Total assets $ 28,150 $ 31,350 ========================================================================================== Liabilities and stockholders' equity Accrued interest payable on subordinated debt $ - $ - Other liabilities 4 11 ------------------------------------------------------------------------------------------ Total liabilities 4 11 ------------------------------------------------------------------------------------------ Subordinated debt 9,928 9,928 ------------------------------------------------------------------------------------------ Stockholders' equity Common stock 30 30 Additional paid-in capital 25,152 25,152 Retained earnings (6,964) (3,771) ------------------------------------------------------------------------------------------ Total stockholders' equity 18,218 21,411 ------------------------------------------------------------------------------------------ Total liabilities and stockholders' equity $ 28,150 $ 31,350 ========================================================================================== 78 79 Greater Atlantic Financial Corp. and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Parent Company - Only Condensed Statements of Operations Year Ended September 30, ------------------------------------------ 2004 2003 2002 ----------------------------------------------------------------------------------------------------------- (In Thousands) Interest income $ 2 $ 17 $ 18 Other income - - - ----------------------------------------------------------------------------------------------------------- Total interest income 2 17 18 ----------------------------------------------------------------------------------------------------------- Interest expense 645 645 341 ----------------------------------------------------------------------------------------------------------- Total interest expense 645 645 341 ----------------------------------------------------------------------------------------------------------- Net interest income (643) (628) (323) ----------------------------------------------------------------------------------------------------------- Noninterest income Gain (loss) on sale of investment securities - - - Other operating income 19 19 10 ----------------------------------------------------------------------------------------------------------- Total noninterest income 19 19 10 ----------------------------------------------------------------------------------------------------------- Noninterest expense Other operating expense 135 109 109 ----------------------------------------------------------------------------------------------------------- Total noninterest expense 135 109 109 ----------------------------------------------------------------------------------------------------------- Loss before income from subsidiaries (759) (718) (422) ----------------------------------------------------------------------------------------------------------- Equity (loss) income from subsidiaries (2,433) 2,979 (2,160) ----------------------------------------------------------------------------------------------------------- Net (loss) income $ (3,192) $ 2,261 $(2,582) =========================================================================================================== Parent Company - Only Condensed Statements of Cash Flows Year Ended September 30, ------------------------------------------- 2004 2003 2002 ------------------------------------------------------------------------------------------------------------ (In Thousands) Cash flows from operating activities: Net income (loss) $ (3,192) $ 2,261 $ (2,582) Adjustments to reconcile net loss to net cash (used in) provided by operating activities (Income) loss from subsidiaries 2,433 (2,979) 2,160 (Increase) decrease in assets (283) 1 (6) Increase in other liabilities (9) (170) 162 ------------------------------------------------------------------------------------------------------------ Net cash used in operating activities (1,051) (887) (266) ------------------------------------------------------------------------------------------------------------ Cash flows from investing activities: Loan originations in excess of repayments - 125 (125) Investment in subsidiary - - (8,298) ------------------------------------------------------------------------------------------------------------ Net cash used in investing activities - 125 (8,423) ------------------------------------------------------------------------------------------------------------ Cash flows from financing activities: Cash dividend from subsidiary 500 - 20 Stock options exercised - - 9,928 ------------------------------------------------------------------------------------------------------------ Net cash provided by financing activities 500 - 9,948 ------------------------------------------------------------------------------------------------------------ Net (decrease) increase in cash and cash equivalents (551) (762) 1,259 Cash and cash equivalents at beginning of period 565 1,327 68 ------------------------------------------------------------------------------------------------------------ Cash and cash equivalents at end of period $ 14 $ 565 $ 1,327 ============================================================================================================ 79 80 GREATER ATLANTIC FINANCIAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 24. QUARTERLY RESULTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE INFORMATION) (UNAUDITED) The following tables set forth the quarterly financial data, which was derived from the consolidated financial statements presented in Form 10-Qs, for the fiscal years ended September 30, 2004 and 2003. For Fiscal Year 2004 -------------------------------------------------------------------------- For the Year Ended September 30, Fourth Third Second First 2004 Quarter Quarter Quarter Quarter -------------------------------------------------------------------------------------------------------------------- Interest income $18,962 $ 4,625 $4,811 $ 4,989 $ 4,537 Interest expense 12,355 3,048 3,083 3,097 3,127 -------------------------------------------------------------------------------------------------------------------- Net interest income 6,607 1,577 1,728 1,892 1,410 Provision for loan losses 209 76 52 2 79 -------------------------------------------------------------------------------------------------------------------- Net interest income, after provision 6,398 1,501 1,676 1,890 1,331 for loan losses Noninterest income 9,929 494 4,967 1,573 2,895 Noninterest expense 19,430 4,409 5,771 4,732 4,518 -------------------------------------------------------------------------------------------------------------------- Income (loss) before income taxes (3,103) (2,414) 872 (1,269) (292) Provision for income taxes 89 - 89 - - -------------------------------------------------------------------------------------------------------------------- Net income (loss) $(3,192) $(2,414) $ 783 $(1,269) $ (292) ==================================================================================================================== Basic earnings (loss) per share $ (1.06) $ (0.80) $ 0.26 $ (0.42) $ (0.10) ==================================================================================================================== Diluted earnings (loss) per share $ (1.06) $ (0.80) $ 0.20 $ (0.42) $ (0.10) ==================================================================================================================== For Fiscal Year 2003 --------------------------------------------------------------------------- For the Year Ended September 30, Fourth Third Second First 2003 Quarter Quarter Quarter Quarter -------------------------------------------------------------------------------------------------------------------- Interest income $20,987 $ 4,970 $5,071 $ 5,153 $ 5,793 Interest expense 13,049 3,156 3,169 3,199 3,525 -------------------------------------------------------------------------------------------------------------------- Net interest income 7,938 1,814 1,902 1,954 2,268 Provision for loan losses 855 76 66 66 647 -------------------------------------------------------------------------------------------------------------------- Net interest income, after provision 7,083 1,738 1,836 1,888 1,621 for loan losses Noninterest income 18,889 6,615 4,583 3,290 4,401 Noninterest expense 23,711 7,096 5,979 5,174 5,462 -------------------------------------------------------------------------------------------------------------------- Income (loss) before income taxes 2,261 1,257 440 4 560 Provision for income taxes - - - - - -------------------------------------------------------------------------------------------------------------------- Net income (loss) $ 2,261 $ 1,257 $ 440 $ 4 $ 560 ==================================================================================================================== Basic earnings (loss) per share $ 0.75 $ 0.41 $ 0.15 $ 0.00 $ 0.19 ==================================================================================================================== Diluted earnings (loss) per share $ 0.60 $ 0.30 $ 0.12 $ 0.00 $ 0.18 ==================================================================================================================== 80 81 Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. GREATER ATLANTIC FINANCIAL CORP. By: /s/ Carroll E. Amos ------------------- Carroll E. Amos Chief Executive Officer, President and Director Dated: December 27, 2004 81