UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------------------------------- FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1996 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: 0-27124 NHS FINANCIAL, INC. (Exact name of registrant as specified in its charter) CALIFORNIA 68-0359326 (State of incorporation) (I.R.S. Employer Identification Number) 1050 Fourth Street SAN RAFAEL, CALIFORNIA 94901 (Address of principal executive office (Zip Code) Registrant's telephone number: (415) 257-3761 Indicate by check mark whether Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that 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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date. Number of Shares of Common Stock Outstanding as of August 5, 1996: 2,522,827 NHS FINANCIAL, INC. FORM 10-Q TABLE OF CONTENTS Item Number Description Page - -------------------------------------------------------------------------- PART I. 1. FINANCIAL INFORMATION CONSOLIDATED STATEMENTS OF CONDITION JUNE 30, 1996 AND DECEMBER 31, 1995. . . . . . . . . . . 3 CONSOLIDATED STATEMENTS OF OPERATIONS THREE AND SIX MONTHS ENDED JUNE 30, 1996 AND 1995 . . . . 4 CONSOLIDATED STATEMENTS OF CASHFLOWS SIX MONTHS ENDED JUNE 30, 1996 AND 1995 . . . . . . . . . 5 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS. . . . . . 6 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. . . . . . . . . . . . . . 8 PART II. OTHER INFORMATION. . . . . . . . . . . . . . . . . . . . . . .18 SIGNATURES . . . . . . . . . . . . . . . . . . . . . . . . . .19 2 PART I FINANCIAL INFORMATION Item 1. FINANCIAL STATEMENTS NHS FINANCIAL, INC. Consolidated Statements of Financial Condition JUNE 30, 1996 December 31, 1995 ------------------------------------- ASSETS Cash, including non-interest bearing deposits $164,762 $169,202 Interest-bearing deposits 6,233,266 5,310,416 Mortgage-backed securities available for sale, at fair value 3,282,315 4,053,873 Investment securities held to maturity (Fair value: 1996, $13,772,502; 1995, $11,025,888) 13,998,793 11,000,000 Mortgage-backed securities held to maturity (Fair value: 1996, $7,804,791; 1995, $8,835,578) 7,868,320 8,829,881 Loans receivable, net of allowance for losses: (1996, $3,603,899; 1995, $3,507,899) 245,186,644 257,040,178 Investment in Federal Home Loan Bank of San Francisco, at cost 2,330,000 2,212,500 Real estate owned 1,409,398 1,652,666 Accrued interest receivable: Loans 1,664,746 1,740,432 Securities 337,258 223,926 Leasehold improvements and equipment, net 698,535 842,338 Other assets 1,017,350 1,170,944 - -------------------------------------------------------------------------------------------------- Total assets $284,191,387 $294,246,356 - -------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------- LIABILITIES AND STOCKHOLDERS' EQUITY Customer deposits $225,817,677 246,952,323 Advances from Federal Home Loan Bank of San Francisco (FHLBSF) 31,000,000 21,000,000 Other liabilities 2,340,735 2,063,389 - -------------------------------------------------------------------------------------------------- Total liabilities 259,158,412 $270,015,712 - -------------------------------------------------------------------------------------------------- Capital stock, no par value; authorized 5,000,000 shares; issued and outstanding, 1996 and 1995: 2,522,827 shares 11,772,003 11,772,003 Unrealized loss on securities available for sale, net of tax (62,519) (27,220) Retained earnings, substantially restricted 13,323,491 12,485,861 - -------------------------------------------------------------------------------------------------- Total stockholders' equity 25,032,975 24,230,644 - -------------------------------------------------------------------------------------------------- Total liabilities and stockholders' equity $284,191,387 $294,246,356 - -------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------- See Accompanying Notes to Consolidated Financial Statements. 3 Item 1. FINANCIAL STATEMENTS (continued) NHS FINANCIAL, INC. Consolidated Statements of Operations Three Months Ended Six Months Ended June 30, June 30, 1996 1995 1996 1995 ------------------------------------------------------- Interest Income: Loans receivable $5,389,150 5,072,265 10,916,947 9,728,153 Mortgage-backed securities 176,173 227,555 366,715 463,697 Other investments 329,767 141,093 599,615 322,960 - --------------------------------------------------------------------------------------------------------- 5,895,090 5,440,913 11,883,277 10,514,810 - --------------------------------------------------------------------------------------------------------- Interest Expense: Customer deposits 2,980,551 3,485,782 6,110,238 6,403,188 Advances from the FHLBSF 441,968 184,393 892,622 465,235 - --------------------------------------------------------------------------------------------------------- 3,422,519 3,670,175 7,002,860 6,868,423 - --------------------------------------------------------------------------------------------------------- Net interest income before provision for loan losses 2,472,571 1,770,738 4,880,417 3,646,387 Provision for loan losses 150,000 1,361,600 290,000 1,361,600 - --------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses 2,322,571 409,138 4,590,417 2,284,787 - --------------------------------------------------------------------------------------------------------- Non-interest income: Gain on sale of real estate owned 85,900 - 232,322 1,068 Income from real estate owned 7,077 11,200 17,982 11,200 Loan and deposit fees 69,350 47,256 119,597 157,847 Other 8,233 12,278 11,902 34,830 - --------------------------------------------------------------------------------------------------------- Total non-interest income 170,560 70,734 381,803 204,945 - --------------------------------------------------------------------------------------------------------- Non-interest expense: General and administrative expense: Compensation and benefits 699,407 417,301 1,413,439 1,072,589 Deposit insurance and regulatory assessments 178,306 142,192 357,167 284,380 Rent and occupancy 139,033 133,656 280,074 263,293 Professional fees 208,004 58,820 330,737 104,614 Depreciation and amortization 95,432 76,434 171,837 149,525 Information systems 37,431 65,222 79,789 118,925 Other 210,130 181,713 390,233 362,125 - --------------------------------------------------------------------------------------------------------- Total general and administrative expense 1,567,743 1,075,338 3,023,276 2,355,451 Expenses of real estate owned 46,934 29,466 99,796 46,868 - --------------------------------------------------------------------------------------------------------- Total non-interest expense 1,614,677 1,104,804 3,123,072 2,402,319 - --------------------------------------------------------------------------------------------------------- Income (loss) before income taxes 878,454 (624,932) 1,849,148 87,413 Income taxes expense (benefit) 406,854 (259,346) 809,692 36,277 - --------------------------------------------------------------------------------------------------------- Net income (loss) $471,600 (365,586) 1,039,456 51,136 - --------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------- Earnings (loss) per share $0.19 (0.14) 0.41 0.02 - --------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------- See Accompanying Notes to Consolidated Financial Statements. 4 Item 1. FINANCIAL STATEMENTS (continued) NHS FINANCIAL, INC. Consolidated Statements of Cash Flows Six Months Ended JUNE 30, 1996 June 30, 1995 ----------------------------------- Cash flows from operating activities: Net income $1,039,456 $51,136 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Amortization of net deferred loan origination fees (416,547) (355,977) Amortization of premiums and discounts on mortgage-backed securities, net 34,238 41,458 Accretion of discounts on loans (43,303) (3,141) Provision for loan losses 290,000 1,361,600 Net gain on sale of real estate owned (232,322) (1,068) Loss on retirement of fixed assets - 16,892 Depreciation and amortization of fixed assets 171,837 149,525 FHLBSF stock dividends (59,700) (56,000) Increase in accrued interest receivable (37,646) (270,483) (Increase)/decrease in other assets (87,396) 66,367 Decrease/(increase) in income tax receivable, net 260,220 (368,723) Increase in other liabilities 277,346 891,744 ----------------------------------- Net cash provided by operating activities 1,196,183 1,523,330 ----------------------------------- Cash flows from investing activities: Net decrease/(increase) in loans resulting from originations, net of principal collections 10,621,648 (12,730,824) Loans purchased - (7,257,245) Purchases of leasehold improvements and equipment (23,155) (283,768) (Purchases)/redemption of FHLBSF stock (57,800) 145,300 Maturity or calls of securities held to maturity 10,000,000 - Purchase of securities held to maturity (12,998,750) - Principal repayments on securities held to maturity 923,548 535,902 Principal repayments on securities available for sale 715,882 528,226 Proceeds from sale of real estate owned 1,877,326 1,029,558 ----------------------------------- Net cash provided by (used in) investing activities 11,058,699 (18,032,851) ----------------------------------- Cash flows from financing activities: Net (decrease)/increase in customer deposits (21,134,646) 35,334,455 Proceeds from FHLBSF advances 15,000,000 3,700,000 Repayments of FHLBSF advances (5,000,000) (14,700,000) Cash dividends (201,826) (201,826) ----------------------------------- Net cash (used in) provided by financing activities (11,336,472) 24,132,629 ----------------------------------- Net increase in cash and cash equivalents 918,410 7,623,108 Cash and cash equivalents at the beginning of period 5,479,618 3,211,334 ----------------------------------- Cash and cash equivalents at the end of period $6,398,028 $10,834,442 ----------------------------------- ----------------------------------- Supplemental disclosures of cash flow information: Cash paid for: Interest $7,199,166 $6,831,917 ----------------------------------- ----------------------------------- Income taxes, net of refunds $770,000 $405,000 ----------------------------------- ----------------------------------- Supplemental disclosure of noncash investment and financing activities: Transfer of loans to real estate owned $1,401,736 $492,248 ----------------------------------- ----------------------------------- See Accompanying Notes to Consolidated Financial Statements. 5 NHS FINANCIAL, INC. Notes to the Consolidated Financial Statements (1) BASIS OF PRESENTATION The financial statements of the Company presented above reflect all adjustments consisting of normal recurring accruals which are, in the opinion of management, necessary to present a fair statement of the financial condition and results of operations for the interim periods presented. The accompanying unaudited financial statements have been prepared in accordance with the instructions to Form 10-Q and therefore do not include all information and footnotes necessary for a fair presentation of financial condition, results of operations and cash flows in accordance with generally accepted accounting principles. Therefore, these financial statements should be read in conjunction with the Company's 1995 Annual Report on Form 10-K which contains the latest audited financial statements and notes thereto. Certain of the 1995 financial statement amounts have been reclassified to conform to the 1996 presentation. (2) EARNINGS PER SHARE Weighted average shares used for calculation of earnings per share for the three months and six months ended June 30, 1996 and 1995 were 2,522,827 shares. Earnings per share for the first half of 1995 has been adjusted to give retroactive effect to a 15% stock dividend paid on February 10, 1995. The Company has not separately reported its fully diluted earnings per share (which includes outstanding stock options as common stock equivalents) as it is not materially different than primary earnings per share. (3) DIVIDEND DECLARATION The Company declared a quarterly dividend on June 18, 1996 of $0.04 per share payable July 15, 1996. The dividend totaling $100,913 was reflected as a reduction of retained earnings in the accompanying Statement of Financial Condition. This dividend represents the tenth consecutive quarterly cash dividend declared since its first such dividend in the third quarter of 1993 and reflects the Company's commitment to enhancing shareholder value. (4) CAPITAL In 1989, the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) stipulated the requirement that insured savings institutions meet three separate capital requirements. Those requirements are to have tangible capital of 1.5% of adjusted total assets, core capital of 3% of adjusted total assets and risk-based capital equal to 8.0% of risk-weighted assets. In response to the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), the Office of Thrift Supervision (OTS) adopted final rules, effective December 19, 1992, based upon FDICIA's five capital tiers: well capitalized, adequately capitalized, under capitalized, significantly undercapitalized, and critically undercapitalized. The rules provide that a savings institution is "well capitalized" if its total risk-based capital ratio is 10% or greater, its tier 1 risk-based capital ratio is 6% or greater and its leverage ratio is 5% or greater. (Continued) 6 NHS FINANCIAL, INC. Notes to Consolidated Financial Statements (Continued) At June 30, 1996, the Association's regulatory capital substantially exceeds the requirements of each regulatory capital standard and the Association is considered "well capitalized" at that date. Table One provides a comparison of the Association's regulatory capital to its minimum requirement at June 30, 1996. TABLE ONE Minimum Excess over (Dollars in thousands) Actual at June 30, 1996 Requirement Requirement ------------------------- ---------------------- ------------------------ Capital Ratio Capital Ratio Capital Ratio ------------------------- ---------------------- ------------------------ FIRREA Capital Standards: Tangible $24,409 8.59% $4,263 1.50% $20,146 7.09% Core (leverage) 24,409 8.59% 8,527 3.00% 15,882 5.59% Risk-based 26,652 14.97% 14,244 8.00% 12,408 6.97% FDICIA Capital Standards (Well Capitalized): Core (leverage) 24,409 8.59% 14,212 5.00% 10,197 3.59% Tier 1 risk-based 24,409 13.71% 10,683 6.00% 13,726 7.71% Total risk-based 26,652 14.97% 17,805 10.00% 8,847 4.97% (5) PROPOSED MERGER WITH LUTHER BURBANK CORPORATION As previously announced, NHS Financial, Inc. has agreed to be acquired by Luther Burbank Corporation, the holding company for Luther Burbank Savings. Luther Burbank, which is headquartered in Santa Rosa, California, is a privately held company. Both corporations have signed a definitive agreement to merge, through which the acquisition will be completed. Under the terms of the agreement, Luther Burbank will pay a total cash consideration of approximately $29.7 million, or $11.50 per share to the shareholders of NHS Financial. The proposed merger, which is subject to approval by the shareholders of both corporations as well as the Office of Thrift Supervision and the California Department of Savings and Loan, is estimated to close at the end of the third quarter of 1996. In connection with the merger, NHS Financial has granted Luther Burbank an option to purchase newly issued shares, giving Luther Burbank 19.9% ownership of NHS Financial. This option would be triggered should NHS Financial accept an offer to be acquired at a higher price. 7 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL NHS Financial, Inc. (the "Company"), a California Corporation, is the holding company for New Horizons Savings and Loan Association (Association). The principal business of the Company is to attract deposits from the general public and invest those funds in residential, construction and, to a lesser extent, commercial real estate loans. The Company's geographical area for attracting deposits and making real estate loans is the San Francisco Bay Area, concentrating in Marin and Sonoma counties, and the City and County of San Francisco. The Company conducts its business in three facilities in Marin County; one located in San Rafael, California, another in Mill Valley, California and the third in Novato, California. The Company's operations are significantly influenced by general economic conditions, the regional real estate market and by related monetary, fiscal and regulatory policies of the federal government. Deposit flows and cost of funds are influenced by interest rates on competing investments and general market rates of interest. Lending activities are affected by the demand for mortgage financing and the types of loans the Company offers, which in turn are affected by the interest rates at which such financing may be offered and other factors affecting the supply of housing and availability of funds. The Company engages primarily in real estate lending for its own portfolio, specializing in short-term fixed rate and longer term adjustable rate real estate loans. The Company attracts and maintains deposit funds by offering competitive interest rates and emphasizing customer service. The Company also uses Federal Home Loan Bank of San Francisco (FHLBSF) advances and occasionally other short term borrowings, such as reverse repurchase agreements (reverse repos), as a supplementary source of funds. Table Two provides a summary of key operating statistics at or for the three months and six months ending June 30, 1996 and June 30, 1995. TABLE TWO At Or For The At Or For The SUMMARY OF KEY STATISTICS Three Months Ended Six Months Ended (in thousands, except per share data) June 30, June 30, June 30, June 30, 1996 1995 1996 1995 - -------------------------------------------------------------------------------------------------- Net interest margin on earning assets: For period 3.48% 2.53% 3.41% 2.65% At period end 3.43% 2.69% 3.43% 2.69% Ratio of G & A expenses to average assets 2.18% 1.50% 2.09% 1.68% Return on average assets 0.66% (0.51)% 0.72% 0.04% Return on average equity 7.59% (5.93)% 8.42% 0.42% Average equity to average assets 8.65% 8.59% 8.51% 8.71% Dividend payout ratio 21.40% N.M. 19.42% N.M. Stockholders' equity per share $9.92 $9.55 Regulatory Capital (the Association): Tangible 8.59% 8.30% Core (leverage) 8.59% 8.30% Risk-based 14.97% 12.56% Ratio of nonperforming assets to total assets 1.44% 1.14% General Valuation Allowances to: Gross loans 1.38% 1.15% Nonperforming loans 134.49% 124.77% N.M. = Not meaningful The discussion that follows focuses on the components of the Company's financial condition, results of operations, liquidity and regulatory matters for the three and six months ended June 30, 1996. 8 FINANCIAL CONDITION CASH AND INVESTMENTS Income from investments provides the second largest source of income for the Company, after interest income on loans. The Company is required by federal regulation to maintain a specified minimum amount of liquid assets which may be invested in specific short term securities. It is the Company's policy to maintain a liquidity portfolio which exceeds regulatory minimum requirements. The Company's cash and investment portfolio consists, from time to time, of mortgage-backed securities, callable U.S. government agency notes, certificates of deposit and overnight investments with the FHLBSF. Cash and investments at June 30, 1996 amounted to $31.5 million compared with $29.4 million at December 31, 1995. The Company utilizes its investment portfolio to effectively invest periodic excess cash flows in interest earning assets, to enhance net interest income and margin and to meet regulatory liquidity requirements. LOAN PORTFOLIO The Company's principal investment activity has been and continues to be the origination of real estate loans. The Company's lending activities consist primarily of making loans secured by first or second liens on residential and other real estate. These loans are made in connection with purchases, refinancing, construction or improvement of property located principally in the San Francisco Bay Area, concentrating in Marin, Sonoma and San Francisco Counties. Historically, the Company has relied upon its ability to provide customized loans for homes and for home construction. The economy of the Bay Area counties is varied and includes manufacturing, technology, services and agricultural industries, providing a balanced deposit and mortgage lending market. The Company's loans are primarily obtained through a selected group of independent loan brokers. Loan applications are also obtained from existing customers and other individuals. The Company has no foreign or out of state loans in its portfolio. The Company principally originates adjustable rate mortgages (ARMs) which re- price at six month intervals in accordance with the FHLBSF's 11th District Cost of Funds Index (COFI). Fixed rate real estate loans are generally made with terms of 5 years or less. Shorter fixed rate loans include construction, swing, and land loans and generally carry terms of 12 to 18 months. As of June 30, 1996 and December 31, 1995, approximately 86% of the Company's portfolio consisted of ARMs. By concentrating on ARMs, as well as short-term construction and fixed rate loans with average maturities of twelve months, the Company believes that it can better manage the sensitivity of its earnings to market interest rate fluctuations. New loan originations and loan participations purchased for the first half of 1996 were $21.9 million, a decrease of $8.8 million from $30.7 million for the same period in 1995. In the first quarter of 1995, the Company also purchased $7.3 million of loans from local lenders. Occasional purchases of loans and loan participations from local lenders are utilized to assist the Company in meeting its asset/liability objectives. Loan originations for the first half 1996 were below those for the 1995 period reflecting the slow real estate market, increased competition and borrower preference during much of the 1996 period for fixed rate loans. The Company's future levels of loan originations and portfolio growth will depend on the pace of recovery of the Northern California real estate market, the extent of competition for loans in the Company's geographical market, borrower preference for fixed or ARM loans and the relationship of loan payoffs to borrower refinancing opportunities. 9 Table Three below is a summary of the Company's gross loan portfolio (before deductions for construction loans in process, deferred loan fees and allowance for loan losses) at June 30, 1996 and December 31, 1995: TABLE THREE (Dollars in thousands) June 30, 1996 December 31, 1995 Amount Percent Amount Percent ------ ------- ------ ------- Mortgage loans: One-to-four family $ 144,613 55.21% $ 157,301 57.21% Multi-family 43,456 16.59% 43,184 15.71% Construction 32,895 12.56% 29,722 10.81% Commercial 36,995 14.12% 39,586 14.40% Land 3,661 1.40% 4,812 1.75% --------- -------- --------- -------- 261,620 99.88% 274,605 99.88% Loans secured by savings accounts 309 0.12% 337 0.12% --------- -------- --------- -------- $ 261,929 100.00% $ 274,942 100.00% --------- -------- --------- -------- --------- -------- --------- -------- Weighted average interest rate 8.23% 8.23% --------- --------- --------- --------- The above weighted average interest rates for loans receivable represent the contractual interest rates on the underlying mortgage loans. If amortization of deferred loan origination fees and loan discounts is factored into the average interest rate calculation, the resulting loan yields would be 8.56% at both June 30, 1996 and December 31, 1995. ASSET QUALITY DELINQUENT LOANS. When a borrower fails to make required payments on a loan within 30 days of the due date, the loan is considered contractually delinquent. Table Four below shows the amount of loan delinquencies by loan type at June 30, 1996 and December 31, 1995. TABLE FOUR Number of Days Delinquent -------------------------------------------------------------------------------- (Dollars in thousands) 30-59 60-89 90 or more Total -------------------------------------------------------------------------------- 6/30/96 12/31/95 6/30/96 12/31/95 6/30/96 12/31/95 6/30/96 12/31/95 ------- -------- ------- -------- ------- -------- ------- -------- One-to-four family $ 3,194 6,761 553 1,747 1,810 2,385 5,557 10,893 Multi-family 260 262 866 867 - - 1,126 1,129 Construction and land 62 728 - 204 870 1,624 932 2,556 Commercial real estate 876 1,722 604 609 - - 1,480 2,331 -------------------------------------------------------------------------------- Total $ 4,392 9,473 2,023 3,427 2,680 4,009 9,095 16,909 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- Delinquencies to Gross Loans 1.68% 3.45% 0.77% 1.25% 1.02% 1.46% 3.47% 6.15% The 46% decline in delinquent loans at June 30, 1996 from year-end 1995 resulted from focused efforts by the Company to increase the rate of collection on delinquent loans, resolve problem loans and to speed-up foreclosure of nonperforming loans. NONACCRUAL LOANS. It is the Company's policy to put loans that are contractually delinquent 90 days or more on non-accrual status. Management reviews other loans less than 90 days contractually delinquent. When the collection of interest and principal payments on a loan appears unlikely the loan is placed on non-accrual status. Accrued interest income deemed uncollectible is reversed. Income is subsequently recognized only to the extent cash payments are received until, in management's judgment, the borrower's ability to make periodic interest and principal payments is in accordance with the loan terms, at which time the loan is returned to accrual status. 10 IMPAIRED LOANS. Management periodically reviews specific loans on an individual basis. The Company considers a loan to be impaired when, based upon the evaluation of the credit worthiness, cash flows and financial condition of the borrower, and the condition and appraised value of the collateral, it is unlikely that the Company will be able to collect all the principal and interest due under the contractual terms of the loan. The Company provides, through a charge to income, for estimated losses on impaired loans when fair value, including consideration of potential holding and disposition costs, exceeds the carrying value of the loan. REAL ESTATE OWNED. Real estate acquired through foreclosure is recorded at estimated fair value (including consideration of costs of holding and disposition) at the time of foreclosure. Valuations are periodically performed and related adjustments, if any, are made as a charge to income when the carrying value exceeds fair value. At June 30, 1996, the Company's real estate owned (REO) portfolio had an aggregate fair value of $1.4 million and consisted of three residential properties, two parcels of land, and one commercial property. At December 31, 1995, the Company's real estate owned portfolio had an aggregate fair value of $1.7 million and consisted of four residential properties, two parcels of land, and one multi-family and commercial mixed use property. During the first half of 1996, the Company foreclosed on and transferred to REO $1.4 million of loans and sold REO properties with a carrying value of $1.6 million. A gain on sale of REO of $232,000 was recorded. The following Table Five sets forth information with respect to the Company's nonperforming assets at June 30, 1996 and December 31, 1995. TABLE FIVE (Dollars in thousands) June 30, 1996 December 31, 1995 ------------- ----------------- Percentage Percentage Book of Book of Value Total Assets Value Total Assets ------- ------------ ------ ------------ Nonaccrual loans: One-to-four family $ 1,920 0.68% $ 2,436 0.83% Construction and land 1,452 0.51% 2,206 0.75% ------- ------------ ------ ------------ 3,372 1.19% 4,642 1.58% Real estate acquired by foreclosure: One-to-four family 1,150 0.40% 984 0.33% Multi-family - - 607 0.21% Commercial 197 0.07% - - Land 62 0.02% 62 0.02% ------- ------------ ------ ------------ 1,409 0.49% 1,653 0.56% Charge-offs of nonaccrual loans (692) -0.24% (633) -0.22% ------- ------------ ------ ------------ Net nonperforming assets $ 4,089 1.44% $ 5,662 1.92% ------- ------------ ------ ------------ ------- ------------ ------ ------------ Table Six below sets forth the relationship of the Company's General Valuation Allowances (GVA) to gross loans and nonperforming loans and assets at June 30, 1996 and December 31, 1995. TABLE SIX June 30, 1996 December 31, 1995 -------------------------------- Ratios of: GVA / nonperforming assets 88.13% 61.96% GVA / gross loans 1.38% 1.28% GVA / nonperforming loans 134.49% 87.50% TROUBLE DEBT RESTRUCTURINGS. As of June 30, 1996, the Company had three mortgage loans for which certain concessions were granted to the borrowers in light of their financial difficulties. Such concessions include the extension of maturity dates and the lowering of interest rates or payments. No reductions in the principal amount of the loans have been granted. The objective of these modifications in terms (i.e., troubled debt restructurings) is to maximize the recovery of the Company's investment. The principal balance of the three loans falling under the definition of troubled debt restructurings amounted to $2.4 million at June 30, 1996, and $3.9 million at December 31, 1995. All such loans were current according to their modified terms. 11 ASSET CLASSIFICATION SYSTEM Under federal regulations, each insured institution is required to classify its assets on a regular basis. In addition, in connection with examinations of insured institutions, OTS examiners have authority to identify problem assets and, if appropriate, direct the Company to classify them. Under the regulations, assets are subject to evaluation under a classification system with three categories: substandard, doubtful and loss. The regulations have also created a special mention category. This category includes assets which do not currently expose an insured institution to a sufficient degree of risk to warrant classification, but do possess credit deficiencies or potential weaknesses deserving management's close attention. At June 30, 1996, the percentage of classified assets to total assets was 6.62% ($18.8 million) compared with 6.38% ($18.8 million) at December 31, 1995. At June 30, 1996 and December 31, 1995, there were no assets classified as doubtful or loss. VALUATION ALLOWANCES The Company maintains an overall loan loss reserve to cover estimated potential losses in the portfolio. This GVA is provided through periodic charges to income and is determined based upon management's analysis. This analysis incorporates a number of factors including current economic considerations and the level of classified and nonperforming loans, management's assessment of credit risk inherent in its portfolio, past loss experience, and the Company's underwriting practices. The provision for loan losses for the six months ended June 30, 1996 was $290,000. The provision for loan loss during the second quarter and first half of 1995 was $1.4 million. This provision was recorded as a result of a re- evaluation of the Company's general and specific loan loss allowances in relation to the portfolio as a whole and the identification of specific loans that were performing but with certain credit weaknesses. The following Table Seven sets forth an analysis of the Company's allowance for loan and real estate losses for the six months ending June 30, 1996 and 1995. TABLE SEVEN (Dollars in thousands) 1996 1995 -------------------------- Loan loss allowance at beginning of year $ 3,508 3,412 Provision for loan losses 290 1,362 Charge offs, net of recoveries (194) 148 -------------------------- Loan loss allowance at June 30 $ 3,604 4,922 -------------------------- -------------------------- Loan loss allowance at June 30: General valuation allowance (GVA) $ 3,604 3,200 Specific valuation allowances $ - 1,722 -------------------------- $ 3,604 4,922 -------------------------- -------------------------- During the third quarter of 1995, the Company adopted the direct charge-off method of accounting for non-performing loans, as well as for performing loans considered by management to be impaired, and accordingly, specific valuation allowances at June 30, 1995 of $1.7 million were charged-off by the Company. At December 31, 1995 and June 30, 1996, no specific valuation allowances were outstanding. This change in procedure did not effect current loss provisions and will not alter provisions for general loan losses in future periods. Management considers its allowance for losses to be adequate to cover losses from loan and REO assets. However, future adjustments may be necessary and earnings could be significantly affected, if circumstances differ substantially from the assumptions used in making such determinations. In addition, various regulatory agencies review the Company's allowances for losses as a part of their examination process. Such agencies may require the Company to recognize additions to this allowance based on their judgment relating to information available to them at the time of their examination. 12 CUSTOMER DEPOSITS, FHLBSF ADVANCES AND OTHER BORROWINGS Deposits are the major source of the Company's funds for lending and other investment purposes. The Company obtains deposits primarily through its retail branches and offers a broad selection of deposit instruments including NOW accounts, money market accounts, regular savings accounts, checking accounts, certificates of deposit and retirement savings plans. While the deregulation of insured deposits has allowed the Company to be more competitive in obtaining funds and given it more flexibility to meet the threat of net deposit outflows, it has also resulted in a more volatile cost of funds. The Company's interest rates paid on deposits are not determined by regulatory authorities but rather by prevailing market conditions. The Company regularly evaluates its internal cost of funds, measures its cost of deposits against the costs of alternative sources of funds, surveys deposit rates offered by competing institutions, reviews liquidity and executes rate changes when deemed appropriate. The Company's primary strategy for attracting and retaining deposits is to emphasize customer service and personal attention, and to pay competitive interest rates on deposits. During the first half of 1996, customer deposits decreased $21.1 million from balances at December 31, 1995. The decrease was primarily the result of a reduction in deposit rates the Company offered combined with the maturity and repricing of approximately $107 million of relatively high cost certificates of deposit during the first quarter of 1996. Approximately $53 million of these maturing deposits represented deposits obtained during the first quarter of 1995 as a result of a one-time marketing program which promoted certificates of deposit by offering attractive rates and other terms. The following Table Eight summarizes customer deposits at June 30, 1996 and December 31, 1995: TABLE EIGHT (Dollars in thousands) 6/30/96 12/31/95 ------------------------- Customer Deposits: Transaction and Money Market Accounts $ 36,679 $ 32,232 Certificates of Deposit: $100,000 and over 55,230 67,620 Under $100,000 133,909 147,100 ------------------------- $ 225,818 $ 246,952 ------------------------- ------------------------- Weighted Average Interest Rate 5.23% 5.84% ------------------------- ------------------------- The Company may rely upon advances from the FHLBSF to supplement its supply of funds for lending and investment purposes. Advances may also be used to fund large deposit withdrawals. Advances from the FHLBSF are typically secured by the Company's stock in the FHLBSF and by pledges of certain real estate loans and securities. The Company had pledged loans and securities with outstanding principal balances of $92.0 million at June 30, 1996. At June 30, 1996, FHLBSF advances and other borrowings amounted to $31.0 million compared to $21.0 million at December 31, 1995. The Company had no other borrowings at June 30, 1996 and December 31, 1995. The increases in FHLBSF advances were used to replace maturing higher costing deposits and to obtain specific maturities of liabilities as determined by the Company's asset/liability analysis, and to assist in reducing the Company's overall cost of funds. The weighted average interest rate on borrowings at June 30, 1996 and December 31, 1995 were 5.51% and 5.46%, respectively. 13 RESULTS OF OPERATIONS GENERAL The Company earned $471,600 or $.19 per share for the second quarter ended June 30, 1996 compared with a loss of $365,586 or $.14 per share for the like quarter a year ago. First half 1996 earnings were $1.0 million or $.41 per share compared with $51,000 or $.02 per share for the same period in 1995. The increase in operating results for both periods in 1996 over 1995 resulted from greatly improved interest margins and a substantial reduction in loan loss provisions as discussed below. INTEREST RATE SPREAD AND MARGIN The following Table Nine sets forth the average interest-earning assets and interest-bearing liabilities, interest income and expense and the average annual interest rates during the six months ended June 30, 1996 and 1995. TABLE NINE Six Months Ended 6/30/96 Six Months Ended 6/30/95 ------------------------------------ ---------------------------------- (Dollars in thousands) Average Yield/ Average Yield/ Balance (3) Interest Rate Balance (3) Interest Rate ----------- -------- ------ ----------- -------- ------ Interest-earning assets: Loans (1) (2) $ 252,300 $ 10,917 8.64% $ 249,415 $ 9,728 7.80% Mortgage-backed securities 12,035 367 6.09% 14,987 464 6.19% Other interest-earning assets 21,500 599 5.57% 11,000 323 5.87% ----------- -------- ------ ----------- -------- ------ Total interest-earning assets 285,835 11,883 8.31% 275,402 10,515 7.64% -------- ------ -------- ------ Non-earning assets 4,167 5,705 ----------- ---------- Total average assets $ 290,002 $ 281,107 ----------- ---------- ----------- ---------- Interest-bearing liabilities: Customer deposits 229,220 6,110 5.33% 236,387 6,403 5.42% FHLBSF advances 32,852 893 5.43% 17,467 465 5.33% Other borrowings - - - % - - - % ----------- -------- ------ ----------- -------- ------ Total interest-bearing liabilities 262,072 7,003 5.35% 253,854 6,868 5.41% -------- ------ -------- ------ Non-interest bearing liabilities 3,243 2,763 Stockholders' equity 24,687 24,490 ----------- ---------- Average liabilities and equity $ 290,002 $ 281,107 ----------- ---------- ----------- ---------- Net interest income and spread $ 4,880 2.96% $ 3,647 2.23% -------- ------ -------- ------ -------- ------ -------- ------ Net margin on interest-earning assets (4) 3.41% 2.65% ------ ------ ------ ------ (1) Average loans exclude nonaccrual loans and are before allowances for loan losses, loans in process and deferred loan origination fees. (2) Loan interest income includes the amortization of deferred loan origination fees (in thousands) of $460 and $359 in 1996 and 1995, respectively. (3) Average balances for 1996 are daily average balances; for 1995, average balances are computed from month-end balances. (4) Net interest margin is computed as net interest income divided by interest- earning assets. 14 NET INTEREST INCOME The Company's net interest income is determined by both its interest rate spread and net interest margin. Interest rate spread is the difference between the yields earned on interest-earning assets and the rates paid on deposits and borrowings. Margin is interest rate spread adjusted for the excess of interest- earning assets over interest-costing liabilities. The Company's interest rate spread and margin are influenced by changes in market interest rates as, for the reasons discussed below, the Company's liabilities tend to respond to interest rate movements more rapidly than its assets. At June 30, 1996, 86% of the Company's gross loan portfolio consists of ARM loans which are tied to the Cost of Funds Index (COFI) with rates that adjust semi-annually. Because of this semi-annual repricing factor and the lag between the monthly change in COFI and the related change in the Company's ARM loans indexed to COFI, the time between a change in COFI and an adjustment to the rate on ARM loans can range from three to six months. Thus, in times of rapidly rising interest rates, the repricing of the ARM loans will adversely lag upward movements in the Company's cost of funds. Conversely, in a significant falling rate environment, ARM loan repricing and interest income will favorably lag the decrease in the Company's cost of funds. Net interest income for the second quarter of 1996 was $2.5 million compared with $1.8 million for the 1995 second quarter. Net interest income for the first half of 1996 was $4.9 million compared with $3.6 million for the same period in 1995. Most of the increase in net interest income for 1996 over 1995 for each period resulted from favorable changes primarily in the yields on interest- earning assets and, secondarily in the interest rate cost of deposits and borrowings. The effect on net interest income of the net change in balances of average interest earning assets and average interest costing liabilities was minor. Market interest rates rose rapidly during the second half of 1994 and peaked during the first quarter of 1995 and moderately declined throughout the rest of 1995. Through the process discussed above, the Company's cost of funds markedly increased during the first half of 1995 compared with much slower increases in the yields on its loan portfolio. In addition, the Company introduced a marketing program for certificates of deposit which increased certificates of deposit by $35 million during the first quarter of 1995. Accordingly, the Company's net interest margin dropped to 2.53% and 2.65% for the second quarter and first half, respectively, of 1995 from the margin at year end 1994 of 3.15%, thereby lowering net interest income for the 1995 periods. During the second quarter and first half of 1996, the yields on the Company's loan portfolio were higher than those for the 1995 periods, reflecting the lagging increases in the COFI index that occurred during 1995. This factor was principally responsible for increasing net interest income for the 1996 periods compared with the 1995 periods. The decline in market interest rates during much of 1995 and the first quarter of 1996, lowered the Company's cost of funds for 1996. In addition, during January 1996, $82.6 million of relatively higher cost term deposits matured. At January 31, 1996, the Company's cost of funds dropped to 5.39% from 5.81% at year end 1995 and its net interest margin increased to 3.33% from 2.90%. INTEREST INCOME Interest income on loans for the second quarter and first half of 1996, compared with the same periods in 1995, increased $317,000 and $1.2 million, respectively. Most of these increases in loan interest income arose from upward repricing adjustments to the Company's ARM loans subsequent to June 30, 1995, as discussed above. Interest income from securities investments for the 1996 periods increased $137,000 and $180,000, respectively, from the comparable 1995 periods. These increases resulted from higher levels of securities investments in 1996 over 1995. INTEREST EXPENSE Interest expense on deposits for the second quarter and first half of 1996, compared with the same periods in 1995, decreased $505,000 and $293,000, respectively. These declines resulted from lower amounts of deposits during the 1996 periods combined with the decrease in interest rates on the Company's deposit portfolio that occurred during the first half of 1996, as discussed above. The lower amounts of deposits during the 1996 periods were replaced with greater borrowings from the FHLBSF thereby increasing interest expense on borrowings in 1996 over 1995. 15 Table Ten below shows the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected the Company's net interest income for the three months ended June 30, 1996 compared with the same period in 1995, and the six months ended June 30, 1996 compared with the same period in 1995. TABLE TEN Second Quarter 1996 and 1995 First Half 1996 and 1995 Variance (1) Variance (1) ----------------------------- --------------------------- (Dollars in thousands) Volume Rate Total Volume Rate Total --------- -------- -------- -------- ------- -------- Interest Income: Loans receivable $ (106) 423 317 $ 125 1,064 1,189 Mortgage-backed securities (49) (3) (52) (90) (7) (97) Other interest-earning assets 164 25 189 279 (2) 277 ----------------------------- -------------------------- Total Interest Income 9 445 454 314 1,055 1,369 ----------------------------- -------------------------- Interest Expense: Customer deposits (253) (252) (505) (192) (101) (293) FHLBSF advances 249 8 257 418 10 428 ----------------------------- -------------------------- Total Interest Expense (4) (244) (248) 226 (91) 135 ----------------------------- -------------------------- Net Interest Income $ 13 689 702 $ 88 1,146 1,234 ----------------------------- -------------------------- ----------------------------- -------------------------- (1) The changes have been computed as follows: average balance changes - change in volume holding initial rate constant; average rate changes - change in average rate holding the initial balance constant; changes attributable to both volume and rate have been allocated proportionately. PROVISION FOR LOAN LOSSES The provision for loan losses for the three months and six months ended June 30, 1996 was $150,000 and $290,000, respectively, compared with $1.4 million for the same periods in 1995. See discussion under VALUATION ALLOWANCES above. NON-INTEREST INCOME AND NON-INTEREST EXPENSE Non-interest income and non-interest expense by major categories are shown in the Consolidated Statements of Operations for the three months and six months ended June 30, 1996 and 1995. Non-interest income was $171,000 and $71,000 for the three months ended June 30, 1996 and 1995, respectively, and $382,000 and $205,000 for the six months ended June 30, 1996, respectively. The greater amounts of non-interest income in the 1996 periods resulted from gains on sale of REO of $86,000 and $232,000, respectively, in 1996 compared with minimal gains in the 1995 periods. See discussion under ASSET QUALITY above. Loans and deposit fees for the first half of 1995 included deposit withdrawal penalties of $90,000 compared with $16,000 for the same 1996 period. Relatively higher market interest rates and a one-time certificate of deposit program in effect during the first quarter of 1995 resulted in certain depositors withdrawing their certificates prior to maturity. Non-interest expense includes general and administrative expenses (G&A) and expenses of real estate owned. G&A expenses for the three and six months ended June 30, 1996 were $1.6 million and $3.0 million, respectively, compared with $1.1 million and $2.4 million, respectively, for the same periods in 1995. The Company's G&A ratio to average assets for the three months and six months ended June 30, 1996 were 2.18% and 2.09%, respectively, compared with 1.50% and 1.68%, respectively, for the same periods in 1995. The increases in 1996 expenses over 1995 expenses primarily resulted from the following: 16 - - Compensation and benefits increased $282,000 (68%) for the second quarter of 1996 and $341,000 (32%) for the first half of 1996 compared with compensation and benefits expenses for the same periods in 1995. During the second quarter of 1995, benefits expense was reduced $116,000 by the reversal of a prior year profit sharing plan accrual. The remaining portion of the 1996 over 1995 increases in compensation and benefits, $166,000 and $225,000, respectively, mainly reflected the cost of additions to staff relating to the planning, loan service, loan credit review and asset evaluation processes. - - Deposit insurance and regulatory assessments increased $36,000 (25%) and $73,000 (26%) for the second quarter and first half of 1996 over assessments for the same periods in 1995. These increases resulted from higher deposit balances during the third and fourth quarters of 1995 and a 13% increase in the Company's deposit insurance assessment rate, effective January 1, 1996. Deposit assessments for any quarter are based on average deposit balances for the prior two quarters. - - Professional fees increased to $208,000 and $331,000 for the second quarter and first half 1996 periods, respectively, compared with $50,000 and $105,000 for the second quarter and first half of 1995. Professional fees for the second quarter of 1996 includes $102,000 of legal and other costs relating to the proposed merger with Luther Burbank Corporation (see Note 5 of Notes to Consolidated Financial Statements). In addition, during the 1996 periods the Company expended greater amounts for professional services to assist in enhancing the loan credit review process and in resolving or disposing of problem loans and real estate owned. INCOME TAX EXPENSE The ratio of income tax expense to pre-tax income is 46.3% and 43.8% for the second quarter and first half of 1996, compared with the Company's normal ratio of 41.5%. The higher 1996 ratios reflect the nondeductibility for tax purposes of the $102,000 of merger-related costs which are discussed above. LIQUIDITY AND CAPITAL RESOURCES LIQUIDITY The Company's primary sources of funds include loan and securities repayment, deposit generation,, advances from the Federal Home Loan Bank of San Francisco, and cash flows generated from operations. The Company uses its liquidity resources principally to fund mortgage loans, repay maturing borrowings, fund maturing time deposit and savings withdrawals and provide for its foreseeable short and long-term needs. The Company expects to be able to fund or refinance, on a timely basis, its commitments and long-term liabilities. Office of Thrift Supervision regulations require savings institutions to maintain a specified liquidity ratio (presently 5%) of cash and specified securities to customer deposits and borrowings due in one year or less. The Company continues to be in compliance with the liquidity regulation. Liquidity ratios at June 30, 1996 and December 31, 1995 were 8.52% and 8.38%, respectively. CAPITAL The Company continues to meet and exceed all regulatory capital tests at June 30, 1996 and is deemed well-capitalized. See Note 4 of Notes to Consolidated Financial Statements for further information. 17 PART II OTHER INFORMATION Item 1. LEGAL PROCEEDINGS The Company was not involved in any claims or lawsuits which, in the opinion of management after conferring with legal counsel, would have a material effect on the financial position of the Company. Item 2. CHANGES IN SECURITIES None Item 3. DEFAULTS UPON SENIOR SECURITIES None Item 4. SUBMISSION OF MATTERS TO A VOTE OF COMMON STOCKHOLDERS At the annual meeting of shareholders held on May 29, 1996, the shareholders reelected Jody Anne Becker, Pat Glasner and Judith A. Waller to the Board of Directors of NHS Financial, Inc. to serve three year terms to 1999. The election of directors was the only business to be presented at the annual meeting. Of the 2,522,827 shares of common stock outstanding as of the record date, April 2, 1996, the following indicates the number of votes cast for each of the three directors: Yes Votes Votes Withheld --------- -------------- Jody Anne Becker 2,050,231 31,788 Pat Glasner 2,049,343 32,676 Judith A. Waller 2,049,678 31,341 Item 5. OTHER INFORMATION None. Item 6. EXHIBITS AND REPORTS ON FORM 8-K On June 10, 1996, the Company filed a report on Form 8-K which consisted of a copy of the press release, dated May 23, 1996, announcing that NHS Financial, Inc. agreed to be acquired by Luther Burbank Corporation and that both corporations have signed a definitive agreement to merge. Under the terms of the agreement, Luther Burbank will pay a total cash consideration of approximately $29.7 million or $11.50 per share to the shareholders of NHS Financial, Inc. 18 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. NHS FINANCIAL, INC. (Registrant) Date: August 5, 1996 /s/ JAMES W. BARNETT ------------------------------------------------- JAMES W. BARNETT President and Chief Executive Officer Date: August 5, 1996 /s/ ALBERT J. THOMSON ------------------------------------------------- ALBERT J. THOMSON Senior Vice President and Chief Financial Officer Date: August 5, 1996 /s/ JARED L. BOOK ------------------------------------------------- JARED L. BOOK Vice President and Chief Accounting Officer 19