UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- ----- EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED: JUNE 30, 1996
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- ----- EXCHANGE ACT OF 1934
Commission File No.: 0-27940
HARRINGTON FINANCIAL GROUP, INC.
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Indiana 48-1050267
- ---------------------------------------- ---------------------------------
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
722 Promenade, P.O. Box 968
Richmond, Indiana 47375
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(Address of Principal (Zip Code)
Executive Offices)
Registrant's telephone number, including area code: (317) 966-9518
Securities registered pursuant to Section 12(b) of the Act:
NOT APPLICABLE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK (PAR VALUE $0.125 PER SHARE)
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(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 preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
----- -----
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K 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
-----
As of September 24, 1996, the aggregate value of the 1,031,923 shares of Common
Stock of the Registrant issued and outstanding on such date, which excludes
2,224,815 shares held by all directors and executive officers of the Registrant
as a group, was approximately $11.1 million. This figure is based on the last
known trade price of $10.75 per share of the Registrant's Common Stock on
September 24, 1996.
Number of shares of Common Stock outstanding as of September 24, 1996:
3,256,738
DOCUMENTS INCORPORATED BY REFERENCE
List hereunder the following documents incorporated by reference and the Part of
the Form 10-K into which the document is incorporated:
(1) Portions of the Annual Report to Stockholders for the fiscal year ended
June 30, 1996 are incorporated into Parts II and IV.
(2) Portions of the definitive proxy statement for the Annual Meeting of
Stockholders are incorporated into Part III.
PART I.
ITEM 1. BUSINESS
GENERAL
Harrington Financial Group, Inc. (the "Company") is an Indiana-chartered,
registered thrift holding company for Harrington Bank, FSB (the "Bank"). The
Bank is a federally chartered savings bank which conducts business through three
full-service offices located in Carmel and Fishers, Indiana, both suburbs of
Indianapolis, and Richmond, Indiana. The Company was organized in March 1988 in
connection with its acquisition of the Bank. The Bank was originally organized
in 1889 as an Indiana-chartered savings association under the name "The Peoples
Home and Savings Association of Richmond, Indiana." In 1936, the Bank obtained
federal insurance and in 1984 adopted a federal charter and changed its name to
"Peoples Federal Savings Association." In 1985, the Bank converted from mutual
to stock form and, in March 1994, changed its name to "Harrington Bank, FSB."
On May 6, 1996, the Company sold 1,265,000 shares of common stock at $10.00 per
share to investors in an initial public offering resulting in gross proceeds of
$12,650,000 to the Company. Net proceeds to the Company after offering expenses
were $11,437,000. At June 30, 1996, the Company had total consolidated assets
of $418.2 million, total consolidated borrowings of $254.1 million, total
consolidated deposits of $135.1 million, and total consolidated stockholders'
equity of $23.1 million.
The Company was organized in March 1988 by certain principals of Smith
Breeden Associates, Inc. ("Smith Breeden") for the sole purpose of acquiring the
Bank. This investor group purchased the Bank with the intention of expanding
the Bank's mortgage and investment operations and improving the Bank's return on
equity through the use of Smith Breeden's "option-adjusted pricing analysis."
Smith Breeden presently advises the Company and the Bank with respect to, among
other things, the management of its investments and borrowings, the pricing of
loans and deposits, as well as the use of various financial instruments to
reduce interest rate risk. Certain directors and officers of the Company and
the Bank are principals or affiliates of Smith Breeden.
The Company attempts to enhance profitability and reduce credit, interest
rate and liquidity risk by: (i) investing in mortgage-backed and related
securities and originating (both directly and through correspondents) loans
secured primarily by single-family residences; (ii) actively managing its
investment portfolio and funding sources in order to secure favorable spreads in
a variety of interest rate environments; (iii) controlling interest rate risk
and net portfolio volatility through the use of interest rate contracts and
mortgage-backed derivative securities; (iv) seeking to access cost-efficient
funding sources given prevailing market conditions, consisting primarily of
deposits, reverse repurchase agreements and FHLB advances; (iv) managing its
costs in order to maintain high operating efficiency; and (v) attempting to grow
its retail banking operations through increased loan originations and retail
deposit growth.
Highlights of the principal elements of the Company's business strategy are
as follows:
* ACTIVE PORTFOLIO MANAGEMENT. The Company actively manages its interest-
earning assets and, with the assistance of Smith Breeden, utilizes "option-
adjusted pricing analysis" to quantify the costs embedded in the yield of an
investment, including the funding cost, the cost of the options embedded in the
investment's cash flows, if any (such as a borrower's ability to prepay a
mortgage), and any servicing costs. The objective of the Company's investment
management process is to select assets (including loans and securities) with
attractive risk-adjusted net spreads (over the Company's funding costs) and
actively manage the underlying risks of these investments. The Company uses
interest rate contracts and mortgage-backed derivative securities to secure
favorable interest rate spreads and to maintain the overall market value of its
assets and liabilities in changing interest rate environments. The Company
believes that this strategy will enhance the long-term market value of the
Company. Nevertheless, because the Company actively manages its portfolio,
nearly all of its mortgage-backed and related securities and interest rate
contracts are classified for accounting purposes as held for trading (with
unrealized gains and losses included in earnings) and, as a result, the
Company's earnings have and may in the future fluctuate significantly on a
period-to-period basis as has been illustrated by the Company's results of
operations over the past five years. The Company attempts to reduce, to the
extent possible, such fluctuations through its asset and liability management
strategies.
* CONTROL INTEREST RATE RISK. The Company attempts to manage its assets and
liabilities in order to maintain a portfolio which produces positive
returns in either an increasing or decreasing interest rate environment.
The Company has sought to control interest rate risk both internally
through the management of the composition of its assets and liabilities and
externally through the utilization of interest rate contracts. Interest
rate contracts are purchased with the intention of protecting both the net
interest income of the Bank and, along with mortgage-backed derivative
securities, the market value of the Bank's portfolio on a mark-to-market
basis.
* CONTROL CREDIT RISK. In order to limit the Company's credit exposure and
as part of its strategy to earn a positive interest rate spread, the
Company maintains a substantial portion of its assets in mortgage-backed
and related securities, which are primarily issued or guaranteed by U.S.
Government agencies or government sponsored enterprises, and single-family
residential loans. At June 30, 1996, the Company's investment in
mortgage-backed and related securities amounted to $318.8 million or 97.7%
of the Company's securities portfolio (both held for trading and available
for sale) and 76.2% of the Company's total assets. In addition, as of such
date, the Company's investment in single-family residential loans amounted
to $64.9 million or 15.5% of total assets. See "- Lending" and "-
Investment Activities."
-2-
* REDUCE FUNDING COSTS. The Company attempts to reduce its overall funding
costs by evaluating all potential sources of funds (including retail and
non-retail deposits and short and long-term borrowings) and identifying
which particular source will result in an all-in cost to the Company that
meets its funding benchmark. At the same time, the Company has attempted
to price the deposits offered through its branch system in order to promote
retail deposit growth and offer a wide array of deposit products to satisfy
its customers. See "- Sources of Funds."
* INCREASE EMPHASIS ON RETAIL BANKING. An integral part of the Company's
strategy is to increase the Bank's emphasis on retail products and
services. The Company's primary lending emphasis is on the origination
(both directly and through correspondents) of loans secured by first liens
on single-family (one-to-four units) residences. Originations of such
loans have increased from $10.3 million during fiscal 1994 to $18.9 million
during fiscal 1995 and further increased to $41.6 million during fiscal
1996. See "- Lending Activities." In addition, the Company's retail
deposits (including transaction accounts and retail certificates of
deposit) have increased from $52.0 million or 48.1% of total deposits at
June 30, 1994 to $106.7 million or 78.9% of total deposits at June 30,
1996. See "- Sources of Funds - Deposits." The Company believes that
single-family residential loan originations generally offer attractive
yields, provide a source of fee income and, with respect to direct
originations, allow the Company to establish a relationship with the
underlying borrower which the Company can utilize to cross-sell additional
products and services. In addition, the Company believes that retail
deposits are a cost-effective source of funds, provide an additional source
of fee income and also permit the further cross-selling of additional
products and services. Consequently, the Company expects to continue to
focus on increasing its retail deposit base and its portfolio of
single-family residential loans.
* CONTROL OPERATING EXPENSES. As a result of the Company maintaining a
substantial portion of its assets in mortgage-backed and related
securities, the Company has been able to maintain a low level of operating
expenses. Accordingly, the Company's total other expenses to average total
assets for the years ended June 30, 1996 and 1995 amounted to 1.13% and
1.30%, respectively. Although the Company strives to maintain a low level
of operating expenses, management recognizes that as the Bank increases its
emphasis on retail banking, its operating expenses will correspondingly
increase.
* ASSET GROWTH AND ACQUISITIONS. The Company has and will continue to pursue
a policy of utilizing its existing capital and infrastructure to grow
through the purchase of mortgage-backed and related securities and the
continued growth of the Bank's retail operations. The Company will also
consider acquisition opportunities when it perceives that they are
advantageous to the Company and its stockholders. There are currently no
plans, arrangements, understandings or
-3-
agreements regarding any such acquisition opportunities. The Company
is deploying the net proceeds of its recent initial public offering of
common stock by purchasing mortgage-backed and related securities
funded primarily through reverse repurchase agreements and plans to
redeploy a portion of such capital into single-family residential
loans or other retail expansion opportunities as market conditions
permit.
The Company, as a registered savings and loan holding company, is subject
to examination and regulation by the Office of Thrift Supervision ("OTS") and is
subject to various reporting and other requirements of the Securities and
Exchange Commission ("SEC"). The Bank, as a federally chartered savings bank,
is subject to comprehensive regulation and examination by the OTS, as its
chartering authority and primary regulator, and by the FDIC, which administers
the SAIF, which insures the Bank's deposits to the maximum extent permitted by
law. The Bank is a member of the FHLB of Indianapolis, which is one of the 12
regional banks which comprise the FHLB System. The Bank is further subject to
regulations of the Board of Governors of the Federal Reserve System ("Federal
Reserve Board") governing reserves required to be maintained against deposits
and certain other matters. See "- Supervision and Regulation."
INVESTMENT ADVISOR
Smith Breeden is a money management and consulting firm involved in (i)
money management for separate accounts such as corporate, state and municipal
pensions, endowments and mutual funds, (ii) financial institution consulting and
investment advice, and (iii) equity investments. Smith Breeden specializes in
mortgage-backed and related securities, interest rate risk management, and the
application of option pricing to loans and investments. Smith Breeden currently
advises, or manages on a discretionary basis, assets totaling in excess of $20
billion. The firm has acted as a consultant to banks, thrifts and governmental
agencies charged with the regulation of financial institutions and the
resolution of troubled thrifts.
Smith Breeden was co-founded in 1982 by Douglas T. Breeden. Dr. Breeden is
a former professor at Stanford University, where he obtained his Ph.D. in
Finance. Dr. Breeden currently serves on the faculty at Duke University's Fuqua
School of Business and previously served on the faculty at the Massachusetts
Institute of Technology and the University of Chicago.
Since 1988, Smith Breeden and certain of its principals have been involved
in making equity investments in financial institutions in tandem with the
application of modern investment and interest rate risk management techniques.
Certain of the principals of Smith Breeden, including Dr. Breeden, the current
Chairman of the Board of the Company, and Craig J. Cerny, the current President
of the Company, are investors in Harrington West Financial Group, Inc. ("HWFG"),
a newly formed savings and loan holding company which recently acquired Los
Padres Savings Bank, F.S.B., a federally chartered savings bank headquartered in
Solvang, California. Certain principals of Smith Breeden have also made
minority investments in other banks and thrift institutions.
-4-
Smith Breeden is based in Overland Park, Kansas, and employs over 60 people
in its main office and its offices in Chapel Hill, North Carolina, Dallas, Texas
and Boulder, Colorado.
LENDING ACTIVITIES
GENERAL. At June 30, 1996, the Bank's net loan portfolio totaled $65.9
million, representing approximately 15.8% of the Company's $418.2 million of
total assets at that date. In addition to utilizing "option-adjusted pricing
analysis" in order to manage the Company's investment portfolio, the Company
also uses such analysis to price its loan originations and ascertain the net
spread expected to be earned with respect to the Bank's loan portfolio. The
Bank's primary focus with respect to its lending operations has historically
been the direct origination and servicing of single-family residential mortgage
loans. The Bank has built an efficient mortgage operation which has produced
record loan volumes each year since fiscal 1993. Since fiscal 1995, the Bank
has also been active in originating whole residential mortgage loans through
correspondents which meet its pricing and credit quality objectives. To a much
lesser extent, the Bank originates commercial real estate loans and consumer
loans. Substantially all of the Bank's loan portfolio consists of conventional
loans, which are loans that are neither insured by the Federal Housing
Administration nor partially guaranteed by the Department of Veterans Affairs.
The risks associated with mortgage lending are well-defined and
controllable. Credit risk is controlled through the adherence, with few
exceptions, to secondary market underwriting guidelines. A strong internal loan
review program monitors compliance with the Bank's underwriting standards, which
is reflected by the low level of non-performing assets. See - "Asset Quality -
Non-Performing Assets." Market risk is controlled by a disciplined approach to
pricing and by regular monitoring and hedging of the institution's overall
sensitivity to interest rate changes.
As a federally chartered savings institution, the Bank has general
authority to originate and purchase loans secured by real estate located
throughout the United States. Notwithstanding this nationwide lending
authority, the Company estimates that at June 30, 1996, approximately 94% of the
loans in the Bank's portfolio are secured by properties located or made to
customers residing in its primary market area, which consists of Wayne and
Hamilton counties in eastern and central Indiana and contiguous counties.
Although the Bank has historically originated loans with lesser dollar
balances than are permitted by federal regulations, current loans-to-one
borrower limitations may restrict its ability to do business with certain
customers. A savings institution generally may not make loans to any one
borrower and related entities in an amount which exceeds 15% of its unimpaired
capital and surplus, although loans in an amount equal to an additional 10% of
unimpaired capital and surplus may be made to a borrower if the loans are fully
secured by readily marketable securities. At June 30, 1996, the Bank's
regulatory limit on loans-to-one borrower was $4.0 million and its five largest
loans or groups of loans-to-one borrower, including related entities, aggregated
$324,000, $346,000, $348,000, $399,000 and $585,000. All five of the Bank's
largest loans or groups of loans are secured primarily by single-family
residential real estate located in its primary market area were performing in
accordance with their terms at June 30, 1996.
-5-
LOAN PORTFOLIO COMPOSITION. The following table sets forth the composition
of the Bank's loan portfolio by type of loan at the dates indicated.
JUNE 30,
-----------------------------------------------------------------------------------
1996 1995 1994
----------------------- ----------------------- -----------------------
Amount Percent Amount Percent Amount Percent
-------- -------- -------- -------- -------- --------
(Dollars in Thousands)
Single-family residential(1) $64,899 97.80% $35,998 96.10% $20,525 96.60%
Commercial real estate(2) 441 0.7 711 1.9 349 1.6
------- ------ ------- ------ ------- ------
Total real estate loans 65,340 98.5 36,709 98 20,874 98.2
Consumer loans:
Deposit secured 267 0.4 255 0.7 150 0.7
Home improvement/equity 732 1.1 498 1.3 210 1.0
Other -- -- -- -- 17 0.1
------- ------ ------- ------ ------- ------
Total consumer loans 999 1.5 753 2.0 377 1.8
------- ------ ------- ------ ------- ------
Total loans 66,339 100.00% 37,462 100.00% 21,251 100.00%
------- ------ ------
------- ------ ------
Less:
Unamortized push-down
accounting adjustment(3) (182) (350) (419)
Unamortized discount on loans (7) (13) (19)
Undisbursed funds(4) (420) (43) (8)
Deferred loan origination
(fees) costs (315) (75) (17)
Allowance for loan losses (120) (121) (106)
------- ------- -------
Net loans (65,925) (37,010) (20,682)
------- ------- -------
------- ------- -------
JUNE 30,
-----------------------------------------------------
1993 1992
---------------------- -----------------------
Amount Percent Amount Percent
------- ------- ------- -------
(Dollars in Thousands)
Single-family residential(1) $16,696 96.00% $21,701 96.80%
Commercial real estate(2) 456 2.6 484 2.2
------- ------ ------- ------
Total real estate loans 17,152 98.6 22,185 99
Consumer loans:
Deposit secured 88 0.5 120 0.5
Home improvement/equity 160 0.9 91 0.4
Other 3 -- 20 0.1
------- ------ ------- ------
Total consumer loans 251 1.4 231 1.0
------- ------ ------- ------
Total loans 17,403 100.00% 22,416 100.00%
------- ------ ------- ------
------- ------ ------- ------
Less:
Unamortized push-down
accounting adjustment(3) (592) (865)
Unamortized discount on loans (21) (33)
Undisbursed funds(4) (7) (1)
Deferred loan origination
(fees) costs (7) (11)
------ -------
Allowance for loan losses (156) (99)
------ -------
Net loans (16,620) (21,409)
------ -------
------ -------
- --------------------------------
(1) Includes single-family residential construction loans. At June 30, 1996,
the Bank's single-family residential loan portfolio included $586,000 of
single-family residential construction loans.
(2) Includes $291,000, $321,000, $349,000, $456,000, $484,000 and $511,000 of
mortgage revenue bonds secured by commercial real estate at each of the
respective dates.
(3) Reflects the balance of the fair value adjustments made on the loan
portfolio as a result of the completion in September 1988 of the Company's
acquisition of the Bank, which acquisition was accounted for under the
purchase method of accounting.
(4) Includes undisbursed funds relating to single-family residential
construction loans.
-6-
CONTRACTUAL PRINCIPAL REPAYMENTS AND INTEREST RATES. The following table
sets forth certain information at June 30, 1996 regarding the dollar amount of
loans maturing in the Bank's total loan portfolio, based on the contractual
terms to maturity, before giving effect to net items.
Due After Due After
Due in One One to Five Five or More
Year or Less Years Years Total
------------ ----------- ------------ -----
(In Thousands)
Single-family residential $ 611 $ 469 $ 63,819 $ 64,899
Commercial real estate 125 26 290 441
Consumer 348 214 437 999
------- ------- -------- --------
Total $ 1,084 $ 709 $ 64,546 $ 66,339
------- ------- -------- --------
------- ------- -------- --------
The following table sets forth the dollar amount of all loans, before net
items, due after one year from June 30, 1996, which have fixed interest rates or
which have floating or adjustable interest rates.
Floating or
Fixed Rates Adjustable-Rates Total
----------- ---------------- -----
(In Thousands)
Single-family residential $47,961 $16,327 $64,288
Commercial real estate 290 26 316
Consumer 613 38 651
------- ------- -------
Total $48,864 $16,391 $65,255
------- ------- -------
------- ------- -------
ORIGINATION, PURCHASE AND SALE OF LOANS. The lending activities of the
Bank are subject to the written, non-discriminatory underwriting standards and
loan origination procedures established by the Bank's Board of Directors and
management. Loan originations are obtained by a variety of sources, including
referrals from real estate brokers, builders, existing customers, walk-in
customers, loan officers and advertising. In its marketing, the Bank emphasizes
its community ties, customized personal service, competitive rates, and an
efficient underwriting and approval process. Loan applications are taken by
lending personnel, and the loan department supervises the obtainment of credit
reports, appraisals and other documentation involved with a loan. Property
valuations are performed by independent outside appraisers approved by the
Bank's Board of Directors. The Bank requires title, hazard and, to the extent
applicable, flood insurance on all security property.
-7-
Mortgage loan applications are initially processed by loan officers who
have approval authority up to designated limits. All loans in excess of an
individual's designated limits are referred to the Bank's Loan Committee, which
has approval authority for all loans up to $1.0 million. Any loans exceeding
$1.0 million (of which, at June 30, 1996, there were none) must be approved by
the Board of Directors of the Bank. In addition, the Board of Directors of the
Bank ratifies all loans originated and purchased by the Bank.
The single-family residential loans originated by the Bank are generally
made on terms, conditions and documentation which permit the sale to the Federal
Home Loan Mortgage Corporation ("FHLMC"), the Federal National Mortgage
Association ("FNMA") and other institutional investors in the secondary market.
From fiscal 1991 to fiscal 1993, the Bank sold substantially all of its
fixed-rate single-family residential loans to FNMA in the secondary market as a
means of generating fee income as well as providing additional funds for
lending, investing and other purposes. Sales of loans were generally under
terms which did not provide any recourse to the Company by the purchaser in
the event of default on the loan by the borrower. With respect to such loan
sales, the Company generally retained responsibility for collecting and
remitting loan payments, inspecting the properties, making certain insurance
and tax payments on behalf of borrowers and otherwise servicing the loans it
sold, and received a fee for performing these services. At June 30, 1996,
the Company was servicing $5.6 million of loans for others.
During fiscal 1994, the Bank determined to increase its portfolio of
single-family residential loans and terminated its loan sale program while at
the same time emphasizing increased originations of such loans. In addition,
during fiscal 1995, the Bank began originating single-family residential loans
through a correspondent mortgage banking company headquartered in Indianapolis,
Indiana. The Bank plans to expand further its single-family residential loan
portfolio through the use of additional correspondent mortgage banking companies
in the future.
The Bank requires that all loans originated through correspondents be
underwritten in accordance with its underwriting guidelines and standards. The
Bank reviews the loans, particularly scrutinizing the borrower's ability to
repay the obligation, the appraisal and the loan-to-value ratio. Such loans are
generally obtained with servicing released.
-8-
The following table sets forth the loan origination and sale activity of
the Company during the periods indicated.
Year Ended June 30,
-----------------------------------------
1996 1995 1994
-------- ---------- --------
(Dollars in Thousands)
Direct loan originations:
Single-family residential $18,895 $ 9,082 $10,295
Commercial real estate -- 1,387 --
Consumer 1,246 1,255 580
------- ------- -------
Total loans originated
directly 20,141 11,724 10,875
Originations by
correspondents(1) 22,721 9,830 --
------- ------- -------
Total loans originated 42,862 21,554 10,875
Sales and loan principal
reductions:
Loans sold(1) -- -- (91)
Loan principal reductions (13,985) (5,343) (6,936)
------- ------- -------
Total loans sold and
principal reductions (13,985) (5,343) (7,027)
------- ------- -------
Net increase (decrease) in
loan portfolio $28,877 $16,211 $ 3,848
------- ------- -------
------- ------- -------
- -------------------
(1) Consisted solely of single-family residential loans.
SINGLE-FAMILY RESIDENTIAL REAL ESTATE LOANS. Historically, savings
institutions such as the Bank have concentrated their lending activities on the
origination of loans secured primarily by first mortgage liens on existing
single-family residences. At June 30, 1996, $64.9 million or 97.8% of the
Bank's total loan portfolio consisted of single-family residential real estate
loans, substantially all of which are conventional loans.
The Bank offers fixed-rate single family residential loans with terms of 10
to 30 years. Such loans are amortized on a monthly basis with principal and
interest due each month. Generally, the value of fixed-rate loans fluctuates
inversely with changes in interest rates. Consequently, if left unhedged,
long-term fixed-rate single-family residential loans would increase the Bank's
interest rate risk. However, the Bank believes that its sophisticated asset and
liability management techniques provide the Bank with a competitive advantage
and allow for the Bank to continue to offer fixed-rate residential mortgage
loans over a variety of interest rate scenarios.
-9-
Since the early 1980s, the Bank has also been offering adjustable-rate
single-family residential mortgage loans. Such loans generally have up to
30-year terms and an interest rate which adjusts after one, three or five years
in accordance with a designated index (the weekly average yield on U.S. Treasury
securities adjusted to a constant comparable maturity of one year, as made
available by the Federal Reserve Board). Such loans currently have a 2% cap on
the amount of any increase or decrease in the interest rate per year, and a 6%
limit on the amount by which the interest rate can increase or decrease over the
life of the loan. In addition, the Bank's adjustable-rate loans are currently
not convertible into fixed-rate loans and do not contain prepayment penalties.
Approximately 24.6% of the single-family residential loans in the Bank's loan
portfolio at June 30, 1996 had adjustable interest rates.
Adjustable-rate mortgage loans decrease but do not eliminate the risks
associated with changes in interest rates. Because periodic and lifetime caps
limit the interest rate adjustments, the value of adjustable-rate mortgage loans
also fluctuates inversely with changes in interest rates. In addition as
interest rates increase, the required payments by the borrower increase, thus
increasing the potential for default.
The demand for adjustable-rate loans in the Bank's primary market area has
been a function of several factors, including the level of interest rates, the
expectations of changes in the level of interest rates and the difference
between the interest rates and loan fees offered for fixed-rate loans and
adjustable-rate loans. The relative amount of fixed-rate and adjustable-rate
residential loans that can be originated at any time is largely determined by
the demand for each in a competitive environment.
The Bank is permitted to lend up to 100% of the appraised value of the real
property securing a residential loan (referred to as the loan-to-value ratio);
however, if the amount of a residential loan originated or refinanced exceeds
90% of the appraised value, the Bank is required by federal regulations to
obtain private mortgage insurance on the portion of the principal amount that
exceeds 80% of the appraised value of the security property. Pursuant to
underwriting guidelines adopted by the Board of Directors, the Bank will
generally lend up to 95% of the appraised value of the property securing a
single-family residential loan. However, the Bank generally obtains private
mortgage insurance on the principal amount that exceeds 80% of appraised value
of the security property.
Although the Bank does not emphasize the origination of residential
construction loans, in recent years the Bank has occasionally originated loans
in its primary market area to construct single-family residences. At June 30,
1996, the Bank had five construction loans amounting to $586,000 in the
aggregate or 0.9% of the Bank's total loan portfolio.
COMMERCIAL REAL ESTATE LOANS. At June 30, 1996, $441,000 or 0.7% of the
Bank's total loan portfolio consisted of loans secured by commercial real
estate. At June 30, 1996, the Bank's commercial real estate loan portfolio
included four loans (which include mortgage revenue bonds) secured by commercial
buildings and vacant land, all of which are
-10-
located within the Company's primary market area. The Company's largest
commercial real estate loan at June 30, 1996 was a $196,000 loan secured by a
commercial building located in Richmond, Indiana.
Commercial real estate lending entails different and significant risks when
compared to single-family residential lending because such loans typically
involve large loan balances to single borrowers and because the payment
experience on such loans is typically dependent on the successful operation of
the project or the borrower's business. The Bank attempts to minimize its risk
exposure by limiting the extent of its commercial lending generally. In
addition, the Bank imposes stringent loan-to-value ratios, requires conservative
debt coverage ratios, and continually monitors the operation and physical
condition of the collateral. The Bank intends to continue to originate small
commercial real estate loans on a case-by-case basis that comply with its strict
underwriting standards.
CONSUMER LOANS. The Bank is authorized to make loans for a wide variety of
personal or consumer purposes. The Bank has been originating consumer loans in
recent years in order to provide a wider range of financial services to its
customers and because such loans generally have higher interest spreads than
mortgage loans. The consumer loans offered by the Bank include home equity
loans and lines of credit, home improvement loans and deposit account secured
loans. At June 30, 1996, $999,000 or 1.5% of the Bank's total loan portfolio
consisted of consumer loans.
Home equity loans and lines of credit are originated by the Bank for up to
80% of the appraised value, less the amount of any existing prior liens on the
property. The Bank also offers home improvement loans in amounts up to 95% of
the appraised value (provided the borrower has or maintains private mortgage
insurance on the principal balance that exceeds 80% of the appraised value),
less the amount of any existing prior liens on the property. Home equity loans
and home improvement loans have a maximum term of twenty years and carry fixed
interest rates. Home equity lines of credit have a maximum repayment term of 10
years, a five-year term with respect to draws, and carry interest rates which
adjust monthly in accordance with a designated prime rate. The Bank will secure
each of these types of loans with a mortgage on the property (generally a second
mortgage) and will originate the loan even if another institution holds the
first mortgage. At June 30, 1996, home equity loans and lines of credit and
home improvement loans totalled $732,000 or 1.1% of the Bank's total consumer
loan portfolio.
The Bank currently offers loans secured by deposit accounts, which amounted
to $267,000 or 0.4% of the Bank's total consumer loan portfolio at June 30,
1996. Such loans are originated for up to 95% of the deposit account balance,
with a hold placed on the account restricting the withdrawal of the account
balance.
Consumer loans generally have shorter terms and higher interest rates than
mortgage loans but generally involve more credit risk than mortgage loans
because of the type and nature of the collateral. In addition, consumer lending
collections are dependent on the
-11-
borrower's continuing financial stability, and thus are more likely to be
adversely affected by job loss, divorce, illness and personal bankruptcy. The
Bank believes that the generally higher yields earned on consumer loans
compensate for the increased credit risk associated with such loans, and the
Company intends to continue to offer consumer loans in order to provide a full
range of services to its customers.
ASSET QUALITY
LOAN DELINQUENCIES. When a borrower fails to make a required payment on a
loan, the Bank attempts to cure the deficiency by contacting the borrower and
seeking payment. Contacts are generally made following the fifteenth day after
a payment is due, at which time a late payment is assessed. In most cases,
deficiencies are cured promptly. If a delinquency extends beyond 15 days, the
loan and payment history is reviewed and efforts are made to collect the loan.
While the Bank generally prefers to work with borrowers to resolve such
problems, when the account becomes 90 days delinquent, the Bank does institute
foreclosure or other proceedings, as necessary, to minimize any potential loss.
NON-PERFORMING ASSETS. All loans are reviewed on a regular basis and are
placed on non-accrual status when, in the opinion of management, the collection
of additional interest is deemed insufficient to warrant further accrual. As a
matter of policy, the Bank does not accrue interest on loans past due 90 days or
more except when the estimated value of the collateral and collection efforts
are deemed sufficient to ensure full recovery. The Bank provides an allowance
for the loss of uncollected interest on all non-accrual loans. Impaired loans
covered under SFAS No. 114 and No. 118 are defined by the Company to consist of
non-accrual commercial loans which have not been collectively evaluated for
impairment. The allowance is established by a charge to interest income equal
to all interest previously accrued, and income is subsequently recognized only
to the extent that cash payments are received until, in management's judgment,
the borrower's ability to make periodic interest and principal payments returns
to normal, in which case the loan is returned to accrual status.
Real estate acquired through foreclosure is carried at the lower of the
loan's unpaid principal balance (cost) or fair value less estimated selling
expenses at the date of transfer. A loan charge-off is recorded for any
writedown in the loan's carrying value to fair value at the date of transfer.
Real estate loss provisions are recorded if the properties' fair value
subsequently declines below the value determined at the recording date. In
determining the lower of cost or fair value at acquisition, costs relating to
development and improvement of property are considered. Costs relating to
holding real estate acquired through foreclosure, net of rental income, are
charged against earnings as incurred.
-12-
The following table sets forth the amounts and categories of the Bank's
non-performing assets at the dates indicated. The Bank did not have any
troubled debt restructuring at any of the periods presented.
June 30,
----------------------------------------------------------------------------------------
1996 1995 1994 1993 1992
-------- -------- -------- -------- --------
(Dollars in Thousands)
Non-accruing loans:
Single-family residential $ 261 $ 350 $ 559 $449 $488
Commercial real estate -- -- -- 50 50
Consumer -- -- -- -- 10
------- ------ ------ ------ ------
Total non-accruing loans 261 350 559 499 548
Accruing loans greater than
90 days delinquent -- -- -- -- --
------- ------ ------ ------ ------
Total non-performing loans 261 350 559 499 548
Real estate owned -- -- -- 26 --
Other non-performing assets(1) 1,088 1,415 2,282 -- --
------- ------ ------ ------ ------
Total non-performing assets $ 1,349 $1,765 $2,841 $525 $548
------- ------ ------ ------ ------
------- ------ ------ ------ ------
Total non-performing loans
as a percentage of total
loans 0.40% 0.95% 2.70% 3.00% 2.56%
------- ------ ------ ------ ------
------- ------ ------ ------ ------
Total non-performing assets
as a percentage of total
assets 0.32% 0.59% 1.34% 0.24% 0.24%
------- ------ ------ ------ ------
------- ------ ------ ------ ------
- -------------------------
(1) Consists of a non-agency participation certificate. See "- Classified
Assets."
The interest income that would have been recorded during the years ended
June 30, 1996, 1995, 1994 and 1993 if the Bank's non-accrual loans at the end of
such periods had been current in accordance with their terms during such periods
was $6,000, $13,000, $26,000 and $46,000, respectively.
CLASSIFIED ASSETS. Federal regulations require that each insured savings
institution classify its assets on a regular basis. In addition, in connection
with examinations of insured institutions, federal examiners have authority to
identify problem assets and, if appropriate, classify them. There are three
classifications for problem assets: "substandard," "doubtful" and "loss."
Substandard assets have one or more defined weaknesses and are characterized by
the distinct possibility that the insured institution will sustain some loss if
the deficiencies are not corrected. Doubtful assets have the weaknesses of
substandard assets with the additional characteristic that the weaknesses make
collection or liquidation in full on the basis of currently existing facts,
conditions and values questionable, and there is a high possibility of loss. An
asset classified loss is considered uncollectible and of such little value that
continuance as an asset of the institution is not warranted. Another category
designated "special mention" also must be established and maintained for assets
which do not currently
-13-
expose an insured institution to a sufficient degree of risk to warrant
classification as substandard, doubtful or loss. Assets classified as
substandard or doubtful require the institution to establish general allowances
for loan losses. If an asset or portion thereof is classified loss, the insured
institution must either establish specific allowances for loan losses in the
amount of 100% of the portion of the asset classified loss, or charge-off such
amount. General loss allowances established to cover possible losses related to
assets classified substandard or doubtful may be included in determining an
institution's regulatory capital, while specific valuation allowances for loan
losses do not qualify as regulatory capital.
The Bank's classified assets at June 30, 1996 consisted of $1.4 million of
assets classified as substandard (including $286,000 of loans and $1.1 million
of securities) and no loans classified as doubtful. In addition, at June 30,
1996, $971,000 of the Bank's loans were designated special mention.
The $1.1 million of securities classified as substandard at June 30, 1996
relates to a single non-agency participation certificate which was purchased by
the Bank during fiscal 1991. The security was issued by a savings institution
located in Huntington Beach, California and the underlying mortgages consist of
six-month adjustable-rate notes (priced off of LIBOR) which are secured by
single-family properties located in southern California. As of June 30, 1996,
approximately 36.9% of the underlying mortgages were at least 30 days past due
and/or in foreclosure or already foreclosed upon by the servicer. The security
was structured into both senior and subordinate classes and the Bank owns only
senior classes. As of June 30, 1996, the pool had cumulative realized losses of
$17.9 million which were initially absorbed by certain credit supports and
subsequently absorbed by subordinate certificate holders. Currently, senior
certificate holders (such as the Bank) are having to absorb some of the losses.
The credit supports, which totalled $11.0 million at the date of issuance, had
been depleted as of June 30, 1996. The security is currently held in the Bank's
available for sale portfolio and its $1.1 million carrying value at June 30,
1996 reflects $53,000 of net unrealized losses as of such date as well as
$414,000 and $253,000 of write-downs with respect to such security which were
recognized by the Bank during fiscal 1995 and 1994, respectively.
ALLOWANCE FOR LOAN LOSSES. It is management's policy to maintain an
allowance for estimated losses on loans based upon the estimated net realizable
value of the underlying collateral, general economic conditions, particularly as
they relate to the Bank's market area, historical loss experience, and other
factors related to the collectibility of the loan portfolio. Although
management believes that it uses the best information available to make such
determinations, future adjustments to the allowance may be necessary, and net
income could be significantly affected, if circumstances differ substantially
from the assumptions used in making the initial determinations.
Effective December 21, 1993, the OTS, in conjunction with the Office of the
Comptroller of the Currency, the FDIC and the Federal Reserve Board, issued an
Interagency Policy Statement on the Allowance for Loan and Lease Losses ("Policy
-14-
Statement"). The Policy Statement, which effectively supersedes the proposed
guidance issued in September 1992, includes guidance (i) on the responsibilities
of management for the assessment and establishment of an adequate allowance and
(ii) for the agencies' examiners to use in evaluating the adequacy of such
allowance and the policies utilized to determine such allowance. The Policy
Statement also sets forth quantitative measures for the allowance with respect
to assets classified substandard and doubtful and with respect to the remaining
portion of an institution's loan portfolio. Specifically, the Policy Statement
sets forth the following quantitative measures which examiners may use to
determine the reasonableness of an allowance: (i) 50% of the portfolio that is
classified doubtful; (ii) 15% of the portfolio that is classified substandard
and (iii) for the portions of the portfolio that have not been classified
(including loans designated special mention), estimated credit losses over the
upcoming twelve months based on facts and circumstances available on the
evaluation date. While the Policy Statement sets forth this quantitative
measure, such guidance is not intended as a "floor" or "ceiling."
The following table sets forth an analysis of the Bank's allowance for loan
losses during the periods indicated.
June 30,
--------------------------------------------------------------------------------------
1996 1995 1994 1993 1992
-------- -------- -------- -------- --------
(Dollars in Thousands)
Total loans outstanding, net $65,925 $37,010 $20,682 $16,620 $21,409
------ ------ ------- ------ ------
------ ------ ------- ------ ------
Average loans outstanding, net $52,399 $25,467 $19,369 $19,437 $24,267
------ ------ ------- ------ ------
------ ------ ------- ------ ------
Balance at beginning of period $ 121 $ 106 $ 156 $ 99 $ 90
Charge-offs:
Single-family residential -- -- 2 -- --
Commercial real estate(1) -- -- 45 -- --
Consumer -- -- -- 10 --
------ ------ ------- ------ ------
Total charge-offs -- -- 47 10 --
Recoveries:
Consumer -- -- -- 1 --
------ ------ ------- ------ ------
Total recoveries -- -- -- 1 --
Net charge-offs -- -- 47 9 --
Provision (recovery) for loan losses (1) 15 (3) 66 9
------ ------ ------- ------ ------
Balance at end of period $ 120 $ 121 $ 106 $ 156 $ 99
------ ------ ------- ------ ------
------ ------ ------- ------ ------
Allowance for loan losses as a
percent of total loans
outstanding 0.2% 0.3% 0.5% 0.9% 0.5%
--- --- --- --- ---
--- --- --- --- ---
Ratio of net charge-offs to
average loans outstanding --% ---% 0.2% ---% ---%
--- --- --- --- ---
--- --- --- --- ---
- -----------------------------
(1) The $45,000 charge-off during fiscal 1994 related to a mortgage revenue
bond secured by commercial real estate.
-15-
The following table sets forth information concerning the allocation of the
Bank's allowance for loan losses by loan categories at the dates indicated.
June 30,
----------------------------------------------------------------------------------------------
1996 1995 1994
--------------------------- -------------------------------- -------------------------------
Percent of Percent of Percent of
Loans in Each Loans in Each Loans in Each
Category to Category to Category to
Amount Total Loans Amount Total Loans Amount Total Loans
------- -------------- -------------- -------------- --------------- --------------
(Dollars in Thousands)
Single-family residential loans $ 95 97.80% $ 96 96.10% $ 91 96.60%
Commercial real estate loans(1) 10 0.7 10 1.9 -- 1.6
Consumer loans 15 1.5 15 2 15 1.8
--- ----- --- ----- --- -----
Total $120 100.0% $121 100.0% $106 100.0%
--- ----- --- ----- --- -----
--- ----- --- ----- --- -----
June 30,
-----------------------------------------------------------
1993 1992
--------------------------- ----------------------------
Percent of Percent of
Loans in Each Loans in Each
Category to Category to
Amount Total Loans Amount Total Loans
---------- -------------- ---------- ---------------
(Dollars in Thousands)
Single-family residential loans $ 96 96.0% $32 96.8%
Commercial real estate loans(1) 45 2.6 40 2.2
Consumer loans 15 1.4 27 1.0
---- ------ --- ------
Total $156 100.0% $99 100.0%
---- ------ --- ------
---- ------ --- ------
- ------------------
(1) Includes mortgage revenue bonds.
-16-
INVESTMENT ACTIVITIES
GENERAL. The Company's securities portfolio is managed by investment
officers in accordance with a comprehensive written investment policy which
addresses strategies, types and levels of allowable investments and which is
reviewed and approved by the Bank's Board of Directors on an annual basis. The
management of the securities portfolio is set in accordance with strategies
developed by the Bank's Investment Committee. In addition, the Bank has entered
into an agreement with Smith Breeden whereby Smith Breeden has been appointed as
investment advisor with respect to the management of the Bank's securities
portfolio. With the assistance of Smith Breeden, the Bank's Chief Executive
Officer (who is also a principal of Smith Breeden), Chief Investment Officer,
and Investment Officer (who is also a principal of Smith Breeden) execute
various transactions with respect to the portfolio and are responsible for
informing the Investment Committee of the types of investments available, the
status and performance of the portfolio and current market conditions. The
investment officers are authorized to: purchase or sell any securities as well
as commitments to hedge eligible investments; purchase or sell eligible
investments under repurchase or reverse repurchase agreements; execute hedging
strategies approved by the Investment Committee; pledge securities owned as
collateral for public agency deposits or repurchase accounts or agreements; and
lend securities to approved dealers in government securities or approved
commercial banks. Any one investment officer has the authority to purchase or
sell securities up to $5.0 million in any one transaction and acting together,
two members of the Investment Committee have authority to purchase or sell
securities up to $10.0 million in any one transaction. For purchases or sales
greater than $10.0 million, the prior approval of a majority of the Investment
Committee is required. Investment officers are also authorized to invest excess
liquidity in approved liquid investment vehicles. In addition, both the
Investment Committee and the Board of Directors of the Bank ratify all
securities purchased and sold by the Bank.
The Company invests in a portfolio of mortgage-backed securities, mortgage-
backed derivative securities, interest rate contracts, equity securities and
municipal bonds. In selecting securities for its portfolio, the Company employs
option-adjusted pricing analysis with the assistance of Smith Breeden in order
to ascertain the net risk-adjusted spread expected to be earned with respect to
the various investment alternatives. The nature of this analysis is to quantify
the costs embedded in the yield of an investment, such as the funding cost, the
costs of the options embedded in the investment's cash flows (such as a
borrower's ability to prepay a mortgage), credit costs, if any, and servicing
costs. The objective of the Company's investment management process is to
select investments with the greatest net spreads and actively manage the
underlying risks of these investments.
The Company actively manages its securities portfolio in order to enhance
net interest and other income on a risk-adjusted basis. As a result, the
Company continuously monitors the net risk-adjusted spreads of its investments
and compares them with the spreads available with respect to other securities in
the market. Accordingly, as market conditions fluctuate (E.G., as risk-adjusted
spreads narrow), the Company will sell individual securities prior to their
maturity and reinvest the proceeds into new investments which generally carry
wider risk-adjusted spreads.
-17-
The Company's securities portfolio also contains various interest rate contracts
(such as interest rate swaps, collars, caps, floors, options and futures) which
are primarily utilized to hedge the Company's interest rate exposure in the
trading portfolio and which require active management in order to respond to
changing market conditions.
In recognition of the Company's business strategy of actively managing its
securities portfolio, during fiscal 1994, the Company reclassified substantially
all of its securities as held for trading. Pursuant to SFAS No. 115, securities
classified as trading securities are reported at fair value with unrealized
gains and losses included in earnings, and securities classified as available
for sale are similarly reported at fair value, but with unrealized gains and
losses excluded from earnings and instead reported as a separate component of
stockholders' equity.
MORTGAGE-BACKED AND RELATED SECURITIES. At June 30, 1996, the Company's
mortgage-backed and related securities portfolio (including $11.0 million of
mortgage-backed derivative securities) amounted to $318.8 million or 97.7% of
the Company's securities portfolio (both held for trading and available for
sale) and 76.2% of the Company's total assets. By investing in mortgage-backed
and related securities, management seeks to achieve a targeted option-adjusted
spread over applicable funding costs.
The Company invests in mortgage-backed and related securities, including
mortgage participation certificates, which are insured or guaranteed by U.S.
Government agencies and government sponsored enterprises, and CMOs and real
estate mortgage investment conduits ("REMICs"). Mortgage-backed securities
(which also are known as mortgage participation certificates or pass-through
certificates) represent a participation interest in a pool of single-family or
multi-family mortgages, the principal and interest payments on which are passed
from the mortgage originators, through intermediaries (generally U.S. Government
agencies and government sponsored enterprises) that pool and repackage the
participation interests in the form of securities, to investors such as the
Company. Such U.S. Government agencies and government sponsored enterprises,
which guarantee the payment of principal and interest to investors, primarily
include the FHLMC, the FNMA and the Government National Mortgage Association
("GNMA").
Mortgage-backed securities typically are issued with stated principal
amounts, and the securities are backed by pools of mortgages that have loans
with interest rates that are within a range and have varying maturities. The
characteristics of the underlying pool of mortgages, i.e., fixed-rate or
adjustable-rate, as well as prepayment risk, are passed on to the certificate
holder. The term of a mortgage-backed pass-through security thus approximates
the term of the underlying mortgages.
The Company's mortgage-backed derivative securities include CMOs, which
include securities issued by entities which have qualified under the Internal
Revenue Code as REMICs. CMOs and REMICs (collectively CMOs) have been developed
in response to investor concerns regarding the uncertainty of cash flows
associated with the prepayment option of the underlying mortgagor and are
typically issued by governmental agencies, government sponsored enterprises
-18-
and special purpose entities, such as trusts, corporations or partnerships,
established by financial institutions or other similar institutions. A CMO can
be collateralized by loans or securities which are insured or guaranteed by
FNMA, FHLMC or GNMA. In contrast to pass-through mortgage-backed securities, in
which cash flow is received pro rata by all security holders, the cash flow from
the mortgages underlying a CMO is segmented and paid in accordance with a
predetermined priority to investors holding various CMO classes. By allocating
the principal and interest cash flows from the underlying collateral among the
separate CMO classes, different classes of bonds are created, each with its own
stated maturity, estimated average life, coupon rate and prepayment
characteristics.
The Company's mortgage-backed derivative securities also include
mortgage-backed residuals and interest-only and principal-only strips.
Mortgage-backed residuals consist of certificates of particular tranches of a
CMO whereby the principal repayments and prepayments with respect to the
underlying pool of loans are generally not allocated to the residual until all
other certificates or tranches have been fully paid and retired. Interest-only
strips are a particular class of mortgage-backed derivative security which
receives and pays only interest with respect to the underlying pool of loans,
while principal-only strips receive and pay only principal repayments and
prepayments. As a result of the foregoing, mortgage-backed derivative
securities often exhibit elasticity and convexity characteristics (i.e., respond
differently to changes in interest rates) which the Company can utilize to
internally hedge other components of the Company's portfolio of assets against
interest rate risk.
The OTS has issued a statement of policy which states, among other things,
that mortgage derivative products (including CMOs and CMO residuals and stripped
mortgage-backed securities such as interest-only and principal-only strips)
which possess average life or price volatility in excess of a benchmark
fixed-rate 30-year mortgage-backed security are "high risk mortgage
securities," and must be carried in the institution's trading account or
as assets held for sale, and therefore marked to market on a regular basis.
At June 30, 1996, $5.9 million or 1.8% of the securities held in the Company's
portfolio consisted of such "high risk mortgage securities," as defined in such
policy statement. However, the Bank is in compliance with this OTS policy
statement since all of such securities are held in the Company's trading account
and marked to market on a regular basis in accordance with generally accepted
accounting principles.
Like most fixed-income securities, mortgage-backed and related securities
are subject to interest rate risk. However, unlike most fixed-income
securities, the mortgage loans underlying a mortgage-backed or related security
generally may be prepaid at any time without penalty. The ability to prepay a
mortgage loan generally results in significantly increased price and yield
volatility (with respect to mortgage-backed and related securities) than is the
case with non-callable fixed-income securities. Furthermore, mortgage-backed
derivative securities often are more sensitive to changes in interest rates and
prepayments than traditional mortgage-backed securities and are, therefore, even
more volatile. Nevertheless, the Company utilizes sophisticated asset and
liability management techniques to hedge against both interest rate and
prepayment risk.
-19-
Although mortgage-backed and related securities often carry lower yields
than traditional mortgage loans, such securities generally increase the quality
of the Company's assets by virtue of the securities' underlying insurance or
guarantees, are more liquid than individual mortgage loans (which enhances the
Company's ability to actively manage its portfolio) and may be used to
collateralize borrowings or other obligations of the Company. At June 30, 1996,
$229.7 million or 72.0% of the Company's mortgage-backed and related securities
were pledged to secure various obligations of the Company (such as reverse
repurchase agreements and interest rate swaps). In addition, as a result of the
Company maintaining a substantial portion of its assets in mortgage-backed and
related securities, the Company has been able to maintain a relatively low level
of operating expenses. Furthermore, mortgage-backed derivative securities are
often utilized by the Company to internally hedge its interest rate exposure and
can be attractive alternatives to other hedge vehicles when their
option-adjusted spreads are abnormally wide.
The following table sets forth information relating to the amortized cost
and market value of the Company's securities held for trading and securities
available for sale portfolios.
June 30,
-----------------------------------------------------------------------------------------
1996 1995 1994
------------------------------ ------------------------------- ------------------------
Amortized Market Amortized Market Amortized Market
Cost Value Cost Value Cost Value
----------- --------------- ----------------- ------------ ------------ ---------
(In Thousands)
Securities held for trading:
FHLMC participation certificates $ 83,329 $ 83,384 $ 54,685 $ 55,247 $ 11,313 $ 11,239
FNMA participation certificates 66,182 65,997 68,286 69,201 65,900 63,347
GNMA participation certificates 153,048 154,240 90,408 91,751 46,121 45,071
Non-agency participation
certificates 3,209 3,154 3,893 3,918 4,650 4,654
-------- -------- -------- -------- -------- --------
Total mortgage-backed securities 305,768 306,775 217,272 220,117 127,984 124,311
Collateralized mortgage obligations 6,131 6,379 12,910 13,022 23,447 23,469
Residuals 707 778 4,470 4,364 3,848 4,806
Interest-only strips 3,442 2,792 4,570 2,998 10,062 9,712
Principal only strips 1,028 1,010 781 803 -- --
-------- -------- -------- -------- -------- --------
Total mortgage-backed
derivative securities 11,308 10,959 22,731 21,187 37,357 37,987
Interest rate swaps -- 620 -- (219) -- 3,358
Interest rate collar 83 (8) 155 (71) 270 58
Interest rate caps 3,692 3074 2,297 1,995 2,573 4,054
Interest rate floors 2,535 2970 1,544 3,409 1,625 751
Options 54 65 266 200 -- --
Futures -- (784) -- (134) -- --
-------- -------- -------- -------- -------- --------
Total interest rate contracts 6,364 5,937 4,262 5,180 4,468 8,221
Equity securities 496 550 223 249 401 401
-------- -------- -------- -------- -------- --------
Total securities held for trading $323,936 $324,221 $244,488 $246,733 $170,210 $170,920
-------- -------- -------- -------- -------- --------
-------- -------- -------- -------- -------- --------
Securities available for sale:
Non-agency participation
certificates $ 1,141 $ 1,088 $ 1,426 $ 1,415 $ 2,363 $ 2,282
-------- -------- -------- -------- -------- --------
Total mortgage-backed securities 1,141 1,088 1,426 1,415 2,363 2,282
Municipal bonds 921 962 1,017 1,126 1,064 1,145
-------- -------- -------- -------- -------- --------
Total securities available for sale $ 2,062 $ 2,050 $ 2,443 $ 2,541 $ 3,427 $ 3,427
-------- -------- -------- -------- -------- --------
-------- -------- -------- -------- -------- --------
-20-
The following table sets forth the market value of the Company's securities
activities (both held for trading and available for sale) for the periods
indicated:
At or For the Years
Ended June 30,
-----------------------------------
1996 1995 1994
----------- ---------- ------------
(In Thousands)
Beginning balance $249,273 $174,347 $186,582
Mortgage-backed securities purchased -
held for trading 385,542 497,661 54,637
Mortgage-backed securities purchased -
available for sale -- -- 107,793
Collateralized mortgage obligations
purchased - held for trading -- 7,093 --
Collateralized mortgage obligations
purchased - available for sale -- -- 11,001
Mortgage-backed derivative securities
purchased - held for trading 495 2,741 975
Mortgage-backed derivative securities
purchased - available for sale -- -- 3,440
Interest rate contracts purchased - held
for trading 4,161 1,935 1,082
Interest rate contracts purchased -
available for sale -- -- 348
Equity securities purchased -
held for trading 545 880 --
Equity securities purchased -
available for sale -- -- 401
-------- -------- --------
Total securities purchased 390,743 510,310 179,677
Less:
Sale of mortgage-backed securities -
held for trading 272,108 394,967 56,602
Sale of mortgage-backed securities -
available for sale -- -- 81,675
Sale of collateralized mortgage
obligations - held for trading 7,798 17,321 --
Sale of collateralized mortgage
obligations - available for sale -- -- 17,022
Sale of mortgage-backed derivative
securities - held for trading 3,642 6,933 284
Sale of mortgage-backed derivative
securities - available for sale -- -- 619
Sale of interest rate contracts -
held for trading 1,973 (1,450) --
Sale of interest rate contracts -
available for sale -- -- (887)
Sale of equity securities -
held for trading 314 1,081 --
Sale of equity securities -
available for sale -- -- 219
-------- -------- --------
Total securities sold 285,835 418,852 155,534
Less proceeds from maturities of
securities 25,966 16,371 31,945
Realized gain (loss) on sale of
securities held for trading 1,834 66 (2,169)
Realized gain on sale of
securities available for sale -- -- 392
Unrealized gain (loss) on securities
held for trading (1,960) 1,535 710
Change in net unrealized gain (loss) on
securities available for sale 69 97 (470)
Amortization of premium (1,887) (1,445) (2,286)
Permanent impairment of securities
available for sale -- (414) (610)
-------- -------- --------
Ending balance $326,271 $249,273 $174,347
-------- -------- --------
-------- -------- --------
-21-
At June 30, 1996, the contractual maturity of substantially all of the
Company's mortgage-backed or related securities was in excess of ten years. The
actual maturity of a mortgage-backed or related security is less than its stated
maturity due to prepayments of the underlying mortgages. Prepayments that are
faster than anticipated may shorten the life of the security and affect its
yield to maturity. The yield to maturity is based upon the interest income and
the amortization of any premium or discount related to the security. In
accordance with generally accepted accounting principles, premiums and discounts
are amortized over the estimated lives of the loans, which decrease and increase
interest income, respectively. The prepayment assumptions used to determine the
amortization period for premiums and discounts can significantly affect the
yield of the mortgage-backed or related security, and these assumptions are
reviewed periodically to reflect actual prepayments. Although prepayments of
underlying mortgages depend on many factors, including the type of mortgages,
the coupon rate, the age of mortgages, the geographical location of the
underlying real estate collateralizing the mortgages and general levels of
market interest rates, the difference between the interest rates on the
underlying mortgages and the prevailing mortgage interest rates generally is the
most significant determinant of the rate of prepayments. During periods of
falling mortgage interest rates, if the coupon rate of the underlying mortgages
exceeds the prevailing market interest rates offered for mortgage loans,
refinancing generally increases and accelerates the prepayment of the underlying
mortgages and the related security. At June 30, 1996, of the $318.8 million of
mortgage-backed and related securities held by the Company, an aggregate of
$154.9 million were secured by fixed-rate mortgage loans and an aggregate of
$163.9 million were secured by adjustable-rate mortgage loans.
OTHER SECURITIES. Other securities owned by the Company at June 30, 1996
include various interest rate contracts, including interest rate swaps, collars,
caps, floors, options and futures, equity securities and municipal bonds. At
June 30, 1996, the carrying value of the Company's interest rate contracts,
equity securities and municipal bonds amounted to $5.9 million, $550,000 and
$962,000 million, respectively. The municipal bonds held by the Company at June
30, 1996 were scheduled to mature between one and five years. See Note 2 to the
Notes to Consolidated Financial Statements.
SOURCES OF FUNDS
GENERAL. The Company will consider various sources of funds to fund its
investing and lending activities and evaluates the available sources of funds in
order to reduce the Company's overall funding costs. Deposits, reverse
repurchase agreements, advances from the FHLB of Indianapolis, notes payable,
and sales, maturities and principal repayments on loans and securities have been
the major sources of funds for use in the Company's lending and investing
activities, and for other general business purposes. Management of the Company
closely monitors rates and terms of competing sources of funds on a daily basis
and utilizes the source which it believes to be cost effective.
-22-
DEPOSITS. The Bank attempts to price its deposits in order to promote
deposit growth and offers a wide array of deposit products in order to satisfy
its customers' needs. The Bank's current deposit products include statement
savings accounts, negotiable order of withdrawal ("NOW") and checking accounts,
money market deposit accounts, fixed-rate, fixed-maturity retail certificates of
deposit ranging in terms from seven days to 10 years, individual retirement
accounts, and non-retail certificates of deposit consisting of jumbo (generally
greater than $95,000) certificates, inverse variable-rate certificates and
brokered certificates of deposit.
The Bank's retail deposits are generally obtained from residents in its
primary market area. The principal methods currently used by the Bank to
attract deposit accounts include offering a wide variety of value-added products
and services and competitive interest rates. The Bank utilizes traditional
marketing methods to attract new customers and savings deposits, including
various forms of advertising. The Bank also utilizes the services of deposit
brokers to attract non-retail certificates of deposit. Management estimates
that as of June 30, 1996, non-retail deposit accounts totalled $28.5 million or
21.1% of the Bank's total deposits. These non-retail deposits consist largely
of jumbo certificates of deposit, inverse variable-rate certificates (which are
obtained through brokers) and brokered deposits. The Bank's jumbo certificates
of deposit and other deposits are also obtained through the posting of deposit
rates on national computerized bulletin boards at no cost to the Bank. The
Bank's inverse variable-rate certificates carry rates which fluctuate inversely
with respect to market rates of interest. For example, if market rates of
interest increase, the rates on the inverse variable-rate certificates would
decrease, while if market rates of interest decrease, the rates on the inverse
variable-rate certificates would increase. As a result, the Bank would
generally be paying a higher rate on such certificates during a declining
interest rate environment. The Bank offers inverse variable-rate certificates
when they represent a lower cost source of funds.
-23-
The following table shows the distribution of and certain other information
relating to the Bank's deposits by type as of the dates indicated.
June 30,
-----------------------------------------------------------------------------------------
1996 1995 1994
-------------------------- ----------------------------- ------------------------
Percent of Percent of Percent of
Amount Deposits Amount Deposits Amount Deposits
-------- ------------ ---------- ------------- ---------- ------------
(Dollars in Thousands)
Transaction accounts:
NOW and checking $ 4,529 3.4% $ 3,266 2.8% $ 3,178 2.9%
Savings accounts 17,342 12.8 15,183 13.2 16,502 15.3
Money market deposit
accounts 1,576 1.2 1,976 1.7 7,563 7.0
-------- ------ --------- ------ --------- ------
Total transaction
accounts 23,447 17.4 20,425 17.7 27,243 25.2
-------- ------ --------- ------ --------- ------
Certificates of deposit:
Within 1 year 75,343 55.7 57,304 49.8 41,911 38.7
1-2 years 19,890 14.7 17,890 15.5 15,909 14.7
2-3 years 8,093 6.0 6,844 5.9 9,292 8.6
3-4 years 2,636 2.0 5,352 4.6 3,620 3.3
Over 4 years 5,734 4.2 7,497 6.5 10,325 9.5
-------- ------ --------- ------ --------- ------
Total certificate accounts 111,696 82.6 94,887 82.3 81,057 74.8
-------- ------ --------- ------ --------- ------
Total deposits $135,143 100.0% $115,312 100.0% $108,300 100.0%
-------- ------ --------- ------ --------- ------
-------- ------ --------- ------ --------- ------
-24-
The following table shows the distribution of and certain other information
relating to the Bank's certificates of deposit as of the dates indicated.
June 30,
-----------------------------------------------------------------------------------------
1996 1995 1994
-------------------------- ----------------------------- ------------------------
Percent of Percent of Percent of
Amount Deposits Amount Deposits Amount Deposits
-------- ------------ ---------- ------------- ---------- ------------
(Dollars in Thousands)
Total retail certificates $ 89,462 66.2% $ 62,465 54.1% $ 31,845 29.4%
-------- ---- -------- ---- -------- ----
Non-retail certificates:
Jumbo certificates 6,041 4.5 9,963 8.6 21,445 19.8
Inverse variable-rate
certificates 8,423 6.2 9,993 8.7 12,065 11.1
Non-brokered out-of-
state deposits 7,276 5.4 11,476 10.0 13,029 12.0
Brokered deposits 494 0.4 990 0.9 2,673 2.5
-------- ---- -------- ---- -------- ----
Total non-retail
certificates(1) 22,234 16.5 32,422 28.2 49,212 45.4
-------- ---- -------- ---- -------- ----
Total certificates of deposit $111,696 82.7% $ 94,887 82.3% $ 81,057 74.8%
-------- ---- -------- ---- -------- ----
-------- ---- -------- ---- -------- ----
- ------------------
(1) Of the Company's $22.2 million of non-retail certificates as of June 30,
1996, $6.7 million was scheduled to mature in six months or less, $5.4
million was scheduled to mature in 7-12 months, $5.3 million was scheduled
to mature in 13-36 months and $4.8 million was scheduled to mature in over
36 months.
-25-
The following table presents the average balance of each deposit type and
the average rate paid on each deposit type for the periods indicated.
Year Ended June 30,
------------------------------------------------------------------------------------------
1996 1995 1994
----------------------------- ------------------------------- --------------------------
Average Average Average Average Average Average
Balance Rate Paid Balance Rate Paid Balance Rate Paid
----------- --------------- ------------ --------------- ------------ ------------
(Dollars in Thousands)
NOW and checking
accounts $ 3,813 2.9% $ 3,352 2.8% $ 2,872 2.9%
Savings accounts 15,922 3.9 16,068 3.5 18,271 3.3
Money market deposit
accounts 1,777 4.3 2,147 4.1 5,396 3.4
Certificates of deposit 103,981 6.1 99,443 5.9 69,336 5.3
------- --- -------- --- ------- ----
Total deposits $125,493 5.7% $121,010 5.5% $95,875 4.7%
-------- --- -------- --- ------- ----
-------- --- -------- --- ------- ----
The following table sets forth the deposit account activities of the Bank
during the periods indicated.
Year Ended June 30,
--------------------------------------
1996 1995 1994
----------- ------------- ----------
(In Thousands)
Deposits $213,601 $184,399 $173,083
Withdrawals 197,550 182,443 157,579
Net increase before
interest credited 16,051 1,956 15,504
Interest credited 3,780 5,056 3,008
--------- --------- --------
Net increase in deposits $ 19,831 $ 7,012 $ 18,512
--------- --------- --------
--------- --------- --------
The following table shows the interest rate and maturity information for the
Bank's certificates of deposit at June 30, 1996.
Maturity Date
-------------------------------------------------------------------------------------------------
Interest Rate One Year or Less Over 1-2 Years Over 2-3 Years Over 3 Years Total
- -------------------------- ------------------- ----------------- ------------------ ------------------ --------
(Dollars in Thousands)
3.00% or less $ 2 $ -- $ 1 $ 13 $ 16
3.01 - 5.00% 4,683 1,050 470 71 6,274
5.01 - 7.00% 65,284 17,535 4,836 4,114 91,769
7.01 - 9.00% 5,374 1,210 2,491 3,492 12,567
9.01% or greater -- 95 295 680 1,070
-------- -------- -------- ------- --------
Total $ 75,343 $ 19,890 $ 8,093 $ 8,370 $111,696
-------- -------- -------- ------- --------
-------- -------- -------- ------- --------
-26-
The following table sets forth the maturities of the Bank's certificates of
deposit having principal amounts of $100,000 or more at June 30, 1996.
Certificates of deposit maturing
in quarter ending: Amount
- ------------------------------------------------------------- --------------
(In Thousands)
September 30, 1996 $10,430
December 31, 1996 2,363
March 31, 1997 1,325
After March 31, 1997 6,037
-------
Total certificates of deposit with
balances of $100,000 or more $20,155
-------
-------
BORROWINGS. The following table sets forth certain information regarding the
borrowings of the Company at or for the dates indicated.
At or For the Year Ended June 30,
---------------------------------
1996 1995 1994
---------- ----------- --------
(Dollars in Thousands)
FHLB advances:
Average balance outstanding $ 27,586 $ 31,051 $31,000
Maximum amount outstanding at
any month-end during the period 31,000 31,000 31,000
Balance outstanding at end of period 26,000 31,000 31,000
Average interest rate during the
period 5.8% 5.6% 3.4%
Average interest rate at end of period 5.4% 6.1% 4.3%
Securities sold under agreements to
repurchase:
Average balance outstanding $148,523 $ 68,277 $66,813
Maximum amount outstanding at
any month-end during the period 219,067 130,217 78,545
Balance outstanding at end of period 219,067 130,217 54,651
Average interest rate during the
period 5.6% 5.4% 3.2%
Average interest rate at end of period 5.2% 6.0% 4.1%
-27-
The Company obtains both fixed-rate and variable-rate long-term and
short-term advances from the FHLB of Indianapolis upon the security of certain
of its residential first mortgage loans and other assets, provided certain
standards related to creditworthiness of the Bank have been met. FHLB of
Indianapolis advances are available for general business purposes to expand
lending and investing activities. Borrowings have generally been used to fund
the purchase of mortgage-backed and related securities or lending activities and
have been collateralized with a pledge of loans, securities in the Company's
portfolio or any mortgage-backed or related securities purchased.
Advances from the FHLB of Indianapolis are made pursuant to several different
credit programs, each of which has its own interest rate and range of
maturities. The Company currently has two variable-rate advances from the FHLB
of Indianapolis which mature in 1997. At June 30, 1996, the Company had total
FHLB of Indianapolis advances of $26.0 million at a weighted average interest
rate of 5.4%.
The Company also obtains funds from the sales of securities to investment
dealers under agreements to repurchase ("reverse repurchase agreements"). In a
reverse repurchase agreement transaction, the Company will generally sell a
mortgage-backed security agreeing to repurchase either the same or a
substantially identical security (i.e., "dollar rolls") on a specified later
date (generally not more than 90 days) at a price less than the original sales
price. The difference in the sale price and purchase price is the cost of the
use of the proceeds. The mortgage-backed securities underlying the agreements
are delivered to the dealers who arrange the transactions. For agreements in
which the Company has agreed to repurchase substantially identical securities,
the dealers may sell, loan or otherwise dispose of the Company's securities in
the normal course of their operations; however, such dealers or third party
custodians safe-keep the securities which are to be specifically repurchased by
the Company. Reverse repurchase agreements represent a competitive cost funding
source for the Company. Nevertheless, the Company is subject to the risk that
the lender may default at maturity and not return the collateral. The amount at
risk is the value of the collateral which exceeds the balance of the borrowing.
In order to minimize this potential risk, the Company only deals with large,
established investment brokerage firms when entering into these transactions.
Reverse repurchase transactions are accounted for as financing arrangements
rather than as sales of such securities, and the obligation to repurchase such
securities is reflected as a liability in the Consolidated Financial Statements.
In April 1993, the Company entered into a $10.0 million loan facility with an
unrelated financial institution. This facility, as amended in 1995, includes a
$9.2 million term loan (the "Refinancing Loan") and a non-revolving line of
credit of $800,000. Proceeds from the Refinancing Loan were utilized to repay
the unpaid balance of a $10.0 million loan that the Company obtained in 1988 in
connection with its acquisition of the Bank (which loan had a principal balance
of $6.6 million as of the date of repayment), reduce the average interest rate
paid on such indebtedness and increase the capitalization of the Bank. The loan
facility matures in March 2000 (which can, under certain circumstances, be
extended for an additional five years) and carries an interest rate of 1/2%
over the prime rate published in the WALL STREET JOURNAL if the ratio of the
loan balance to the Bank's capital is equal to or less than 50%; otherwise, the
interest
-28-
rate is 1% over the prime rate. The loan facility requires quarterly principal
and interest repayments. The loan facility is secured by (i) a general pledge
agreement between the parties pursuant to which the Company has pledged 100% of
the outstanding stock of the Bank; (ii) a security agreement between the parties
pursuant to which the Company has provided a blanket security interest in all of
its assets; and (iii) the assignment of life insurance policies on Messrs.
Breeden and Cerny by the Company in the aggregate amount of $1.25 million. At
June 30, 1996, the total balance of the loan facility was $9.0 million. A July
1996 amendment to the loan facility recharacterized the aggregate $9.3 principal
balance outstanding as a term loan and provided an additional $3.0 million
non-revolving line of credit, which is intended to further increase the capital
of the Bank. In addition, the amended loan agreement also removed the corporate
guarantee of Smith Breeden Associates, Inc. and the personal guarantee from a
stockholder of the Company.
TRUST AND FIDUCIARY SERVICES
The Company also provides a full range of trust and investment services, and
acts as executor or administrator of estates and as trustee for various types of
trusts. Trust and investment services are offered through Harrington Investment
Management and Trust Services ("Trust Department"), which was created in
December 1994 as a separate division of the Bank. Services offered include
financial services related to trusts and estates, money management, custodial
services and pension and employee benefits consulting and plan administration.
As of June 30, 1996, the Trust Department administered approximately 60
trust/fiduciary accounts, with aggregate assets of $13.4 million at such date.
Gross fee income from the Trust Department amounted to $31,000 and $4,000 during
fiscal 1996 and 1995, respectively, while the Trust Department recognized net
losses with respect to its operations of $59,000 and $91,000 during the
respective periods.
SUBSIDIARIES
The Bank is permitted to invest up to 2% of its assets in the capital stock
of, or secured or unsecured loans to, subsidiary corporations, with an
additional investment of 1% of assets when such additional investments is
utilized primarily for community development purposes. The Bank's only
subsidiary, Pine Tree Mortgage Corp., is an inactive corporation formed in 1987
to originate mortgage loans in North Carolina, and has conducted no business
since 1988. The Bank's investment in the subsidiary is not material to its
operations or financial condition.
SUPERVISION AND REGULATION
SET FORTH BELOW IS A BRIEF DESCRIPTION OF THOSE LAWS AND REGULATIONS WHICH,
TOGETHER WITH THE DESCRIPTIONS OF LAWS AND REGULATIONS CONTAINED ELSEWHERE
HEREIN, ARE DEEMED MATERIAL TO AN INVESTOR'S UNDERSTANDING OF THE EXTENT TO
WHICH THE COMPANY AND THE BANK ARE REGULATED. THE DESCRIPTION OF THE LAWS AND
REGULATIONS HEREUNDER, AS WELL AS DESCRIPTIONS OF LAWS AND REGULATIONS CONTAINED
ELSEWHERE HEREIN, DOES NOT PURPORT TO BE COMPLETE AND IS QUALIFIED IN ITS
ENTIRETY BY REFERENCE TO APPLICABLE LAWS AND REGULATIONS.
-29-
THE COMPANY
GENERAL. The Company is a registered savings and loan holding company
within the meaning of the Home Owners' Loan Act ("HOLA"), and is subject to OTS
regulations, examinations, supervision and reporting requirements. As a
subsidiary of a savings and loan holding company, the Bank is subject to certain
restrictions in its dealings with the Company and affiliates thereof.
ACTIVITIES RESTRICTIONS. Although there are generally no restrictions on
the activities of a savings and loan holding company which holds only one
subsidiary savings institution under applicable OTS regulations, the Company may
be considered to be a multiple savings and loan holding company because
principals and affiliates of Smith Breeden are deemed for regulatory purposes to
control both the Company and HWFG, a recently formed savings and loan holding
company which owns all of the outstanding common stock of Los Padres Savings
Bank, F.S.B., Los Padres, California.
Multiple savings and loan holding companies are subject to restrictions
which do not apply to unitary savings and loan holding companies. Among other
things, no multiple savings and loan holding company or subsidiary thereof which
is not a savings institution shall commence or continue for a limited period of
time after becoming a multiple savings and loan holding company or subsidiary
thereof any business activity, upon prior notice to, and no objection by the
OTS, other than: (i) furnishing or performing management services for a
subsidiary savings institution; (ii) conducting an insurance agency or escrow
business; (iii) holding, managing, or liquidating assets owned by or acquired
from a subsidiary savings institution; (iv) holding or managing properties used
or occupied by a subsidiary savings institution; (v) acting as trustee under
deeds of trust; (vi) those activities authorized by regulation as of March 5,
1987 to be engaged in by multiple savings and loan holding companies; or (vii)
unless the Director of the OTS by regulation prohibits or limits such activities
for savings and loan holding companies, those activities authorized by the
Federal Reserve Board as permissible for bank holding companies. Those
activities described in (vii) above also must be approved by the Director of the
OTS prior to being engaged in by a multiple savings and loan holding company.
The Company does not believe that if the OTS designates it as a multiple thrift
holding company, such a designation will limit its ability to conduct its normal
business operations.
In addition, if the Director of the OTS determines that there is reasonable
cause to believe that the continuation by a savings and loan holding company of
an activity constitutes a serious risk to the financial safety, soundness or
stability of its subsidiary savings institution, the Director may impose such
restrictions as deemed necessary to address such risk, including limiting (i)
payment of dividends by the savings institution; (ii) transactions between the
savings institution and its affiliates; and (ii) any activities of the savings
institution that might create a serious risk that the liabilities of the
holding company and its affiliates may be imposed on the savings institution.
-30-
LIMITATIONS ON TRANSACTIONS WITH AFFILIATES. Transactions between savings
institutions and any affiliate are governed by Sections 23A and 23B of the
Federal Reserve Act. An affiliate of a savings institution is any company or
entity which controls, is controlled by or is under common control with the
savings institution. In a holding company context, the parent holding company
of a savings institution (such as the Company) and any companies which are
controlled by such parent holding company are affiliates of the savings
institution. Generally, Sections 23A and 23B (i) limit the extent to which the
savings institution or its subsidiaries may engage in "covered transactions"
with any one affiliate to an amount equal to 10% of such institution's capital
stock and surplus, and contain an aggregate limit on all such transactions with
all affiliates to an amount equal to 20% of such capital stock and surplus and
(ii) require that all such transactions be on terms substantially the same, or
at least as favorable, to the institution or subsidiary as those provided to a
non-affiliate. The term "covered transaction" includes the making of loans,
purchase of assets, issuance of a guarantee and other similar transactions. In
addition to the restrictions imposed by Sections 23A and 23B, no savings
institution may (i) loan or otherwise extend credit to an affiliate, except for
any affiliate which engages only in activities which are permissible for bank
holding companies, or (ii) purchase or invest in any stocks, bonds, debentures,
notes or similar obligations of any affiliate, except for affiliates which are
subsidiaries of the savings institution.
In addition, Sections 22(h) and (g) of the Federal Reserve Act places
restrictions on loans to executive officers, directors and principal
stockholders. Under Section 22(h), loans to a director, an executive officer
and to a greater than 10% stockholder of a savings institution, and certain
affiliated interests of either, may not exceed, together with all other
outstanding loans to such person and affiliated interests, the savings
institution's loans to one borrower limit (generally equal to 15% of the
institution's unimpaired capital and surplus). Section 22(h) also requires that
loans to directors, executive officers and principal stockholders be made on
terms substantially the same as offered in comparable transactions to other
persons and also requires prior board approval for certain loans. In addition,
the aggregate amount of extensions of credit by a savings institution to all
insiders cannot exceed the institution's unimpaired capital and surplus.
Furthermore, Section 22(g) places additional restrictions on loans to executive
officers. At June 30, 1996, the Bank was in compliance with the above
restrictions.
RESTRICTIONS ON ACQUISITIONS. Except under limited circumstances, savings
and loan holding companies are prohibited from acquiring, without prior approval
of the Director of the OTS, (i) control of any other savings institution or
savings and loan holding company or substantially all the assets thereof or (ii)
more than 5% of the voting shares of a savings institution or holding company
thereof which is not a subsidiary. Except with the prior approval of the
Director of the OTS, no director or officer of a savings and loan holding
company or person owning or controlling by proxy or otherwise more than 25% of
such company's stock, may acquire control of any savings institution, other than
a subsidiary savings institution, or of any other savings and loan holding
company.
The Director of the OTS may only approve acquisitions resulting in the
formation of a multiple savings and loan holding company which controls savings
institutions in more than one
-31-
state if (i) the multiple savings and loan holding company involved controls a
savings institution which operated a home or branch office located in the state
of the institution to be acquired as of March 5, 1987; (ii) the acquiror is
authorized to acquire control of the savings institution pursuant to the
emergency acquisition provisions of the Federal Deposit Insurance Act ("FDIA");
or (iii) the statutes of the state in which the institution to be acquired is
located specifically permit institutions to be acquired by the state-chartered
institutions or savings and loan holding companies located in the state where
the acquiring entity is located (or by a holding company that controls such
state-chartered savings institutions).
Under the Bank Holding Company Act of 1956, the Federal Reserve Board is
authorized to approve an application by a bank holding company to acquire
control of a savings institution. In addition, a bank holding company that
controls a savings institution may merge or consolidate the assets and
liabilities of the savings institution with, or transfer assets and liabilities
to, any subsidiary bank which is a member of the BIF with the approval of the
appropriate federal banking agency and the Federal Reserve Board. As a result
of these provisions, there have been a number of acquisitions of savings
institutions by bank holding companies in recent years.
THE BANK
GENERAL. The OTS has extensive authority over the operations of federally
chartered savings institutions. As part of this authority, savings institutions
are required to file periodic reports with the OTS and are subject to periodic
examinations by the OTS. The last regulatory examination of the Bank by the OTS
was conducted in March 1996. The Bank was not required to make any material
changes to its operations as a result of such examination. The investment and
lending authority of savings institutions are prescribed by federal laws and
regulations, and such institutions are prohibited from engaging in any
activities not permitted by such laws and regulations. Those laws and
regulations generally are applicable to all federally chartered savings
institutions and may also apply to state-chartered savings institutions. Such
regulation and supervision is primarily intended for the protection of
depositors.
The OTS' enforcement authority over all savings institutions and their
holding companies includes, among other things, the ability to assess civil
money penalties, to issue cease and desist or removal orders and to initiate
injunctive actions. In general, these enforcement actions may be initiated for
violations of laws and regulations and unsafe or unsound practices. Other
actions or inactions may provide the basis for enforcement action, including
misleading or untimely reports filed with the OTS.
INSURANCE OF ACCOUNTS. The deposits of the Bank are insured to the maximum
extent permitted by the SAIF, which is administered by the FDIC, and are backed
by the full faith and credit of the U.S. Government. As insurer, the FDIC is
authorized to conduct examinations of, and to require reporting by, FDIC-insured
institutions. It also may prohibit any FDIC-insured institution from engaging
in any activity the FDIC determines by regulation or order to pose a serious
threat to the FDIC. The FDIC also has the authority to initiate enforcement
actions against savings institutions, after giving the OTS an opportunity to
take such action.
-32-
Both the SAIF and BIF are statutorily required to be capitalized to a ratio
of 1.25% of insured reserve deposits. While the BIF has reached the required
reserve ratio, the SAIF is not expected to be recapitalized until 2002 at the
earliest. Legislation has authorized $8 billion for the SAIF; however, such
funds only become available to the SAIF if the FDIC determines that the funds
are needed to cover losses of the SAIF and several other stringent criteria are
met.
Effective January 1, 1996, deposit insurance premiums for BIF member
institutions were reduced to zero basis points (subject to a $2,000 minimum) for
institutions in the lowest risk category, while deposit insurance premiums for
SAIF members were maintained at their current levels (23 basis points for
institutions in the lowest risk category, as discussed below.)
Under current FDIC regulations, SAIF member institutions are assigned to
one of three capital groups which are based solely on the level of an
institution's capital--"well capitalized," "adequately capitalized," and
"undercapitalized." These three groups are then divided into three subgroups
which reflect varying levels of supervisory concern, from those which are
considered to be healthy to those which are considered to be of substantial
supervisory concern. The matrix so created results in nine assessment risk
classifications, with rates ranging from .23% for well capitalized, healthy
institutions to .31% for undercapitalized institutions with substantial
supervisory concerns. The insurance premium for the Bank for 1996 was .23% (per
annum) of insured deposits.
The FDIC may terminate the deposit insurance of any insured depository
institution, including the Bank, if it determines after a hearing that the
institution has engaged or is engaging in unsafe or unsound practices or is in
an unsafe or unsound condition to continue operations, or if the insured
depository institution or any of its directors or trustees have violated any
applicable law, regulation, order or any condition imposed by an agreement with
the FDIC. It also may suspend deposit insurance temporarily during the hearing
process for the permanent termination of insurance, if the institution has no
tangible capital. If insurance of accounts is terminated, the accounts at the
institution at the time of the termination, less subsequent withdrawals, shall
continue to be insured for a period of six months to two years, as determined by
the FDIC. Management is aware of no existing circumstances which would result
in termination of the Bank's deposit insurance.
REGULATORY CAPITAL REQUIREMENTS. Federally insured savings institutions
are required to maintain minimum levels of regulatory capital. The OTS has
established capital standards applicable to all savings institutions. These
standards generally must be as stringent as the comparable capital requirements
imposed on national banks. The OTS also is authorized to impose capital
requirements in excess of these standards on individual institutions on a case-
by-case basis.
Current OTS capital standards require savings institutions to satisfy three
different capital requirements. Under these standards, savings institutions
must maintain "tangible" capital equal to at least 1.5% of adjusted total
assets, "core" capital equal to at least 3.0% of adjusted total assets and
"total" capital (a combination of core and "supplementary" capital) equal to at
least
-33-
8.0% of "risk-weighted" assets. For purposes of the regulation, core capital
generally consists of common stockholders' equity (including retained earnings),
noncumulative perpetual preferred stock and related surplus, minority interests
in the equity accounts of fully consolidated subsidiaries, certain
nonwithdrawable accounts and pledged deposits and "qualifying supervisory
goodwill." Tangible capital is given the same definition as core capital but
does not include qualifying supervisory goodwill and is reduced by the amount of
all the savings institution's intangible assets, with only a limited exception
for purchased mortgage servicing rights. The Bank had no goodwill or other
intangible assets at June 30, 1996. Both core and tangible capital are further
reduced by an amount equal to a savings institution's debt and equity
investments in subsidiaries engaged in activities not permissible to national
banks (other than subsidiaries engaged in activities undertaken as agent for
customers or in mortgage banking activities and subsidiary depository
institutions or their holding companies). At June 30, 1996, there were no such
adjustments to the Bank's regulatory capital.
In determining compliance with the risk-based capital requirement, a
savings institution is allowed to include both core capital and supplementary
capital in its total capital, provided that the amount of supplementary capital
included does not exceed the savings institution's core capital. Supplementary
capital generally consists of hybrid capital instruments; perpetual preferred
stock which is not eligible to be included as core capital; subordinated debt
and intermediate-term preferred stock; and general allowances for loan losses up
to a maximum of 1.25% of risk-weighted assets. In determining the required
amount of risk-based capital, total assets, including certain off-balance sheet
items, are multiplied by a risk weight based on the risks inherent in the type
of assets. The risk weights assigned by the OTS for principal categories of
assets are (i) 0% for cash and securities issued by the U.S. Government or
unconditionally backed by the full faith and credit of the U.S. Government; (ii)
20% for securities (other than equity securities) issued by U.S.
Government-sponsored agencies and mortgage-backed securities issued by, or
fully guaranteed as to principal and interest by, FNMA or FHLMC, except for
those classes with residual characteristics or stripped mortgage-related
securities; (iii) 50% for prudently underwritten permanent one- to four-family
first lien mortgage loans not more than 90 days delinquent and having a
loan-to-value ratio of not more than 80% at origination unless insured to such
ratio by an insurer approved by FNMA or FHLMC, qualifying residential bridge
loans made directly for the construction of one- to four-family residences and
qualifying multi-family residential loans; and (iv) 100% for all other loans and
investments, including consumer loans, commercial loans, and one- to four-family
residential real estate loans more than 90 days delinquent, and for repossessed
assets.
Any savings institution that fails any of the capital requirements is
subject to possible enforcement actions by the OTS or the FDIC. Such actions
could include a capital directive, a cease and desist order, civil money
penalties, the establishment of restrictions on the institution's operations
(including growth), termination of federal deposit insurance and the appointment
of a conservator or receiver. The OTS' capital regulation provides that such
actions, through enforcement proceedings or otherwise, could require one or more
of a variety of corrective actions.
-34-
LIQUIDITY REQUIREMENTS. All savings institutions are required to maintain
an average daily balance of liquid assets equal to a certain percentage of the
sum of its average daily balance of net withdrawable deposit accounts and
borrowings payable in one year or less. The liquidity requirement may vary from
time to time (between 4.0% and 10.0%) depending upon economic conditions and
savings flows of all savings institutions. At the present time, the required
minimum liquid asset ratio is 5.0%. At June 30, 1996, the Bank's liquidity
ratio was 5.5%.
CAPITAL DISTRIBUTIONS. OTS regulations govern capital distributions by
savings institutions, which include cash dividends, stock redemptions or
repurchases, cash-out mergers, interest payments on certain convertible debt and
other transactions charged to the capital account of a savings institution to
make capital distributions. Generally, the regulation creates a safe harbor for
specified levels of capital distributions from institutions meeting at least
their minimum capital requirements, so long as such institutions notify the OTS
and receive no objection to the distribution from the OTS. Savings institutions
and distributions that do not qualify for the safe harbor are required to obtain
prior OTS approval before making any capital distributions.
Generally, a savings institution that before and after the proposed
distribution meets or exceeds its fully phased-in capital requirements (Tier 1
institutions) may make capital distributions during any calendar year equal to
the higher of (i) 100% of net income for the calendar year-to-date plus 50% of
its "surplus capital ratio" at the beginning of the calendar year or (ii) 75% of
net income over the most recent four-quarter period. The "surplus capital
ratio" is defined to mean the percentage by which the institution's ratio of
total capital to assets exceeds the ratio of its fully phased-in capital
requirement to assets. "Fully phased-in capital requirement" is defined to mean
an institution's capital requirement under the statutory and regulatory
standards applicable on December 31, 1994, as modified to reflect any applicable
individual minimum capital requirement imposed upon the institution. Failure to
meet fully phased-in or minimum capital requirements will result in further
restrictions on capital distributions, including possible prohibition without
explicit OTS approval. In order to make distributions under these safe harbors,
Tier 1 institutions such as the Bank must submit 30 days written notice to the
OTS prior to making the distribution. The OTS may object to the distribution
during that 30-day period based on safety and soundness concerns.
In December 1994, the OTS published a notice of proposed rulemaking to
amend its capital distribution regulation. Under the proposal, institutions
would be permitted to only make capital distributions that would not result in
their capital being reduced below the level required to remain "adequately
capitalized." Because the Bank will be a subsidiary of a holding company, the
proposal would require the Bank to provide notice to the OTS of its intent to
make a capital distribution. The Bank does not believe that the proposal will
adversely affect its ability to make capital distributions if it is adopted
substantially as proposed.
LOANS TO ONE BORROWER. The permissible amount of loans-to-one borrower now
generally follows the national bank standard for all loans made by savings
institutions, as compared to the pre-FIRREA rule that applied that standard only
to commercial loans made by federally chartered savings institutions. The
national bank standard generally does not permit loans-to-one borrower to exceed
the greater of $500,000 or 15% of unimpaired capital and
-35-
surplus. Loans in an amount equal to an additional 10% of unimpaired capital
and surplus also may be made to a borrower if the loans are fully secured by
readily marketable securities. For information about the largest borrowers from
the Bank, see "- Lending Activities."
BRANCHING BY FEDERAL SAVINGS INSTITUTIONS. OTS policy permits interstate
branching to the full extent permitted by statute (which is essentially
unlimited). Generally, federal law prohibits federal savings institutions from
establishing, retaining or operating a branch outside the state in which the
federal institution has its home office unless the institution meets the IRS'
domestic building and loan test (generally, 60% of a thrift's assets must be
housing-related) ("IRS Test"). The IRS Test requirement does not apply if,
among other things, the law of the state where the branch would be located would
permit the branch to be established if the federal savings institution were
chartered by the state in which its home office is located. Furthermore, the
OTS will evaluate a branching applicant's record of compliance with the
Community Reinvestment Act of 1977 ("CRA"). An unsatisfactory CRA record may be
the basis for denial of a branching application.
QUALIFIED THRIFT LENDER TEST. All savings institutions are required to
meet a QTL test to avoid certain restrictions on their operations. A savings
institution that does not meet the QTL test must either convert to a bank
charter or comply with the following restrictions on its operations: (i) the
institution may not engage in any new activity or make any new investment,
directly or indirectly, unless such activity or investment is permissible for a
national bank; (ii) the branching powers of the institution shall be restricted
to those of a national bank; (iii) the institution shall not be eligible to
obtain any advances from its FHLB; and (iv) payment of dividends by the
institution shall be subject to the rules regarding payment of dividends by a
national bank. Upon the expiration of three years from the date the savings
institution ceases to be a QTL, it must cease any activity and not retain any
investment not permissible for a national bank and immediately repay any
outstanding FHLB advances (subject to safety and soundness considerations).
Currently, the QTL test requires that 65% of an institution's "portfolio
assets" (as defined) consist of certain housing and consumer-related assets on a
monthly average basis in nine out of every 12 months. Assets that qualify
without limit for inclusion as part of the 65% requirement are loans made to
purchase, refinance, construct, improve or repair domestic residential housing
and manufactured housing; home equity loans; mortgage-backed securities (where
the mortgages are secured by domestic residential housing or manufactured
housing); stock issued by the FHLB of Indianapolis; and direct or indirect
obligations of the FDIC. In addition, the following assets, among others, may
be included in meeting the test subject to an overall limit of 20% of the
savings institution's portfolio assets: 50% of residential mortgage loans
originated and sold within 90 days of origination; 100% of consumer and
educational loans (limited to 10% of total portfolio assets); and stock issued
by FHLMC or FNMA. Portfolio assets consist of total assets minus the sum of (i)
goodwill and other intangible assets, (ii) property used by the savings
institution to conduct its business, and (iii) liquid assets up to 20% of the
institution's total assets. At June 30, 1996, the qualified thrift investments
of the Bank were approximately 97.8% of its portfolio assets.
-36-
ACCOUNTING REQUIREMENTS. Applicable OTS accounting regulations and
reporting requirements apply the following standards: (i) regulatory reports
will incorporate generally accepted accounting principles ("GAAP") when GAAP is
used by federal banking agencies; (ii) savings institution transactions,
financial condition and regulatory capital must be reported and disclosed in
accordance with OTS regulatory reporting requirements that will be at least as
stringent as for national banks; and (iii) the Director of the OTS may prescribe
regulatory reporting requirements more stringent than GAAP whenever the Director
determines that such requirements are necessary to ensure the safe and sound
reporting and operation of savings institutions.
FEDERAL HOME LOAN BANK SYSTEM. The Bank is a member of the FHLB of
Indianapolis, which is one of 12 regional FHLBs that administers the home
financing credit function of savings institutions. Each FHLB serves as a
reserve or central bank for its members within its assigned region. It is
funded primarily from proceeds derived from the sale of consolidated obligations
of the FHLB System. It makes loans to members (i.e., advances) in accordance
with policies and procedures established by the Board of Directors of the FHLB.
At June 30, 1996, the Company had $26.0 million of FHLB advances. See "-
Sources of Funds - Borrowings."
As a member, the Bank is required to purchase and maintain stock in the
FHLB of Indianapolis in an amount equal to at least 1% of its aggregate unpaid
residential mortgage loans, home purchase contracts or similar obligations at
the beginning of each year. At June 30, 1996, the Bank had $2.6 million in FHLB
stock, which was in compliance with this requirement.
The FHLBs are required to provide funds for the resolution of troubled
savings institutions and to contribute to affordable housing programs through
direct loans or interest subsidies on advances targeted for community investment
and low- and moderate-income housing projects. These contributions have
adversely affected the level of FHLB dividends paid in the past and could
continue to do so in the future. These contributions also could have an adverse
effect on the value of FHLB stock in the future.
FEDERAL RESERVE SYSTEM. The Federal Reserve Board requires all depository
institutions to maintain reserves against their transaction accounts (primarily
NOW and Super NOW checking accounts) and non-personal time deposits. As of June
30, 1996, the Bank was in compliance with this requirement. Because required
reserves must be maintained in the form of vault cash or a noninterest-bearing
account at a Federal Reserve Bank, the effect of this reserve requirement is to
reduce an institution's earning assets.
FEDERAL TAXATION
GENERAL. The Company and Bank are subject to the generally applicable
corporate tax provisions of the Code, and Bank is subject to certain additional
provisions of the Code which apply to thrifts and other types of financial
institutions. The following discussion of federal taxation is intended only to
summarize certain pertinent federal income tax matters material to the taxation
of the Company and the Bank and is not a comprehensive discussion of the tax
rules applicable to the Company and Bank.
-37-
YEAR. The Company files a consolidated federal income tax return on the
basis of a fiscal year ending on June 30. The Company's federal income tax
returns for the tax years ended June 30, 1993 forward are open under the statute
of limitations and are subject to review by the IRS.
BAD DEBT RESERVES. Savings institutions, such as the Bank, which meet
certain definitional tests primarily relating to their assets and the nature of
their businesses, are permitted to establish a reserve for bad debts and to make
annual additions to the reserve. These additions may, within specified formula
limits, be deducted in arriving at the institution's taxable income. For
purposes of computing the deductible addition to its bad debt reserve, the
institution's loans are separated into "qualifying real property loans" (i.e.,
generally those loans secured by certain interests in real property) and all
other loans ("non-qualifying loans"). The deduction with respect to
non-qualifying loans must be computed under the experience method as
described below. The following formulas may be used to compute the bad debt
deduction with respect to qualifying real property loans: (i) actual loss
experience, or (ii) a percentage of taxable income. Reasonable additions to the
reserve for losses on non-qualifying loans must be based upon actual loss
experience and would reduce the current year's addition to the reserve for
losses on qualifying real property loans, unless that addition is also
determined under the experience method. The sum of the additions to each
reserve for each year is the institution's annual bad debt deduction.
Under the experience method, the deductible annual addition to the
institution's bad debt reserves is the amount necessary to increase the balance
of the reserve at the close of the taxable year to the greater of (a) the amount
which bears the same ratio to loans outstanding at the close of the taxable year
as the total net bad debts sustained during the current and five preceding
taxable years bear to the sum of the loans outstanding at the close of the six
years, or (b) the lower of (i) the balance of the reserve account at the close
of the Bank's "base year," which was its tax year ended December 31, 1987, or
(ii) if the amount of loans outstanding at the close of the taxable year is less
than the amount of loans outstanding at the close of the base year, the amount
which bears the same ratio to loans outstanding at the close of the taxable year
as the balance of the reserve at the close of the base year bears to the amount
of loans outstanding at the close of the base year.
Under the percentage of taxable income method, the bad debt deduction
equals 8% of taxable income determined without regard to that deduction and with
certain adjustments. The availability of the percentage of taxable income
method permits a qualifying savings institution to be taxed at a lower effective
federal income tax rate than that applicable to corporations in general. This
resulted generally in an effective federal income tax rate payable by a
qualifying savings institution fully able to use the maximum deduction permitted
under the percentage of taxable income method, in the absence of other factors
affecting taxable income, of 31.3% exclusive of any minimum tax or environmental
tax (as compared to 34.0% for corporations generally). For tax years beginning
on or after January 1, 1993, the maximum corporate tax rate was increased to
35.0%, which increased the maximum effective federal income tax rate payable by
a qualifying savings institution fully able to use the maximum deduction to
32.2%. Any savings institution at least 60.0% of whose assets are qualifying
assets, as described in the Code,
-38-
will generally be eligible for the full deduction of 8.0% of taxable income. As
of June 30, 1996, approximately 88.4% of the assets of the Bank were "qualifying
assets" as defined in the Code, and the Bank anticipates that at least 60.0% of
its assets will continue to be qualifying assets in the immediate future. If
this ceases to be the case, the institution may be required to restore some
portion of its bad debt reserve to taxable income in the future.
Under the percentage of taxable income method, the bad debt deduction for
an addition to the reserve for qualifying real property loans cannot exceed the
amount necessary to increase the balance in this reserve to an amount equal to
6.0% of such loans outstanding at the end of the taxable year. The bad debt
deduction is also limited to the amount which, when added to the addition to the
reserve for losses on non-qualifying loans, equals the amount by which 12.0% of
deposits at the close of the year exceeds the sum of surplus, undivided profits
and reserves at the beginning of the year. Based on experience, it is not
expected that these restrictions will be a limiting factor for the Bank in the
foreseeable future. In addition, the deduction for qualifying real property
loans is reduced by an amount equal to all or part of the deduction for
non-qualifying loans.
At June 30, 1996, the federal income tax reserves of the Company included
$3.0 million for which no federal income tax has been provided. Deferred income
taxes have not been provided on such bad debt deductions since the Company does
not intend to use the accumulated bad debt deductions for purposes other than to
absorb loan losses. If, in the future, this portion of retained earnings is
used for any purpose other than to absorb bad debt losses, federal income taxes
may be imposed on such amounts at the then current corporation income tax rate.
In August 1996, the "Small Business Job Protection Act of 1996" was passed
into law. One provision of the act repeals the special bad debt reserve method
for thrift institutions currently provided for in Section 593 of the Code. The
provision requires thrifts to recapture any reserve accumulated after 1987 but
forgives taxes owed on reserves accumulated prior to 1988. Thrift institutions
will be given six years to account for the recaptured excess reserves, beginning
with the first taxable year after 1995, and will be permitted to delay the
timing of this recapture for one or two years, subject to whether they meet
certain residential loan test requirements. Management does not believe that
this legislation will have a material adverse effect on the Company's
consolidated financial position.
STATE TAXATION
The State of Indiana imposes a franchise tax on the "adjusted gross income"
of financial institutions at a fixed rate of 8.5% per annum. This franchise tax
is imposed in lieu of the gross income tax, adjusted gross income tax, and
supplemental net income tax otherwise imposed on certain corporate entities.
"Adjusted gross income" is computed by making certain modifications to an
institution's federal taxable income. Tax-exempt interest, for example, is
included in the savings association's adjusted gross income and the bad debt
deduction is limited to actual charge-offs for purposes of the financial
institutions tax.
-39-
ITEM 2. PROPERTIES
The Company's principal executive office is located at 722 Promenade,
Richmond, Indiana, 47375. The following table sets forth certain information
with respect to the offices and other properties of the Bank at June 30, 1996.
Net Book Value
Description/Address Leased/Owned of Property(1) Deposits
------------------------- ------------- --------------- ----------
(In Thousands)
Main Office Owned $1,680 $80,810
722 Promenade
Richmond, Indiana
Carmel Branch(2) Leased(3) 112 41,900
11592 Westfield Boulevard
Carmel, Indiana
Fishers Branch(4) Owned 950 12,433
7150 East 116th Street
Fishers, Indiana
- ------------------------
(1) Includes leasehold improvements.
(2) Branch opened in May 1994.
(3) The lease expires in June 2008 and may be extended for an additional ten
years provided that proper notice is timely given.
(4) Branch opened in December 1995.
-40-
ITEM 3. LEGAL PROCEEDINGS.
There are no material legal proceedings to which the Company is a party or
to which any of their property is subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Not applicable.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS.
Shares of the Company's common stock are traded nationally under the symbol
"HFGI" on the NASDAQ National Market System. The following table shows market
price information for the Company's common stock. The prices set forth below
represent the high and low prices during the period indicated:
Price Per Share
------------------------------------
High Low
---------------- -----------------
June 30, 1996(1) $11.00 $10.125
(1) The Company's common stock commenced trading on May 10, 1996.
The Company has declared no cash dividends on its common stock. There have
been no stock dividends, stock splits or reverse stock splits.
At September 24, 1996 the Company had approximately 54 stockholders of
record.
ITEM 6. SELECTED FINANCIAL DATA.
The information required herein is incorporated by reference from page 14
of the Registrant's 1996 Annual Report.
-41-
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
The information required herein is incorporated by reference from pages 15
to 29 of the Registrant's 1996 Annual Report.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The information required herein is incorporated by reference from pages 30
to 61 of the Registrant's 1996 Annual Report.
ITEM 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE.
Not applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required herein is incorporated by reference from pages two
to 9 of the Registrant's Proxy Statement dated September 25, 1996 ("Proxy
Statement").
ITEM 11. EXECUTIVE COMPENSATION.
The information required herein is incorporated by reference from pages 11
to 19 of the Registrant's Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required herein is incorporated by reference from pages 9
and 10 of the Registrant's Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required herein is incorporated by reference from pages 15
and 16 of the Registrant's Proxy Statement.
-42-
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) Document filed as part of this Report.
(1) The following documents are filed as part of this report and are
incorporated herein by reference from the Registrant's 1996 Annual Report.
Independent Auditors' Report.
Consolidated Balance Sheets as of June 30, 1996 and 1995.
Consolidated Statements of Income for the Years Ended June 30, 1996, 1995
and 1994.
Consolidated Statements of Changes in Stockholders' Equity for the Years
Ended June 30, 1996, 1995 and 1994.
Consolidated Statements of Cash Flows for the Years Ended June 30, 1996,
1995 and 1994.
Notes to Consolidated Financial Statements.
(2) All schedules for which provision is made in the applicable
accounting regulation of the Securities and Exchange Commission are omitted
because they are not applicable or the required information is included in the
Consolidated Financial Statements or notes thereto.
(3) Report of predecessor accountant is attached as Exhibit 99.1.
-43-
(3)(a) The following exhibits are filed as part of this Form 10-K,
and this list includes the Exhibit Index.
No. Description
- ------ ---------------------------------------------------------------------
3.1 Amended and Restated Articles of Incorporation of Harrington Financial
Group, Inc.(1)
3.2 Amended and Restated Bylaws of Harrington Financial Group, Inc.(1)
10.1 Stock Option Plan of Harrington Financial Group, Inc.(1)(*)
10.2 Loan Agreement between Financial Research Corporation (now Harrington
Financial Group, Inc.) and Mark Twain Kansas Bank, dated April 14,
1994, First Amendment and Loan Agreement between such parties and
Smith Breeden Associates, Inc. and Douglas T. Breeden, dated July 21,
1995.(1)
10.2.1 Second Amendment and Loan Modification Agreement between Harrington
Financial Group, Inc. and Mark Twain Kansas City Bank, dated July 26,
1996 (modifies version set forth in Exhibit 10.2)
10.3 Investment Advisory Agreement between Peoples Federal Savings
Association (now Harrington Bank, FSB) and Smith Breeden Associates,
Inc. dated April 1, 1992, as amended on March 1, 1995.(1)
10.4 Lease Agreement on Carmel Branch Office Facility, set forth in
Assignment of Lease, between NBD Bank, N.A. and Peoples Federal
Savings Association, dated November 8, 1993.(1)
10.5 Trust Services Agreement dated September 30, 1994 by and between
Harrington Bank, FSB and The Midwest Trust Company.(1)
11.1 Statement of Computation of Per Share Earnings
13 1996 Annual Report to Stockholders specified portion (p. 1 and pp.
13-61) of the Registrant's Annual Report to Stockholders for the year
ended June 30, 1996.
21 Subsidiaries of the Registrant - Reference is made to Item 1.
"Business" for the Required information
23.1 Consent of Deloitte & Touche LLP
23.2 Consent of Geo. S. Olive & Co. LLC
27 Financial Data Schedule
99.1 Report of Geo. S. Olive & Co. LLC
- ----------------------
(1) Incorporated by reference from the Registration Statement on Form S-1
(Registration No. 333-1556) filed by the Registrant with the Securities and
Exchange Commission ("SEC") on February 20, 1996, as amended.
(*) Management contract or compensatory plan or arrangement.
(3)(b) Reports filed on Form 8-K.
None.
-44-
SIGNATURES
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.
HARRINGTON FINANCIAL GROUP, INC.
By: /s/ Craig J. Cerny
------------------------------
Craig J. Cerny
President
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
/s/ Craig J. Cerny
- ---------------------------------------- September 30, 1996
Craig J. Cerny
President (Principal Executive Officer)
/s/ Catherine A. Habschmidt
- ---------------------------------------- September 30, 1996
Catherine A. Habschmidt
Chief Financial Officer and Treasurer
(Principal Accounting Officer)
/s/ William F. Quinn, Jr.
- ---------------------------------------- September 30, 1996
William F. Quinn, Jr.
Executive Vice President and Director
/s/ Douglas T. Breeden
- ---------------------------------------- September 30, 1996
Douglas T. Breeden
Chairman of the Board
/s/ Gerald J. Madigan
- ---------------------------------------- September 30, 1996
Gerald J. Madigan
Director
/s/ Michael J. Giarla
- ---------------------------------------- September 30, 1996
Michael J. Giarla
Director
/s/ Stephen A. Eason
- ---------------------------------------- September 30, 1996
Stephen A. Eason
Director
/s/ Lawrence E. Golaszewski
- ---------------------------------------- September 30, 1996
Lawrence E. Golaszewski
Director
/s/ David F. Harper
- ---------------------------------------- September 30, 1996
David F. Harper
Director
/s/ Stanley J. Kon
- ---------------------------------------- September 30, 1996
Stanley J. Kon
Director
/s/ John J. McConnell
- ---------------------------------------- September 30, 1996
John J. McConnell
Director