EXHIBIT 13
FINANCIAL HIGHLIGHTS
(DOLLARS IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
FOR THE YEAR ENDED JUNE 30, 1996 1995
--------------------------
Net interest income $ 5,480 $ 4,781
Income before tax provision and gain (loss) on securities 1,997 1,837
Net realized and unrealized gain (loss) on securities (126) 1,187
Net income 1,223 1,853
Return on average assets 0.37% 0.76%
Return on average equity 9.49% 22.24%
AT JUNE 30
Total assets $ 418,196 $ 300,174
Total loans 65,925 37,010
Total securities 326,271 249,274
Total deposits 135,143 115,312
Stockholders' equity 23,117 10,361
Common shares outstanding 3,256,738 1,961,626
AVERAGE BALANCES
Assets $ 329,938 $ 242,910
Loans 52,399 25,467
Core retail deposits 91,902 72,175
Other deposits 33,591 48,835
Total deposits 125,493 121,010
PER SHARE
Net income $ 0.57 $ 1.20
Book value, fiscal year end 7.10 5.28
Market price, fiscal year end 10.50 N/A
ASSET QUALITY AT JUNE 30
Non-performing assets to total assets 0.32% 0.59%
Loan loss reserves to non-performing loans 45.98% 34.57%
CAPITAL RATIOS AT JUNE 30(HARRINGTON BANK)
Tangible capital 6.27% 6.12%
Core capital 6.27% 6.12%
Risk-based capital 30.10% 24.62%
CONTENTS
FINANCIAL REVIEW
Selected Consolidated Financial Data 14
Management's Discussion and Analysis
of Financial Condition and
Results of Operations 15
Consolidated Balance Sheets 30
Consolidated Statements of Income 31
Consolidated Statements of Changes
in Stockholders' Equity 32
Consolidated Statements
of Cash Flows 33
Notes to Consolidated
Financial Statements 35
Independent Auditors' Report 61
13
SELECTED CONSOLIDATED
FINANCIAL DATA
The following table represents selected consolidated financial and other data of
the Company for the five years in the period ended June 30, 1996. The selected
consolidated financial data should be read in conjunction with the Consolidated
Financial Statements of the Company, including the accompanying Notes, presented
elsewhere herein.
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
AT OR FOR THE YEAR ENDED JUNE 30, 1996 1995 1994 1993 1992
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BALANCE SHEET DATA
Securities held for trading and available for sale $326,271 $249,274 $174,347 $186,582 $185,805
Loans receivable-net 65,925 37,010 20,682 16,620 21,409
Total assets 418,196 300,174 211,688 220,095 226,622
Deposits 135,143 115,312 108,300 89,788 93,476
Securities sold under agreements to repurchase 219,067 130,217 54,651 83,709 116,993
Federal Home Loan Bank advances 26,000 31,000 31,000 31,000
Note payable 8,998 9,200 7,880 7,431 8,435
Stockholders' equity 23,117(1) 10,361 5,926 5,294 5,128
Stockholders' equity per share 7.10 5.28 4.20 3.75 3.63
INCOME STATEMENT DATA
Interest income $ 23,484 $ 17,560 $ 13,607 $ 12,746 $ 15,407
Interest expense 18,004 12,779 8,284 8,975 12,714
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Net interest income 5,480 4,781 5,323 3,771 2,693
Provision for loan losses (1) 15 (3) 66 8
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Net interest income after provision for loan losses 5,481 4,766 5,326 3,705 2,685
Retail banking fees and other income 256 238 267 249 106
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Total net revenue 5,737 5,004 5,593 3,954 2,791
Operating expenses 3,740 3,167 2,519 2,749(2) 1,835
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Income before tax provision and gain (loss) on securities 1,997 1,837 3,074 1,205 956
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Gain (loss) on sale of securities held for trading 1,834 66 (2,169)
Gain on sale of securities available for sale 392 1,384 1,108
Unrealized gain (loss) on securities held for trading (1,960) 1,535 710
Permanent impairment of securities available for sale (414) (610) (2,531) (1,057)
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Net gain (loss) on securities (126) 1,187 (1,677) (1,147) 51
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Income before income tax provision and cumulative effect
of change in accounting for deferred income taxes 1,871 3,024 1,397 58 1,007
Income tax provision 648 1,171 391 188 190
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Income (loss) before cumulative effect of change in
accounting for deferred income taxes 1,223 1,853 1,006 (130) 817
Cumulative effect of change in accounting for deferred
income taxes (3) (79)
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Net income (loss) $ 1,223 $ 1,853 $ 927 $ (130) $ 817
-----------------------------------------------------------------
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Net income (loss) per share $ 0.57 $ 1.20 $ 0.66 $ (0.09) $ 0.58
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PERFORMANCE RATIOS
Return on average assets .37% .76% 0.44% -0.06% 0.36%
Return on average equity 9.49 22.24 14.98 -2.67 17.06
Interest rate spread 1.64 2.13 2.63 1.79 1.65
Net interest margin 1.73 2.10 2.64 1.81 1.25
Average interest-earning assets to average interest
bearing liabilities 101.55 99.57 100.25 100.39 100.61
Net interest income after provision for loan losses to total
other expenses 146.55 150.49 211.43 134.78 146.32
Total other expenses to average total assets 1.13 1.30 1.19 1.27 0.82
Full service offices 3 2 2 1 1
ASSET QUALITY RATIOS (AT END OF PERIOD)
Non-performing loans to total loans (4) .40 0.95 2.70 3.00 2.56
Non-performing assets to total assets (4) .32 0.59 1.34 0.24 0.24
Allowance for loan losses to total loans .18 0.33 .51 0.94 0.46
Allowance for loan losses to total non-performing loans 45.98 34.57 18.96 29.71 18.07
CAPITAL RATIOS (5)
Tangible capital ratio 6.27 6.12 6.07 5.58 5.31
Core capital ratio 6.27 6.12 6.07 5.58 5.35
Risk-based capital ratio 30.10 24.62 21.40 18.56 16.59
Equity to assets at end of period 5.53 3.45 2.80 2.41 2.26
(1)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 after offering expenses
were $11,437,000.
(2)Includes a write-off of goodwill and core deposit of $663,000.
(3)Reflects the Company's adoption of Statement of Financial Accounting
Standards ("SFAS") No. 109, "Accounting for Income Taxes," effective July 1,
1993.
(4)Non-performing loans consist of non-accrual loans and accruing loans that are
contractually past due 90 days or more, and non-performing assets consist of
non-performing loans, real estate acquired by foreclosure or deed-in-lieu
thereof and a single non-agency participation certificate classified as
substandard.
(5)Regulatory capital ratios apply to the Bank (Harrington Bank, FSB) as a
federally chartered savings bank.
14
MANAGEMENT'S DISCUSSION
AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Harrington Financial Group, Inc. ("Harrington" or the "Company") is an Indiana-
chartered, registered thrift holding company for Harrington Bank, FSB (the
"Bank"). The following financial review presents an analysis of the Company's
operations and financial position for the periods presented in this annual
report.
GENERAL
Harrington's business strategy focuses on achieving attractive returns
consistent with prudent risk management. Harrington has sought to implement this
strategy by (i) controlling interest rate risk by using interest rate risk
management contracts to match the interest rate sensitivity of its assets to
that of its liabilities; (ii) controlling credit risk by maintaining a
substantial portion of the Company's assets in mortgage-backed and related
securities and single-family residential loans; (iii) reducing funding costs
through the utilization of retail and non-retail deposits and other borrowings;
(iv) increasing its emphasis on retail banking through the origination of
single-family residential loans and the expansion of its core deposit base; (v)
maintaining a relatively low level of operating expenses; and (vi) continued
internal growth and the pursuit of acquisition opportunities when appropriate.
Harrington invests primarily in mortgage-backed and related securities and
originates (both directly and through correspondents) loans secured by single-
family residences located primarily in eastern and central Indiana. While
Harrington's focus is to expand its portfolio of originated mortgage loans, over
75% of its assets currently consist of purchased mortgage-backed and related
securities. Although mortgage-backed 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 and may be used to
collateralize borrowings or other obligations of the Company. Management
believes that the lower operating expenses and reduced credit and interest rate
risk associated with the investment in securities have enhanced Harrington's
overall profitability as well as its ability to remain profitable over a variety
of interest rate scenarios.
Harrington's funding strategy focuses on accessing cost-efficient funding
sources, including securities sold under agreements to repurchase, retail and
non-retail deposits and FHLB advances. The Company continues to build a
community-oriented retail banking operation in order to sustain loan
originations and deposit growth and generate additional fee income. Management's
primary goal is to increase stockholders' value, as measured on a risk-adjusted
total return basis.
To reduce the institution's exposure to interest rate risk, the Company utilizes
interest rate risk management contracts and mortgage-backed derivative
securities in conjunction with regular adjustments to the composition of the
Company's investment portfolio. Harrington marks a substantial portion of its
assets and interest rate contracts to market in order to fully account for the
market value changes in the Company's investment portfolio. This method of
accounting is consistent with Harrington's strategy of active portfolio
management and provides the Company with the flexibility to quickly adjust the
mix of its interest-earning assets in response to changing market conditions or
to take advantage of retail growth opportunities.
The Company recognizes that marking substantially all of its assets to market
subjects Harrington to potential earnings volatility. Market value volatility is
not unique to Harrington, though, as most unhedged financial institutions have
even greater volatility in market values. The difference is that Harrington
reflects the changes in market values directly in earnings, while most other
institutions do not.
15
ASSET AND LIABILITY MANAGEMENT
In general, financial institutions are negatively affected by an increase in
interest rates to the extent that interest-bearing liabilities mature or reprice
more rapidly than interest-earning assets. The lending activities of savings
institutions have historically emphasized the origination of long-term, fixed-
rate loans secured by single-family residences, and the primary source of funds
of such institutions has been deposits, which largely mature or are subject to
repricing within a shorter period of time.
This factor has historically caused the income and market value of portfolio
equity ("MVPE") of savings institutions to be more volatile than other financial
institutions. MVPE is defined as the net present value of an institution's
existing assets, liabilities and off-balance sheet instruments. While having
liabilities that reprice more frequently than assets is generally beneficial to
net interest income and market value of portfolio equity in times of declining
interest rates, such an asset/liability mismatch is generally detrimental during
periods of rising interest rates.
The Company believes that its asset and liability management strategy, as
discussed below, provides Harrington with a competitive advantage over other
financial institutions. Harrington's ability to effectively hedge its interest
rate exposure through the use of various financial instruments allows the
Company to acquire loans and investments which offer attractive net risk-
adjusted spreads whether the individual loans or investments are fixed-rate or
adjustable-rate or short-term or long-term. Similarly, the Company can choose a
cost-effective source of funds and subsequently engage in an interest rate swap
or other hedging transaction so that the interest rate sensitivities of its
interest-earning assets and interest-bearing liabilities are generally matched.
Harrington's asset and liability management strategy is formulated and monitored
by the Boards of Directors of both the Company and Bank, the Company's wholly-
owned subsidiary. The Boards' written policies and procedures are implemented by
the Investment Committee of the Bank, which is comprised of the Chief Executive
Officer, Chief Financial Officer, Chief Investment Officer, Investment Officer,
and three outside directors. The Investment Committee meets at least monthly to
review, among other things, the sensitivity of the Bank's assets and liabilities
to interest rate changes, the book and market values of assets and liabilities
with the resulting unrealized gains and losses, the past month's purchase and
sale activity and maturities of investments and borrowings.
The Investment Committee also consults with the Chief Operating Officer of the
Bank regarding retail pricing and funding decisions with respect to the Bank's
overall asset and liability composition. In accordance therewith, the Investment
Committee reviews the Bank's liquidity, cash flow needs, interest rate
sensitivity of investments, deposits and borrowings, core deposit activity,
current market conditions and interest rates on both a local and national level.
Harrington has contracted with Smith Breeden Associates, Inc. ("Smith Breeden")
for the provision of consulting services regarding, among other things, the
management of its investments and borrowings, the pricing of loans and deposits,
and the use of various financial instruments to reduce interest rate risk. Smith
Breeden is a consulting firm which renders investment advice and asset and
liability management services to financial institutions, corporate and
government pension plans, foundations and government agencies nationally.
Certain directors and officers of the Company and the Bank are principals or
affiliates of Smith Breeden.
The Investment Committee regularly reviews interest rate risk by utilizing
analyses prepared by Smith Breeden with respect to the impact of alternative
interest rate scenarios on net interest income and on the Bank's market value of
portfolio equity. The Investment Committee also reviews analyses prepared by
Smith Breeden concerning the impact of changing market volatility, prepayment
forecast error, changes in option-adjusted spreads and non-parallel yield curve
shifts.
16
MVPE analysis is used by regulatory authorities for assessing an institution's
interest rate risk. The extent to which assets will gain or lose value net of
the gains or losses of liabilities and/or interest rate contracts determines the
appreciation or depreciation in equity on a market-value basis. Such market
value analysis is intended to evaluate the impact of immediate and sustained
parallel interest-rate shifts upon the market value of the current balance
sheet.
In the absence of the Company's hedging activities, the MVPE of the Company
would decline as a result of a general increase in market rates of interest.
This decline would be due to the market values of Harrington's assets being
generally more sensitive to interest rate fluctuations than are the market
values of the Company's liabilities due to Harrington's investment in generally
longer-term assets which are funded with shorter-term liabilities. Consequently,
the elasticity (i.e., the change in the market value of an asset or liability as
a result of a change in interest rates) of Harrington's assets is greater than
the elasticity of its liabilities.
Accordingly, the primary goal of Harrington's asset and liability management
policy is to effectively increase the elasticity of the Company's liabilities
and/or effectively contract the elasticity of the Company's assets so that the
respective elasticities are matched as closely as possible. This elasticity
adjustment can be accomplished internally by restructuring Harrington's balance
sheet, or externally by adjusting the elasticities of Harrington's assets and/or
liabilities through the use of interest rate contracts, such as interest rate
swaps, collars, caps, floors, options and futures. Harrington's strategy is to
hedge either internally through the use of longer-term certificates of deposits,
FHLB advances and mortgage-backed derivative securities or externally through
the use of various interest rate contracts.
External hedging involves the use of interest rate swaps, collars, caps, floors,
options and futures. The notional amount of interest rate contracts represents
the underlying amount on which periodic cash flows are calculated and exchanged
between counterparties. However, this notional amount does not represent the
principal amount of securities which would effectively be hedged by that
interest rate contract.
In selecting the type and amount of interest rate contract to utilize, the
Company compares the elasticity of a particular contract to that of the
securities to be hedged. An interest rate contract with the appropriate
offsetting elasticity may have a notional amount much greater than the face
amount of the securities being hedged.
An interest rate swap is an agreement where one party (generally the Company)
agrees to pay a fixed rate of interest on a notional principal amount to a
second party (generally a broker) in exchange for receiving from the second
party a variable rate of interest on the same notional amount for a
predetermined period of time. No actual assets are exchanged in a swap of this
type and interest payments are generally netted. These swaps are generally
utilized by Harrington to synthetically convert fixed-rate assets into
adjustable-rate assets without having to sell or transfer the underlying assets.
At June 30, 1996, Harrington was a party to eight interest rate swap agreements.
The agreements had an aggregate notional amount of approximately $63.5 million
and maturities from August 1996 to April 2001. With respect to the agreements
whereby the Company pays a fixed-rate and receives a floating-rate (which
constitute the majority of the agreements), Harrington makes fixed interest
payments ranging from 4.55% to 6.58% and receives payments based upon the three-
month London Interbank Offer Rate ("LIBOR").
The net expense (income) relating to Harrington's fixed-pay interest rate swaps
(which are held in the Company's trading portfolio) was $(168,000), $(113,000)
and $1.3 million during the years ended June 30, 1996, 1995 and 1994,
respectively. The approximate market value of these fixed-pay interest rate
swaps was $620,000 and $(219,000) as of June 30, 1996 and 1995, respectively.
17
The Company also has two swaps whereby it pays a floating rate (based on three-
month LIBOR) and receives fixed rates of 6.12% and 6.96%, respectively.
Harrington's two floating-pay swaps, which have an aggregate notional amount of
$17.5 million, are not included in the Company's trading portfolio. These swaps
are used to modify the interest rate sensitivity of certain certificates of
deposit issued by the Bank. These certificates of deposit, called inverse
variable-rate certificates, adjust according to a formula in such a way as to
pay a higher rate of interest when rates fall, and a lower rate of interest when
rates rise. The swaps protect the Company against the exposure to falling rates
inherent in these certificates of deposit.
The net (income) relating to Harrington's floating-pay swaps was $(129,000),
$(158,000) and $(596,000) during the years ended June 30, 1996, 1995 and 1994,
respectively. This income is netted against interest expense in the Company's
Consolidated Statements of Income. The approximate market value of the Company's
floating-pay interest rate swaps (which are not reflected in the Company's
financial statements) was $110,000 and $403,000 as of June 30, 1996 and 1995,
respectively.
An interest rate cap or an interest rate floor consists of a guarantee given by
the issuer (i.e., a broker), to the purchaser (i.e., the Company), in exchange
for the payment of a premium. This guarantee states that if interest rates rise
above (in the case of a cap) or fall below (in the case of a floor) a specified
rate on a specified interest rate index, the issuer will pay to the purchaser
the difference between the then current market rate and the specified rate on a
notional principal amount. No funds are actually borrowed or repaid.
Similarly, an interest rate collar is a combination of a purchased cap and a
written floor at different strike rates. Accordingly, an interest rate collar
requires no payments if interest rates remain within a specified range, but will
require the Company to be paid if interest rates rise above the cap rate or
require the Company to pay if interest rates fall below the floor rate.
Consequently, interest rate caps are a means of reducing interest expense by
placing a ceiling on the cost of floating-rate liabilities, or offsetting the
caps on the coupons inherent in the Company's adjustable rate mortgage loans and
securities. Interest rate floors permit Harrington to maintain its desired
interest rate spread in the event that falling interest rates lead to increased
prepayments with respect to the Company's mortgage-backed and related securities
portfolio requiring reinvestment at lower rates.
At June 30, 1996, Harrington held eight interest rate cap agreements, seven
interest rate floor agreements and one interest rate collar in its trading
portfolio. These contracts, which expire from October 1996 to June 2004, have an
aggregate notional amount of approximately $329.5 million. The interest rate cap
agreements are triggered, depending on the particular contract, whenever the
defined floating-rate exceeds 5.0% to 9.0%. The interest rate floor agreements
are triggered, depending on the particular contract, whenever the defined
floating-rate is less than 5.0% to 7.5%. The interest rate collar is triggered
whenever the defined floating-rate is greater than 10.25% or less than 5.25%.
The aggregate net expense (income) relating to the Company's interest rate caps,
collars and floors held in the trading portfolio was $(245,000), $58,000 and
$542,000 during the years ended June 30, 1996, 1995 and 1994, respectively. The
approximate market value of Harrington's interest rate caps, collars and floors
which are maintained in the trading portfolio was $6.0 million and $5.3 million
as of June 30, 1996 and 1995, respectively.
During fiscal 1996 Harrington also purchased one interest rate cap with a
notional amount of $30.0 million which is not held in the Company's trading
portfolio. This cap, which matures in May 2001, is triggered whenever the
defined floating rate exceeds 7.0%. The instrument is used to effectively cap at
7.0% the interest rate on the Company's floating-rate borrowings from the FHLB.
Net expense on this cap was $25,000 for the year ended June 30, 1996. The
approximate market value of the cap, which is not reflected in the Company's
financial statements, was $747,000 at June 30, 1996.
18
Interest rate futures are commitments to either purchase or sell designated
instruments at a future date for a specified price. Futures contracts are
generally traded on an exchange, are marked to market daily and subject to
initial and maintenance margin requirements. Harrington generally uses 91-day
Eurodollar certificates of deposit contracts ("Eurodollar futures contracts")
which are priced off LIBOR as well as Treasury Note futures contracts. The
Company will from time to time agree to sell a specified number of contracts at
a specified date. To close out a contract, Harrington will enter into an
offsetting position to the original transaction.
If interest rates rise, the value of the Company's short futures positions
increases. Consequently, sales of futures contracts serve as a hedge against
rising interest rates. At June 30, 1996, Harrington has sold Eurodollar and
Treasury Note futures contracts with an aggregate notional amount of
approximately $1.4 billion. The Company had total gains (losses) on its futures
contracts of $1.9 million and $(2.0) million for the fiscal years ended June 30,
1996 and 1995, respectively.
Options are contracts which grant the purchaser the right to buy or sell the
underlying asset by a certain date for a specified price. Generally Harrington
will purchase options on financial futures to hedge the changing elasticity
exhibited by mortgage loans and mortgage-backed securities. The changing
elasticity results from the ability of a borrower to prepay a mortgage. As
market interest rates decline, borrowers are more likely to prepay their
mortgages, shortening the elasticity of the mortgages. Consequently, where
interest rates are declining, the value of mortgage loans or mortgage-backed
securities will increase at a slower rate than would be expected if borrowers
did not have the ability to prepay their mortgages.
Harrington, therefore, generally purchases out-of-the-money calls and puts so
that the increase in value of the options resulting from interest rate movements
offsets the reductions in MVPE resulting from the changing elasticity inherent
in the Company's balance sheet. At June 30, 1996, Harrington had 130 purchased
options contracts covering an aggregate notional amount of approximately $13.0
million. The net expense relating to the Company's options contracts was
$640,000, $148,000 and $0 during the years ended June 30, 1996, 1995 and 1994,
respectively. The approximate market value of the Company's options contracts
which are maintained in the trading portfolio was $65,000 and $200,000 as of
June 30, 1996 and 1995, respectively.
The following table summarizes the periodic exchanges of interest payments with
counterparties including the amortization of premiums paid for interest rate
contracts as discussed above. Such payments and amortization amounts are
accounted for as adjustments to the yields of securities held for trading, and
are reported as a separate component of interest income.
(DOLLARS IN THOUSANDS)
YEAR ENDED
JUNE 30, 1996 1995 1994
-------------------------------------
Interest rate contract
(income) expense:
Swaps $(168) $(113) $1,334
Caps, floors, and collars (220) 58 542
Futures 4
Options 640 148
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Net interest expense on
interest rate contracts $ 252 $ 93 $1,880
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-------------------------------------
The above table does not include realized and unrealized gains and losses with
respect to the market value of interest rate contracts held in the trading
portfolio. Such gains and losses are generally offset by fluctuations in the
market value of the Company's assets held for trading. All realized and
unrealized gains and losses pertaining to interest rate contracts in the trading
portfolio are reported as other income in the Company's Consolidated Statements
of Income.
Harrington is subject to the risk that its counterparties with respect to
various interest rate contracts (such as swaps, collars, caps, floors, options
and futures) may default at or prior to maturity of a particular instrument. In
such a case, the Company might be unable to recover any unrealized gains with
respect to a particular contract.
19
To reduce this potential risk, the Company generally deals with large,
established investment brokerage firms when entering into these transactions. In
addition, if the Company enters into an interest rate contract with a non-AA-
rated (or above) entity and the Company has an unrealized gain with respect to
such contract, the Company generally requires the entity to post some form of
collateral to secure its obligations. Furthermore, the Company has a policy
whereby it limits its unsecured exposure to any one counterparty to 25% of the
Bank's equity during any two-month period and 35% of the Bank's equity during
any one-month period.
The Office of Thrift Supervision ("OTS") requires each thrift institution to
calculate the estimated change in the institution's MVPE assuming an
instantaneous, parallel shift in the Treasury yield curve of 100 to 400 basis
points either up or down in 100 basis point increments. The OTS permits
institutions to perform this MVPE analysis using their own internal model (based
upon reasonable assumptions) or they may utilize the OTS' model, which is based
upon data submitted in the institution's quarterly thrift financial reports. The
Company retains Smith Breeden to perform the required calculation of the
sensitivity of its market value to changes in interest rates.
Both Smith Breeden and the OTS use option-adjusted pricing analysis and present
value calculations of estimated cash flows in their simulation models.
Nevertheless, the results of the OTS model may vary from Smith Breeden's results
primarily due to differences between assumptions utilized in the respective
models, including estimated interest rates and volatilities, prepayment rates,
reinvestment rates and decay rates. In addition, Smith Breeden utilizes detailed
data on individual loans and securities while the OTS model uses aggregated data
for similar instruments. The OTS reviews the Smith Breeden analysis in
conjunction with its regular examinations of the Bank.
The following table sets forth at June 30, 1996 the estimated sensitivity of the
Bank's MVPE to parallel yield curve shifts using Harrington's internal market
value. The table demonstrates the sensitivity of the Bank's assets and
liabilities both before and after the inclusion of its interest rate contracts.
(DOLLARS IN THOUSANDS)
CHANGE IN
INTEREST RATES -400 -300 -200 -100 -- +100 +200 +300 +400
----------------------------------------------------------------------------------------------------
(IN BASIS POINTS)(1)
Market value gain (loss)
of assets $ 25,277 $ 20,270 $ 15,499 $9,580 -- $(12,973) $(28,169) $(44,451) $(60,996)
Market value gain (loss)
of liabilities (7,556) (5,695) (3,815) (1,864) -- 1,750 3,411 5,016 6,554
----------------------------------------------------------------------------------------------------
Market value gain (loss)
of net assets before
interest rate contracts 17,721 14,575 11,684 7,716 -- (11,223) (24,758) (39,435) (54,442)
Market value gain (loss)
of interest rate
contracts (21,335) (17,555) (13,057) (7,395) -- 9,834 21,455 34,097 47,045
----------------------------------------------------------------------------------------------------
Total change in MVPE(2) $ (3,614) $ (2,980) $ (1,373) $ 321 -- $ (1,389) $(3,303) $ (5,338) $ (7,397)
----------------------------------------------------------------------------------------------------
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Change in MVPE as a
percent of:
MVPE(2) (13.1)% (11.5)% (5.3)% 1.2% -- (5.3)% (12.7)% (20.5)% (28.5)%
Total assets of
the Bank (0.9)% (0.7)% (0.3)% 0.1% -- (0.3)% (0.8)% (1.3)% (1.8)%
(1) Assumes an instantaneous parallel change in interest rates at all
maturities.
(2) Based on the Bank's pre-tax MVPE of $26.0 million at June 30, 1996.
The table set forth above does not purport to show the impact of interest rate
changes on Harrington's equity under generally accepted accounting principles.
Market value changes only impact the Company's income statement or the balance
sheet (i) to the extent the affected instruments are marked to market, and (ii)
over the life of the instruments as an impact on recorded yields. Since a large
portion of Harrington's assets is recorded at market value, the following table
is included to show the estimated impact on the Company's equity of instan-
20
taneous, parallel shifts in the yield curve. The assets and interest rate
contracts included in the table below are only those which are either classified
by the Company as held for trading or available for sale and, therefore,
reflected at market value. Consequently, Harrington's liabilities, which are
reflected at cost, are not included in the table below. All amounts are shown
net of taxes, with an estimated effective tax rate of 36.0%.
(DOLLARS IN THOUSANDS)
CHANGE IN
INTEREST RATES -400 -300 -200 -100 -- +100 +200 +300 +400
----------------------------------------------------------------------------------------------------
(IN BASIS POINTS)
Market value gain (loss)
of assets $12,649 $10,028 $ 7,596 $ 4,703 -- $(6,564) $(14,463) $(23,064) $(31,896)
Market value gain (loss)
of interest rate
contracts (13,920) (11,325) (8,322) (4,659) -- 6,088 13,183 20,854 28,700
----------------------------------------------------------------------------------------------------
After tax gain (loss)
in equity $(1,271) $ (1,297) $ (726) $ 44 -- $ (476) $ (1,280) $ (2,210) $ (3,196)
----------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------
After tax gain (loss)
in equity as a percent
of the Company's equity
at June 30, 1996 (5.5)% (5.6)% (3.1)% 0.2% -- (2.1)% (5.5)% (9.6)% (13.8)%
CHANGES IN FINANCIAL CONDITION
GENERAL - At June 30, 1996, Harrington's total assets amounted to $418.2
million, as compared to $300.2 million at June 30, 1995. The increase in total
assets was primarily due to the completion in fiscal 1996 of the Company's
initial offering of common stock, which raised $11.4 million in net proceeds.
The Company utilized the proceeds from the offering to purchase additional
mortgage-backed securities funded primarily by securities sold under agreements
to repurchase.
CASH AND INTEREST-BEARING DEPOSITS - Cash and interest-bearing deposits amounted
to $17.1 million and $5.7 million at June 30, 1996 and 1995, respectively.
Harrington actively manages its cash and cash equivalents based upon the
Company's operating, investing and financing activities. Based upon the
Company's current size, cash and cash equivalents generally fluctuate within a
range of $5.0 million to $20.0 million. Harrington generally attempts to invest
its excess liquidity into higher yielding assets such as loans or securities.
SECURITIES HELD FOR TRADING AND AVAILABLE FOR SALE - In order to reduce the
Company's credit risk exposure and to earn a positive interest rate spread,
Harrington 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. Almost all of these securities and
their related interest rate risk management contracts are classified as held for
trading and, pursuant to SFAS 115, are reported at fair value with unrealized
gains and losses included in earnings. The remainder of the securities are
classified as available for sale and thus also reported at fair value, but with
unrealized gains and losses excluded from earnings and reported instead as a
separate component of stockholders' equity.
Securities held for trading (consisting of mortgage-backed securities, mortgage-
backed derivative securities, interest rate contracts and equity securities)
amounted to $324.2 million and $246.7 million at June 30, 1996 and 1995,
respectively. During the year ended June 30, 1996, securities held for trading
increased by $77.5 million or 31.4%, due primarily to an increase in mortgage-
backed securities resulting from the utilization of the capital raised during
the May 1996 initial public offering of the Company's common stock.
Securities classified as available for sale (consisting of a non-agency
mortgage-backed security and municipal bonds) remained relatively stable at $2.1
million and $2.5 million at June 30, 1996 and 1995, respectively.
LOANS RECEIVABLE - At June 30, 1996, loans receivable (net of the Company's
allowance for loan losses) amounted to $65.9 million, an increase of 78.1% over
the June 30,
21
1995 total of $37.0 million. Harrington has actively attempted to increase its
retail banking operations, particularly the origination (both directly and
through correspondent mortgage banking companies) of single-family residential
loans to individuals residing in eastern and central Indiana.
Currently, Harrington is originating single-family residential loans through a
correspondent mortgage banking company headquartered in Indianapolis, Indiana.
The Company desires to expand further its originations of single-family
residential loans through the use of additional correspondent mortgage banking
companies located within central Indiana. Loans originated through
correspondents must meet the same pricing and underwriting standards as loans
originated internally.
ALLOWANCE FOR LOAN LOSSES - At June 30, 1996, Harrington's allowance for loan
losses totaled $120,000, compared to $121,000 at June 30, 1995. At June 30,
1996, the Company's allowance represented approximately 0.2% of the total loan
portfolio and 46.0% of total non-performing loans, as compared to 0.3% and 34.6%
at June 30, 1995. The ratio of total non-performing loans to total loans
amounted to 0.4% at June 30, 1996, compared to 1.0% at June 30, 1995, which
reflects Harrington's emphasis on reducing credit risk with respect to its
operations.
Although Harrington management believes that its allowance for loan losses at
June 30, 1996 was adequate based on facts and circumstances available to it
(including the historically low level of loan charge-offs), there can be no
assurances that additions to the allowance will not be necessary in future
periods, which could adversely affect the Company's results of operations.
DEPOSITS - At June 30, 1996, deposits totaled $135.1 million, as compared to
$115.3 million as of June 30, 1995. Retail deposits increased $29.5 million,
from $82.3 million at June 30, 1995 to $111.8 million at June 30, 1996,
primarily due to Harrington's expansion in Hamilton County. Non-retail deposits
declined by $9.7 million during the same period, for a total increase in
deposits of $19.8 million.
Harrington 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 Bank 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. In addition to providing a cost-
efficient funding source, these retail deposits provide a source of fee income
and the ability to cross-sell other products or services.
BORROWINGS - At June 30, 1996, reverse repurchase agreements and dollar rolls
(both of which are securities sold under agreements to repurchase and are
accounted for as a financing) totaled $219.1 million, as compared to $130.2
million as of June 30, 1995. The substantial increase during the year ended June
30, 1996 was principally due to reverse repurchase agreements which were used to
fund the purchase of mortgage-backed securities. Although a substantial portion
of Harrington's growth in recent periods has been funded by reverse repurchase
agreements, part of management's strategy is to gradually replace such
borrowings with retail deposits.
Advances from the FHLB of Indianapolis amounted to $26.0 million and $31.0
million as of June 30, 1996 and 1995, respectively. At June 30, 1996, all $26.0
million of FHLB advances were scheduled to mature in fiscal 1998, with an
average interest rate thereon of 5.4%, as compared to 6.1% at June 30, 1995.
The Company's note payable amounted to $9.0 million and $9.2 million at June 30,
1996 and 1995, respectively. The note payable relates to a loan facility which
was used to refinance, to a significant extent, the unpaid balance of a $10.0
million acquisition loan which financed the Company's acquisition of the Bank. A
July 1996 amendment to the loan facility provided an additional $3.0 million
non-revolving line of credit which is intended to further increase the capital
of the Bank to support additional asset growth.
22
STOCKHOLDERS' EQUITY - Stockholders' equity increased from $10.4 million at June
30, 1995 to $23.1 million at June 30, 1996. This increase was due to (i) $1.2
million of net income recognized during fiscal 1996; (ii) $11.4 million in net
proceeds from the fiscal 1996 initial public offering of the Company's common
stock; and (iii) $165,000 raised in connection with the exercise of existing
stock options during fiscal 1996. In addition, at June 30, 1995 and 1996, the
Company's stockholders' equity included $61,000 and $(8,000), respectively, of
unrealized gains (losses) on securities classified as available for sale, net of
deferred taxes.
RESULTS OF OPERATIONS
SUMMARY OF EARNINGS - Harrington reported net income of $1.2 million or $0.57
per share for the year ended June 30, 1996, compared to $1.9 million or $1.20
per share for the year ended June 30, 1995. This $630,000 or 34.0% decrease in
net income was due primarily to a decrease in the net gain on the trading
portfolio.
Gains and losses in the trading portfolio are included as a component of
reported earnings whether or not the assets are sold. Gains or losses on assets
sold are referred to as realized gains or losses. Market value gains or losses
on assets held in the trading portfolio are unrealized gains or losses. The net
realized or unrealized gain or loss refers to the combination of both these
components of income. Harrington reported a net realized and unrealized loss of
$126,000 on the securities portfolio in fiscal 1996, compared to a net realized
and unrealized gain on this portfolio of $1.2 million in fiscal 1995. The
decrease in the securities gain, as well as a $573,000 increase in other
expense, were partially offset by a $699,000 increase in net interest income and
a $523,000 decrease in the income tax provision.
Net income for the year ended June 30, 1995 was $1.9 million or $1.20 per share,
compared to $927,000 or $0.66 per share during the year ended June 30, 1994. The
$926,000 or 99.8% increase in net income was due to a $2.8 million increase in
total other income which was partially offset by a $780,000 increase in the
income tax provision, a $647,000 increase in total other expense, and a $542,000
decrease in net interest income.
23
AVERAGE BALANCES, NET INTEREST INCOME AND YIELDS EARNED AND RATES PAID. The
following table presents for the periods indicated the total dollar amount of
interest from average interest-earning assets and the resultant yields, as well
as the interest expense on average interest-bearing liabilities, expressed both
in dollars and rates, and the net interest margin. The table does not reflect
any effect of income taxes. All average balances are based on average month end
balances for the Company and average daily balances for the Bank during the
periods presented.
(DOLLARS IN THOUSANDS)
YEAR ENDED
JUNE 30, 1996 1995 1994
------------------------------------------------------------------------------------------
AVERAGE YIELD/ Average Yield/ Average Yield/
BALANCE INTEREST RATE (1) Balance Interest Rate Balance Interest Rate
------------------------------------------------------------------------------------------
INTEREST-EARNING ASSETS:
Interest-bearing deposits $ 14,520 $ 780 5.37% $ 11,493 $ 603 5.25% $ 12,454 $ 415 3.33%
Securities held for trading (2)(3) 243,862 18,038 7.40 185,014 14,332 7.75 163,825 10,996 6.71
Securities available for sale 2,672 190 7.11 3,110 250 8.04 3,928 311 7.92
Loans receivable, net (4) 52,399 4,276 8.16 25,467 2,223 8.73 19,369 1,778 9.18
Federal Home Loan Bank stock 2,533 200 7.90 2,172 152 7.00 1,843 107 5.81
------------------------------------------------------------------------------------------
Total interest-earning assets 315,986 23,484 7.43% 227,256 17,560 7.73% 201,419 13,607 6.76%
Non-interest-earning assets 13,952 15,654 10,904
------------------------------------------------------------------------------------------
Total assets $329,938 $242,910 $212,323
------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------
INTEREST-BEARING LIABILITIES:
Deposits:
NOW and checking accounts $ 3,813 $ 110 2.88% $ 3,352 $ 94 2.80% $ 2,872 $ 83 2.89%
Savings accounts 15,922 613 3.85 16,068 568 3.53 18,271 598 3.27
Money market deposit accounts 1,777 77 4.33 2,147 88 4.10 5,396 184 3.41
Certificates of deposit 103,981 6,351 6.11 99,443 5,904 5.94 69,336 3,651 5.27
------------------------------------------------------------------------------------------
Total deposits 125,493 7,151 5.70 121,010 6,654 5.50 95,875 4,516 4.71
Securities sold under agreements
to repurchase 148,523 8,352 5.62 68,277 3,654 5.35 66,813 2,134 3.19
Federal Home Loan Bank advances 27,586 1,596 5.79 31,051 1,722 5.55 31,000 1,057 3.41
Note payable 9,553 905 9.47 7,890 749 9.49 7,227 577 7.98
------------------------------------------------------------------------------------------
Total interest-bearing liabilities 311,155 18,004 5.79% 228,228 $12,779 5.60% 200,915 8,284 4.12%
Non-interest bearing liabilities 5,894 6,349 5,221
------------------------------------------------------------------------------------------
Total liabilities 317,049 234,577 206,136
Stockholders' equity 12,889 8,333 6,187
------------------------------------------------------------------------------------------
Total liabilities and stockholders'
equity $329,938 $242,910 $212,323
------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------
Net interest income; interest
rate spread (3)(5) $ 5,480 1.64% $ 4,781 2.13% $ 5,323 2.64%
------------------------------------------------------------------------------------------
Net interest margin (3)(5)(6) 1.73% 2.10% 2.64%
------------------------------------------------------------------------------------------
Average interest-earning assets
to average interest-bearing
liabilities 101.55% 99.57% 100.25%
------------------------------------------------------------------------------------------
(1) At June 30, 1996, the yields earned and rates paid were as follows:
interest-bearing deposits, 5.44%; securities held for trading, 7.42%;
securities avaliable for sale, 7.21%; loans receivable, net 8.11%; FHLB
stock, 6.79%; total interest-earning assets, 7.45%; deposits, 5.51%;
securities sold under agreements to repurchase, 5.21%; FHLB advances, 5.41%;
note payable, 9.27%; total interest-bearing liabilities, 5.42%; interest
rate spread, 2.03%.
(2) Both the interest and yields earned on the Company's securities portfolio
reflect the net interest expense incurred with respect to various interest
rate contracts (such as interest rate swaps, collars, caps, floors, options
and futures) which were utilized to hedge the Company's interest rate
exposure. During the years ended June 30, 1996, 1995 and 1994, the net
costs of hedging the Company's interest rate exposure with respect to its
securities held for trading amounted to $252,000 or 0.21%, $93,000 or 0.05%
and $1.9 million or 1.15%, respectively.
(3) During fiscal 1994, interest earned on securities held for trading reflected
$1.5 million of non-recurring interest earned from the call of two mortgage-
backed securities. Excluding this non-recurring income, the Company's
interest rate spread and net interest margin would have amounted to 1.87%
and 1.88%, respectively.
(4) Net of deferred loan fees, loan discounts and undisbursed loan funds.
Includes nonaccrual loans. Interest on nonaccrual loans is recorded when
received.
(5) Excluding the costs of hedging the Company's interest rate exposure (which
has effectively reduced the yields earned on the Company's securities
portfolio), the Company's interest rate spread amounted to 1.72%, 2.17% and
3.57%, and the Company's net interest margin amounted to 1.81%, 2.14% and
3.58% for the years ended June 30, 1996, 1995 and 1994, respectively.
(6) Net interest margin is net interest income divided by average interest-
earning assets.
24
RATE/VOLUME ANALYSIS - The following table describes the extent to which changes
in interest rates and changes in volume of interest-related assets and
liabilities have affected the Company's interest income and interest expense
during the periods indicated. For each category of interest-earning assets and
interest-bearing liabilities, information is provided on changes attributable to
(i) changes in volume (change in volume multiplied by prior year rate), (ii)
changes in rate (change in rate multiplied by prior year volume), and (iii)
total change in rate and volume. The combined effect of changes in both rate and
volume has been allocated in proportion to the absolute dollar amounts of the
changes due to rate and volume.
(DOLLARS IN THOUSANDS)
YEAR ENDED JUNE 30, 1996 VS. 1995 1995 vs. 1994
---------------------------------------------------------------------------------
INCREASE INCREASE
(DECREASE) TOTAL (DECREASE) TOTAL
DUE TO INCREASE DUE TO INCREASE
RATE VOLUME (DECREASE) RATE VOLUME (DECREASE)
---------------------------------------------------------------------------------
Interest-earning assets:
Interest-bearing deposits $ 15 $ 162 $ 177 $ 222 $ (34) $ 188
Securities held for trading and
securities available for sale (700) 4,346 3,646 1,810 1,465 3,275
Loans receivable, net (154) 2,207 2,053 (91) 536 445
Federal Home Loan Bank stock 21 27 48 24 21 45
---------------------------------------------------------------------------------
Total interest-earning assets $(818) $6,742 5,924 $1,965 $1,988 3,953
---------------------------------------------------------------------------------
---------------------------------------------------------------------------------
Interest-bearing liabilities:
NOW and checking accounts $ 3 $ 13 16 $ (3) $ 14 11
Savings accounts 50 (5) 45 46 (76) (30)
Money market deposit accounts 5 (16) (11) 32 (128) (96)
Certificates of deposit 173 274 447 511 1,742 2,253
---------------------------------------------------------------------------------
Total deposits 231 266 497 586 1,552 2,138
Securities sold under agreements
to repurchase 194 4,504 4,698 1,472 48 1,520
Federal Home Loan Bank advances 72 (198) (126) 663 2 665
Note payable (2) 158 156 116 56 172
---------------------------------------------------------------------------------
Total interest-bearing liabilities $ 495 $4,730 $5,225 $2,837 $1,658 4,495
---------------------------------------------------------------------------------
---------------------------------------------------------------------------------
Increase (decrease) in net
interest income $ 699 $ (542)
---------------------------------------------------------------------------------
---------------------------------------------------------------------------------
NET INTEREST INCOME - Net interest income is determined by the Company's
interest rate spread (i.e., the difference between the yields earned on its
interest-earning assets and the rates paid on its interest-bearing liabilities)
and the relative amounts of interest-earning assets and interest-bearing
liabilities. For the year ended June 30, 1996, Harrington's net interest income
increased by $699,000 or 14.4% to $5.5 million, compared to the year ended June
30, 1995. The increase was primarily due to a $88.7 million increase in the
amount of average interest-earning assets.
25
The growth in asset size is a major component of Harrington's strategic plan. As
capital is raised, either internally through the retention of profits or
externally through the issuance of stock, the proceeds are invested initially in
the Company's securities portfolio. As retail expansion opportunities become
available and as mortgage loans are originated, these funds will be redeployed
in those sectors.
The increase in net interest income caused by asset growth was partially offset
by a 49 basis point decline in the Company's interest rate spread during the
year, from 2.13% to 1.64%. Interest rate spread is the difference between
interest income as a percentage of interest-earning assets and interest expense
as a percentage of interest-bearing liabilities. This decline was primarily due
to the Bank investing the capital raised in Harrington's initial public stock
offering in mortgage-backed and related securities, which earn somewhat lower
option-adjusted spreads than the mortgage loans in the Company's portfolio.
These purchases were funded primarily through reverse repurchase agreements.
For the year ended June 30, 1995, Harrington's net interest income amounted to
$4.8 million, compared to $5.3 million for the year ended June 30, 1994. The
$542,000 decrease was primarily due to a 51 basis point decline in the Company's
interest rate spread, from 2.64% to 2.13%. A principal reason for the decrease
in the interest rate spread was $1.5 million of non-recurring interest earned
during fiscal 1994 due to the call of two mortgage-backed residuals during the
year. Excluding this non-recurring income, Harrington's interest rate spread
would have increased by 26 basis points during the year.
PROVISION FOR LOAN LOSSES - The provision for loan losses is charged to earnings
to bring the total allowance to a level considered appropriate by management
based on the estimated net realizable value of the underlying collateral,
general economic conditions, particularly as they relate to the Company's market
area, historical loan loss experience and other factors related to the
collectability of the Company's loan portfolio. While management endeavors to
use the best information available in making its evaluations, future allowance
adjustments may be necessary if economic conditions change substantially from
the assumptions used in making the evaluations.
Harrington established provisions (recoveries) for loan losses of $(1,000),
$15,000, and $(3,000) during the years ended June 30, 1996, 1995 and 1994,
respectively. During such respective periods, loan charge-offs (net of
recoveries) amounted to $0, $0 and $47,000, respectively. The allowance for loan
losses as a percentage of total non-performing loans was 46.0%, 34.6% and 19.0%
at June 30, 1996, 1995 and 1994, respectively. The allowance for loan losses as
a percentage of total loans was 0.2%, 0.3% and 0.5% at June 30, 1996, 1995 and
1994, respectively.
OTHER INCOME - Other income is comprised of two distinct components: gains and
losses on the Company's investment portfolios, and fee and other income from
retail bank operations. Total other income has fluctuated considerably over the
years presented, due primarily to the component related to securities gains and
losses.
Since Harrington has classified most of its investment securities and related
hedge instruments as held for trading, all market value changes in this
portfolio are reported in earnings whether or not the assets are sold. Gains or
losses on assets which have been sold are reported as realized gains or losses,
and market value gains or losses on assets and hedges which remain in the
Company's portfolio are reported as unrealized gains or losses.
Management's goal is to attempt to offset any change in the market value of its
securities portfolio with the change in the market value of the interest rate
risk management contracts and mortgage-backed derivative securities utilized by
the Company to hedge its interest rate exposure. In addition, management
attempts to produce an overall gain with respect to its securities portfolio
through the use of option-adjusted pricing analysis. The Company utilizes such
analysis to select securities with wider spreads for purchase and to select
securities to sell for a gain as spreads tighten (net of the gain or loss
recognized with respect to related interest rate contracts).
26
However, the use of mark-to-market accounting for the trading portfolio can
cause volatility in reported earnings due to short-term fluctuations in the
market value of the securities relative to that of the hedge instruments.
Harrington accepts this volatility and realizes that a major benefit of marking
assets to market is that it provides shareholders with more timely information
on the economic value of the Company's portfolio.
The following table sets forth information regarding other income for the
periods shown.
(DOLLARS IN THOUSANDS)
YEAR ENDED
JUNE 30, 1996 1995 1994
------------ ------------ ------------
Gain (loss) on sale of
securities held
for trading $ 1,834 $ 66 $(2,169)
Gain on sale of securities
available for sale 392
Unrealized gain (loss) on
securities held
for trading (1,960) 1,535 710
Permanent impairment
of securities available
for sale (414) (610)
Other(1) 256 238 267
------------ ------------ ------------
Total other income $ 130 $ 1,425 $(1,410)
------------ ------------ ------------
------------ ------------ ------------
(1) Consists primarily of loan servicing fees and late charges, checking account
fees, trust and investment management service fees, rental income and other
miscellaneous fees.
Total other income amounted to $130,000 for the year ended June 30, 1996. This
total was comprised of fee and other retail bank income of $256,000 which was
reduced by a net realized and unrealized loss of $126,000 on securities held for
trading. The securities loss resulted from changes in the market values of
mortgage-backed securities which were not entirely offset by changes in the
market values of the interest rate contracts in the trading portfolio.
Total other income amounted to $1.4 million during the year ended June 30, 1995,
primarily due to $1.6 million of net realized and unrealized gains on securities
held for trading. This gain was partially offset by a $414,000 charge relating
to the permanent impairment of securities classified as available for sale.
Pursuant to SFAS No. 115, if a security classified as available for sale
experiences an other than temporary decline in value below the amortized cost of
the security, the cost basis of the security is required to be written down to
fair value and the amount of the write-down deducted from earnings. As a result,
during fiscal 1995 the Company recorded $414,000 of such impairment adjustments
which related to a non-agency participation certificate secured by a significant
amount of delinquent single-family residential loans.
Total other income amounted to a loss of $1.4 million for the year ended June
30, 1994, due primarily to a $1.5 million net realized and unrealized loss on
securities held for trading. This loss was caused by less proceeds than
anticipated being realized at the early call of two mortgage-backed residuals,
as well as by a general widening of net risk-adjusted spreads with respect to
mortgage-backed securities. A $610,000 impairment adjustment on securities
available for sale was partially offset by a $392,000 gain on sale of such
securities.
OTHER EXPENSE. In order to enhance the Company's profitability, management
strives to maintain a low level of operating expenses relative to its peer
group. During the years ended June 30, 1996, 1995 and 1994, total other expense
as a percentage of average total assets amounted to 1.1%, 1.3% and 1.2%,
respectively. The following table sets forth certain information regarding other
expense for the periods shown.
27
(DOLLARS IN THOUSANDS)
YEAR ENDED
JUNE 30, 1996 1995 1994
--------------------------------------
Salaries and employee
benefits $1,552 $1,295 $ 925
Premises and equipment 466 414 331
FDIC insurance premiums 276 260 238
Marketing 200 122 136
Computer services 143 112 83
Consulting fees 232 195 183
Other(1) 871 769 623
--------------------------------------
Total other expense $3,740 $3,167 $2,519
--------------------------------------
--------------------------------------
(1) Consists primarily of costs relating to postage, forms and supplies,
professional fees, supervisory assessments and other miscellaneous expenses.
The principal category of Harrington's other expense is salaries and employee
benefits, which increased by $257,000 or 19.8% and $370,000 or 40.0% during
fiscal 1996 and 1995, respectively. A major cause of these increases was the
opening of two new branch offices in Hamilton County, Indiana. One branch was
opened in Carmel, Indiana in May 1994, and a second one was opened in Fishers,
Indiana in December 1995. Additional factors impacting salaries and employee
benefits expense were the additional employees hired in connection with the
growth in the Bank's mortgage lending operations and the opening of Harrington's
Investment Management and Trust Services.
Premises and equipment expense increased by $52,000 or 12.6% and $83,000 or
25.0% during fiscal 1996 and 1995, respectively. The increase in premises and
equipment expense during the periods was primarily due to the opening of new
branches during fiscal years 1994 and 1996.
FDIC insurance premiums increased by $16,000 or 6.2% and $22,000 or 9.2% during
fiscal 1996 and 1995, respectively. FDIC insurance premiums are a function of
the size of the Bank's deposit base. Harrington currently pays 23 basis points
on its deposits for FDIC insurance. Since the Company has experienced
significant growth in its deposit base, its insurance expense has increased as
well.
Harrington incurred marketing expense of $200,000, $122,000 and $136,000 during
the years ended June 30, 1996, 1995 and 1994, respectively. The fluctuations in
marketing expense during the periods reflected the advertising costs associated
with the opening of the Bank's new branch offices during fiscal 1994 and 1996.
Computer services expense increased by $31,000 or 27.7% and $29,000 or 34.9%
during fiscal 1996 and 1995, respectively. Computer services expense relates to
the fees paid by Harrington to a third party who performs the Company's data
processing functions as well as to the third party servicer who performs the
back-office functions with respect to the Company's trust and investment
management services which were implemented in December 1994. The increase in
expense for the years presented relates primarily to the increase in the number
of deposit and loan accounts held by Harrington.
Harrington has contracted with Smith Breeden to provide investment advisory
services and interest rate risk analysis. Certain stockholders of the Company
are also principals of Smith Breeden. The consulting fees paid by Harrington to
Smith Breeden during the years ended June 30, 1996, 1995 and 1994, which are
based on the Company's asset size, amounted to $232,000, $195,000 and $183,000,
respectively.
INCOME TAX PROVISION. The Company incurred income tax expense of $648,000, $1.2
million and $391,000 during the years ended June 30, 1996, 1995 and 1994,
respectively. The Company's effective tax rate amounted to 34.6%, 38.7% and
28.0% during the years ended June 30, 1996, 1995 and 1994, respectively.
Effective July 1, 1993, the Company changed its method of accounting for income
taxes pursuant to SFAS No. 109. SFAS No. 109 establishes an asset and liability
approach for financial accounting and reporting for income taxes. The cumulative
effect of the change in adopting SFAS No. 109 amounted to a $79,000 charge to
earnings for the year ended June 30, 1994.
28
LIQUIDITY
The Bank is required under applicable federal regulations to maintain specified
levels of "liquid" investments in qualifying types of U.S. Government and
government agency obligations and other similar investments having maturities of
five years or less. Such investments are intended to provide a source of
relatively liquid funds upon which the Bank may rely if necessary to fund
deposit withdrawals and for other short-term funding needs. The required level
of such liquid investments is currently 5% of certain liabilities as defined by
the OTS.
The regulatory liquidity of the Bank was 5.53% at June 30, 1996, as compared to
5.36% at June 30, 1995. At June 30, 1996, the Bank's liquid assets as defined by
the OTS totaled approximately $17.0 million, which was $1.6 million in excess of
the current OTS minimum requirement.
The Company manages its liquidity so as to maintain a minimum regulatory ratio
of 5%. However, as a result of the Company's active portfolio management, the
Bank's regulatory liquidity can be expected to fluctuate from a minimum of 5% to
approximately 6%, based upon investment alternatives available and market
conditions. In addition, the Company also calculates the amount of cash which
could be raised in one, seven or thirty days, either by selling unpledged assets
or by borrowing against them. The ratio of this amount of liquidity to total
deposits generally ranges from over 50% to 90% or more for one- and thirty-day
time frames, respectively. Harrington believes that it has adequate resources to
fund ongoing commitments such as deposit account withdrawals and loan
commitments.
INFLATION AND CHANGING PRICES
The Consolidated Financial Statements and related data presented herein have
been prepared in accordance with generally accepted accounting principles, which
require the measurement of financial position and operating results in terms of
historical dollars (except with respect to securities which are carried at
market value), without considering changes in the relative purchasing power of
money over time due to inflation. Unlike most industrial companies,
substantially all of the assets and liabilities of the Company are monetary in
nature. As a result, interest rates have a more significant impact on the
Company's performance than the effects of general levels of inflation. Interest
rates do not necessarily move in the same direction or in the same magnitude as
the prices of goods and services.
RECENT ACCOUNTING PRONOUNCEMENTS
The Financial Accounting Standards Board has issued Statement Nos. 121, 122, 123
and 125 that the Company will be required to adopt in future periods. See Note 1
to the consolidated financial statements for further discussion of these
pronouncements.
29
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS EXCEPT SHARE DATA)
JUNE 30, 1996 1995
---------------------
ASSETS
Cash $ 1,036 $ 773
Interest-bearing deposits (Note 13) 16,107 4,932
---------------------
Total cash and cash equivalents 17,143 5,705
Securities held for trading - at fair value (amortized cost of
$323,936 and $244,488) (Notes 2, 8, 13) 324,221 246,733
Securities available for sale - at fair value (amortized cost of
$2,062 and $2,444) (Note 2) 2,050 2,541
Loans receivable (net of allowance for loan losses of
$120 and $121) (Note 3) 65,925 37,010
Interest receivable, net (Note 4) 1,807 1,353
Premises and equipment, net (Note 5) 3,105 2,392
Federal Home Loan Bank of Indianapolis stock - at cost 2,645 2,500
Other 1,300 1,940
---------------------
TOTAL ASSETS $418,196 $300,174
---------------------
---------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits (Note 6) $135,143 $115,312
Securities sold under agreements to repurchase (Note 7) 219,067 130,217
Federal Home Loan Bank advances (Note 8) 26,000 31,000
Interest payable 1,970 1,692
Note payable (Note 9) 8,998 9,200
Advance payments by borrowers for taxes and insurance 392 264
Deferred income taxes, net (Note 10) 663 1,576
Accrued income taxes payable (Note 10) 115 195
Deferred compensation payable (Note 12) 119 152
Accrued expenses payable and other liabilities 2,612 205
---------------------
Total liabilities 395,079 289,813
---------------------
COMMITMENTS AND CONTINGENCIES (NOTES 13, 14, 16)
STOCKHOLDERS' EQUITY (NOTES 1, 10, 11, 12, 16):
Preferred Stock ($1 par value) Authorized and unissued -
5,000,000 shares
Common Stock:
Voting ($.125 par value) Authorized - 10,000,000 shares
issued and outstanding 3,256,738 and 1,961,626 407 245
Additional paid-in capital 15,623 4,183
Unrealized gain (loss) on securities available for sale, net of deferred
taxes of $(4) and $36 (8) 61
Retained earnings 7,095 5,872
---------------------
Total stockholders' equity 23,117 10,361
---------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $418,196 $300,174
---------------------
---------------------
See notes to consolidated financial statements.
30
CONSOLIDATED STATEMENTS OF INCOME
(DOLLARS IN THOUSANDS EXCEPT SHARE DATA)
YEARS ENDED JUNE 30, 1996 1995 1994
--------------------------------------
INTEREST INCOME:
Securities held for trading $18,290 $14,425 $12,876
Net interest expense on interest rate contracts maintained in
the trading portfolio (Note 13) (252) (93) (1,880)
Securities available for sale 190 250 311
Loans receivable (Note 3) 4,276 2,223 1,778
Dividends on Federal Home Loan Bank of Indianapolis stock 200 152 107
Deposits 780 603 415
--------------------------------------
23,484 17,560 13,607
--------------------------------------
INTEREST EXPENSE:
Deposits (Notes 6, 13) 7,151 6,654 4,516
Federal Home Loan Bank advances (Note 8) 1,596 1,722 1,057
Short-term borrowings (Note 7) 8,352 3,654 2,134
Long-term borrowings (Note 9) 905 749 577
--------------------------------------
18,004 12,779 8,284
--------------------------------------
NET INTEREST INCOME 5,480 4,781 5,323
PROVISION (CREDIT) FOR LOAN LOSSES (NOTE 3) (1) 15 (3)
--------------------------------------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 5,481 4,766 5,326
--------------------------------------
OTHER INCOME (LOSS):
Gain (loss) on sale of securities held for trading (Note 13) 1,834 66 (2,169)
Gain on sale of securities available for sale 392
Unrealized gain (loss) on securities held for trading (Notes 2, 13) (1,960) 1,535 710
Permanent impairment of securities available for sale (Note 2) (414) (610)
Other 256 238 267
--------------------------------------
130 1,425 (1,410)
--------------------------------------
OTHER EXPENSE:
Salaries and employee benefits (Note 12) 1,552 1,295 925
Premises and equipment expense (Note 5) 466 414 331
FDIC insurance premiums 276 260 238
Marketing 200 122 136
Computer services 143 112 83
Consulting fees (Note 15) 232 195 183
Other 871 769 623
--------------------------------------
3,740 3,167 2,519
--------------------------------------
INCOME BEFORE INCOME TAX PROVISION AND CUMULATIVE EFFECT
OF CHANGE IN ACCOUNTING FOR DEFERRED INCOME TAXES 1,871 3,024 1,397
INCOME TAX PROVISION (NOTE 10) 648 1,171 391
--------------------------------------
INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN
ACCOUNTING FOR DEFERRED INCOME TAXES 1,223 1,853 1,006
CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING FOR
DEFERRED INCOME TAXES (NOTE 10) (79)
--------------------------------------
NET INCOME $ 1,223 $ 1,853 $ 927
--------------------------------------
--------------------------------------
EARNINGS PER SHARE (NOTE 1):
INCOME PER SHARE BEFORE CUMULATIVE EFFECT OF
ACCOUNTING CHANGE $ 0.57 $ 1.20 $ 0.72
CUMULATIVE EFFECT OF ACCOUNTING CHANGE (0.06)
--------------------------------------
NET INCOME PER SHARE $ 0.57 $ 1.20 $ 0.66
--------------------------------------
--------------------------------------
See notes to consolidated financial statements.
31
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
Additional Unrealized Total
Shares Common Paid-In Gain Retained Stockholders'
Outstanding Stock Capital (Loss) Earnings Equity
--------------------------------------------------------------------------------------
(DOLLARS IN THOUSANDS EXCEPT SHARE DATA)
BALANCES, JULY 1, 1993 176,548 $176 $ 1,730 $ 296 $3,092 $ 5,294
Reclassification of securities available
for sale to securities held for trading (252) (252)
Net income 927 927
Net change in unrealized gain (loss) on
securities available for sale (44) (44)
--------------------------------------------------------------------------------------
BALANCES, JUNE 30, 1994 176,548 176 1,730 4,019 5,925
Stock split 4 for 1 529,644
Issuance of common stock under equity
offering (Note 16) 263,821 66 2,355 2,421
Stock options exercised (Note 12) 10,800 3 98 101
Net income 1,853 1,853
Net change in unrealized gain (loss) on
securities available for sale, net of
deferred tax of $36 61 61
--------------------------------------------------------------------------------------
BALANCES, JUNE 30, 1995 980,813 245 4,183 61 5,872 10,361
Stock split 2 for 1 980,813
Stock options exercised (Note 12) 30,112 4 161 165
Issuance of common stock under initial
public offering (Note 1) 1,265,000 158 11,279 11,437
Net income 1,223 1,223
Net change in unrealized gain (loss)
on securities available
for sale, net of deferred tax of $(4) (69) (69)
--------------------------------------------------------------------------------------
BALANCES, JUNE 30, 1996 3,256,738 $407 $15,623 $ (8) $7,095 $23,117
--------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------
See notes to consolidated financial statements.
32
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
YEARS ENDED JUNE 30, 1996 1995 1994
-----------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 1,223 $ 1,853 $ 927
Adjustments to reconcile net income to net
cash provided by (used in) operating activities:
Provision (credit) for loan losses (1) 15 (3)
Depreciation 210 176 141
Premium and discount amortization on securities, net 1,887 1,485 2,286
Amortization of premiums and discounts on loans receivable (37) (132) (210)
(Gain) loss on sale of securities held for trading (1,834) (66) 2,169
Gain on sale of securities available for sale (392)
Unrealized (gain) loss on securities held for trading 1,960 (1,535) (710)
Permanent impairment of securities available for sale 414 610
Deferred income tax provision (913) 673 165
(Increase) decrease in interest receivable (454) (41) 271
Increase in interest payable 278 219 175
Increase (decrease) in accrued income taxes (80) (254) 449
Purchases of securities held for trading (390,743) (510,309) (69,425)
Proceeds from maturities of securities held for trading 25,407 15,798 7,809
Proceeds from sales of securities held for trading 285,835 419,340 66,433
(Increase) decrease in other assets 640 (1,511) (192)
Increase (decrease) in accrued expenses 2,374 (642) 412
Increase in other liabilities 128 124 33
-----------------------------------------
Net cash provided by (used in) operating activities (74,120) (74,393) 10,948
-----------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of Federal Home Loan Bank of Indianapolis stock (145) (657)
Purchases of securities available for sale (110,251)
Proceeds from maturities of securities available for sale 422 574 24,134
Proceeds from sales of securities available for sale 89,101
Loan originations, net of principal repayments (28,877) (16,211) (3,822)
Purchases of premises and equipment (923) (411) (471)
-----------------------------------------
Net cash used in investing activities (29,523) (16,705) (1,309)
-----------------------------------------
(continued)
33
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(DOLLARS IN THOUSANDS)
YEARS ENDED JUNE 30, 1996 1995 1994
-----------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits 19,831 7,011 18,511
Increase (decrease) in securities sold under
agreements to repurchase 88,850 75,565 (29,058)
Proceeds from issuance of common stock under equity offering 2,421
Proceeds from issuance of common stock under initial public offering 11,437
Proceeds from stock options exercised 165 101
Proceeds from Federal Home Loan Bank advances 10,000
Proceeds from note payable 800 1,900 8,000
Principal repayments on Federal Home Loan Bank advances (15,000)
Principal repayments on note payable (1,002) (600) (7,631)
-----------------------------------------
Net cash provided by (used in) financing activities 115,081 86,398 (10,178)
-----------------------------------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 11,438 (4,700) (539)
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 5,705 10,405 10,944
-----------------------------------------
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 17,143 $ 5,705 $ 10,405
-----------------------------------------
-----------------------------------------
SUPPLEMENTAL DISCLOSURES OF CASH FLOW
INFORMATION:
Cash paid for interest $ 18,354 $ 12,562 $ 8,109
Cash paid (refunded) for income taxes 1,600 753 (427)
Non-cash reclassification of securities from available
for sale to held for trading 166,092
See notes to consolidated financial statements.
34
NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS
I. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BUSINESS OF THE COMPANY - Harrington Financial Group, Inc. ("HFG" or the
"Company") is a savings and loan holding company incorporated on March 3, 1988
to acquire and hold all of the outstanding common stock of Harrington Bank, FSB
(the "Bank"), a federally chartered savings bank with principal offices in
Richmond, Indiana and branch locations in Hamilton County, Indiana. 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.
BASIS OF PRESENTATION - The consolidated financial statements include the
accounts of HFG and the Bank. All significant intercompany accounts and
transactions have been eliminated. The preparation of financial statements in
conformity with generally accepted accounting principles requires management to
make estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.
CASH AND CASH EQUIVALENTS - All highly liquid investments with an original
maturity of three months or less are considered to be cash equivalents.
SECURITIES HELD FOR TRADING AND AVAILABLE FOR SALE - Statement of Financial
Accounting Standards (SFAS) No. 115, ACCOUNTING FOR CERTAIN INVESTMENTS IN DEBT
AND EQUITY SECURITIES, addresses the accounting and reporting for investments in
equity securities that have readily determinable fair values and all investments
in debt securities. SFAS No. 115 requires these securities to be classified in
one of three categories and accounted for as follows:
- - Debt securities that the Company has the positive intent and ability to hold
to maturity are classified as "securities held to maturity" and reported at
amortized cost.
- - Debt and equity securities that are acquired and held principally for the
purpose of selling them in the near term with the objective of generating
economic profits on short-term differences in market characteristics are
classified as "securities held for trading" and reported at fair value, with
unrealized gains and losses included in earnings.
- - Debt and equity securities not classified as either held to maturity or
trading securities are classified as "securities available for sale" and
reported at fair value, with unrealized gains and losses, after applicable
taxes, excluded from earnings and reported in a separate component of
stockholders' equity. Declines in the value of debt securities and marketable
equity securities that are considered to be other than temporary are recorded as
a permanent impairment of securities available for sale in the statement of
income.
Premiums and discounts are amortized over the contractual lives of the related
securities using the level yield method. Gains or losses on sales of these
securities are based on the specific identification method. The Company records
the balance sheet effects of security transactions on a settlement date basis,
however, unrealized and realized gains and losses from security transactions are
recorded as of the trade date in the statement of income for the year in which
the securities are purchased or sold. Net unsettled mortgage-backed security
purchases were approximately $38,390,000 as of June 30, 1996, which consisted of
$93,526,000 of purchases and $55,136,000 of sales. Net unsettled mortgage-backed
security purchases as of June 30, 1995, were approximately $18,100,000 which
consisted of $49,762,000 of purchases and $31,662,000 of sales.
35
In implementing SFAS No. 115 on June 30, 1993, the Company designated all of its
securities as available for sale. During fiscal year 1994, the Company
reclassified substantially all of its securities into the trading portfolio. At
the time of reclassification to the trading category from the available for sale
category, gross gains of $7,210,000 and gross losses of $6,958,000 were included
in earnings. The Company's trading portfolio consists of mortgage-backed
securities, mortgage-backed security derivatives, equity securities and interest
rate contracts, which accordingly are carried at fair value. Realized and
unrealized changes in fair values are recognized in other income in the period
in which the changes occur. Interest income from trading activities is included
in the statement of income as a component of net interest income.
The Company's available for sale portfolio consists of municipal bonds and a
non-agency participation certificate.
Management's estimates of fair value of securities are based upon a number of
assumptions such as prepayments which may shorten the life of such securities.
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. While management
endeavors to use the best information available in determining prepayment
assumptions, actual results could differ from those assumptions.
FINANCIAL INSTRUMENTS HELD FOR ASSET AND LIABILITY MANAGEMENT PURPOSES -
Effective June 30, 1995, the Bank adopted the provisions of SFAS No. 119,
DISCLOSURE ABOUT DERIVATIVE INSTRUMENTS AND FAIR VALUE OF FINANCIAL INSTRUMENTS.
The statement addresses disclosures of derivative financial instruments such as
futures, forward rate agreements, interest rate swap agreements, option
contracts and other financial instruments with similar characteristics. SFAS No.
119 requires disclosures about amounts and the nature and terms of derivative
financial instruments regardless of whether they result in off-balance-sheet
risk or risk of accounting loss. The Bank has incorporated the requirements of
this statement in Note 13.
The Bank is party to a variety of interest rate contracts consisting of interest
rate futures, options, caps, swaps, floors and collars in the management of its
interest rate exposure of the trading portfolio. These financial instruments are
included in the trading portfolio and are reported at fair value with realized
and unrealized gains and losses on these instruments recognized in other income
(see Note 2).
The Bank enters into certain other interest rate swap agreements as a means of
managing the interest rate exposure of certain inverse variable rate deposits.
The Bank also entered into an interest rate cap agreement to effectively fix the
interest rate on floating-rate Federal Home Loan Bank advances. These interest
rate agreements are accounted for under the accrual method. Under this method,
the differential to be paid or received on these interest rate agreements is
recognized over the lives of the agreements in interest expense. Changes in fair
value of interest rate swaps and of the interest rate cap accounted for under
the accrual method are not reflected in the accompanying financial statements.
Realized gains and losses on terminated interest rate swaps accounted for under
the accrual method are deferred as an adjustment to the carrying amount of the
designated instruments and amortized over the remaining original life of the
agreements. If the designated instruments are disposed of, the fair value of the
interest rate swap, interest rate cap or unamortized deferred gains or losses
are included in the determination of the gain or loss on the disposition of such
instruments. To qualify for such accounting, the interest rate swaps are
designated to the inverse variable rate deposits and the interest rate cap is
designated to the Federal Home Loan Bank advances which alter the designated
instruments' interest rate characteristics.
36
LOANS RECEIVABLE are carried at the principal amount outstanding, adjusted for
premiums or discounts which are amortized or accreted using a level-yield
method. The Company adopted SFAS No. 114 and No. 118, ACCOUNTING BY CREDITORS
FOR IMPAIRMENT OF A LOAN AND INCOME RECOGNITION AND DISCLOSURES, as amended,
effective July 1, 1995. These statements require that impaired loans be measured
based on the present value of future cash flows discounted at the loan's
effective interest rate or the fair value of the underlying collateral, and
specifies alternative methods for recognizing interest income on loans that are
impaired or for which there are credit concerns. For purposes of applying these
standards, impaired loans have been defined as all nonaccrual commercial loans
which have not been collectively evaluated for impairment. The Company's policy
for income recognition was not affected by adoption of these standards. The
adoption of SFAS No. 114 and No. 118 did not have any effect on the total
reserve for credit losses or related provision. At July 1, 1995 and June 30,
1996, the Company had no impaired loans required to be disclosed under SFAS No.
114 and No. 118.
Discounts and premiums on purchased residential real estate loans are amortized
to income using the interest method over the remaining period to contractual
maturity, adjusted for anticipated prepayments.
Nonrefundable origination fees net of certain direct origination costs are
deferred and recognized, as a yield adjustment, over the life of the underlying
loan.
ALLOWANCE FOR LOAN LOSSES - A provision for estimated losses on loans is charged
to operations based upon management's evaluation of the potential losses. Such
an evaluation, which includes a review of all loans for which full
collectibility may not be reasonably assured, considers, among other matters,
the estimated net realizable value of the underlying collateral, as applicable,
economic conditions, historical loan loss experience and other factors that are
particularly susceptible to changes that could result in a material adjustment
in the near term. While management endeavors to use the best information
available in making its evaluations, future allowance adjustments may be
necessary if economic conditions change substantially from the assumptions used
in making the evaluations.
INTEREST RECEIVABLE - Interest income on securities and loans is accrued
according to the contractual terms of the underlying asset including interest
rate, basis and date of last payment. Income on derivatives of mortgage-backed
securities is recorded based on the median of major brokers' prepayment
assumptions for the underlying securities. The Bank provides an allowance for
the loss of uncollected interest on loans which are more than 90 days past due.
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.
PREMISES AND EQUIPMENT are carried at cost less accumulated depreciation.
Depreciation is computed on the straight-line method over estimated useful lives
ranging from 3 to 40 years. Maintenance and repairs are expensed as incurred
while major additions and improvements are capitalized. Gains and losses on
dispositions are included in current operations.
FEDERAL INCOME TAXES - The Company and its wholly-owned subsidiary file a
consolidated tax return. The Company adopted SFAS No. 109 effective July 1,
1993. The statement requires, among other things, a change from the deferred
method to the liability method of accounting for deferred income taxes. Deferred
income tax assets and liabilities reflect the impact of temporary differences
between amounts of assets and liabilities for financial reporting purposes and
basis of such assets and liabilities as measured by tax laws and regulations.
37
EARNINGS PER SHARE - Earnings per share of common stock is based on the weighted
average number of common shares outstanding during the year. The weighted
average number of common shares outstanding was 2,160,233, 1,544,080 and
1,412,384 for fiscal 1996, 1995 and 1994, respectively. All per share
information has been restated to reflect the Company's four-for-one stock split
in October 1994 and the Company's two-for-one stock split in October 1995. The
assumed exercise of stock options does not have a materially dilutive effect.
NEW ACCOUNTING PRONOUNCEMENTS - SFAS No. 121, ACCOUNTING FOR THE IMPAIRMENT OF
LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF, is effective for
fiscal years beginning after December 15, 1995. This statement establishes
accounting standards for the impairment of long-lived assets, certain
liabilities, certain intangibles and goodwill. Management does not believe the
adoption of this statement will have a material effect on the financial position
or results of operations of the Company.
SFAS No. 122, ACCOUNTING FOR MORTGAGE SERVICING RIGHTS AN AMENDMENT OF FASB
STATEMENT NO. 65, is effective for fiscal years beginning after December 15,
1995. This Statement specifies conditions under which mortgage servicing rights
should be accounted for separately from the underlying mortgage loans.
Management does not believe the adoption of this statement will have a material
effect on the financial position or results of operations of the Company.
SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, was issued in October
1995 and requires adoption no later than fiscal years beginning after December
15, 1995. The new standard defines a fair value method of accounting for stock
options and similar equity instruments. Under the fair value method,
compensation cost is measured at the grant date based on the fair value of the
award and is recognized over the service period, which is usually the vesting
period.
Pursuant to the new standard, companies are encouraged, but not required, to
adopt the fair value method of accounting for employee stock-based transactions.
Companies are also permitted to continue to account for such transactions under
Accounting Principles Board Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO
EMPLOYEES, but would be required to disclose in a note to the financial
statements pro forma net income and, if presented, earnings per share as if the
company had applied the new method of accounting.
The accounting requirements of the new method are effective for all employee
awards granted after the beginning of the fiscal year of adoption. The Company
has not yet determined if it will elect to change to the fair value method, nor
has it determined the effect the new standard will have on net income and
earnings per share should it elect to make such a change. Adoption of the new
standard will have no effect on the Company's cash flows.
SFAS No. 125, ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND
EXTINGUISHMENTS OF LIABILITIES, was issued in June 1996 and provides accounting
and reporting standards for transfers and servicing of financial assets and
extinguishments of liabilities. SFAS 125 applies to transactions occurring after
December 31, 1996. Management has not yet quantified the effect, if any, of this
new standard on the consolidated financial statements.
The Financial Accounting Standards Board issued EXPOSURE DRAFT, ACCOUNTING FOR
DERIVATIVE AND SIMILAR FINANCIAL INSTRUMENTS AND FOR HEDGING ACTIVITIES, in June
1996. Management has not yet quantified the effect, if any, of this Exposure
Draft on the consolidated financial statements.
RECLASSIFICATIONS of certain amounts in the 1995 and 1994 consolidated financial
statements have been made to conform to the 1996 presentation.
38
2. SECURITIES
The amortized cost and estimated fair values of securities held for trading and
securities available for sale are summarized as follows:
(DOLLARS IN THOUSANDS)
JUNE 30, 1996
GROSS GROSS APPROXIMATE
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
---------------------------------------------------------
SECURITIES HELD FOR TRADING:
GNMA certificates $153,048 $1,515 $ 323 $154,240
FHLMC certificates 83,329 211 156 83,384
FNMA certificates 66,182 304 489 65,997
Non-Agency participation certificates 3,209 55 110 3,154
Collateralized mortgage obligations 6,131 248 6,379
Residuals 707 115 44 778
Interest-only strips 3,442 105 755 2,792
Principal-only strip 1,028 16 34 1,010
Interest rate swaps 620 620
Interest rate collar 83 91 (8)
Interest rate caps 3,692 214 832 3,074
Interest rate floors 2,535 1,049 614 2,970
Options 54 12 1 65
Futures 784 (784)
Equity securities 496 58 4 550
---------------------------------------------------------
TOTALS $323,936 $4,522 $4,237 $324,221
---------------------------------------------------------
---------------------------------------------------------
SECURITIES AVAILABLE FOR SALE:
Municipal bonds $ 921 $ 41 $ 962
Non-Agency participation certificate 1,141 $ 53 1,088
---------------------------------------------------------
TOTALS $ 2,062 $ 41 $ 53 $ 2,050
---------------------------------------------------------
---------------------------------------------------------
The Bank's CMO portfolio at June 30, 1996 consisted of
two agency investments with an estimated remaining
weighted average life of 13.6 years.
39
(DOLLARS IN THOUSANDS)
JUNE 30, 1996
GROSS GROSS APPROXIMATE
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
---------------------------------------------------------
SECURITIES HELD FOR TRADING:
GNMA certificates $ 90,408 $ 1,400 $ 58 $ 91,750
FHLMC certificates 54,685 750 189 55,246
FNMA certificates 68,286 1,008 92 69,202
Non-Agency participation certificates 3,893 43 18 3,918
Collateralized mortgage obligations 12,910 116 4 13,022
Residuals 4,470 385 492 4,363
Interest-only strips 4,570 36 1,607 2,999
Principal-only strip 781 22 803
Interest rate swaps 1,320 1,539 (219)
Interest rate collar 155 226 (71)
Interest rate caps 2,297 317 619 1,995
Interest rate floors 1,544 1,914 49 3,409
Options 266 9 74 201
Futures 3 137 (134)
Equity securities 223 26 249
---------------------------------------------------------
TOTALS $244,488 $ 7,349 $ 5,104 $246,733
---------------------------------------------------------
---------------------------------------------------------
SECURITIES AVAILABLE FOR SALE:
Municipal bonds $ 1,018 $ 109 $ 1,127
Non-Agency participation certificate 1,426 $ 12 1,414
---------------------------------------------------------
TOTALS $ 2,444 $ 109 $ 12 $ 2,541
---------------------------------------------------------
---------------------------------------------------------
The Bank's CMO portfolio at June 30, 1995 consisted of
four agency investments with an estimated remaining
weighted average life of 9.2 years.
For a complete discussion of the Bank's Risk
Management Activities, see Note 13.
40
The amortized cost and estimated fair values of securities
by contractual maturity are as follows:
(DOLLARS IN THOUSANDS)
JUNE 30, 1996
Held for Trading Available for Sale
------------------------- --------------------------
Amortized Fair Amortized Fair
Cost Value Cost Value
------------------------------------------------------
Debt securities:
Due after 1 year through 5 years $ 921 $ 962
Mortgage-backed securities $302,559 $303,621
Non-agency participation certificates 3,209 3,154 1,141 1,088
Collateralized mortgage obligations 6,131 6,379
Mortgage-backed derivatives 5,177 4,580
Interest rate contracts 6,364 5,937
Equity securities 496 550
------------------------------------------------------
$323,936 $324,221 $2,062 $2,050
------------------------------------------------------
------------------------------------------------------
Securities with a total amortized cost of $230,558,000 and $134,988,000 and a
total fair value of $229,680,000 and $138,026,000 were pledged at June 30, 1996
and 1995, respectively to secure interest rate swaps and securities sold under
agreements to repurchase. As of June 30, 1996, the Bank had a blanket collateral
agreement for the advances instead of utilizing specific securities as
collateral and as of June 30, 1995, securities with a total amortized cost of
$37,124,000 and a total fair value of $37,605,000 were pledged for advances.
Activities related to the sale of securities are summarized as follows:
(DOLLARS IN THOUSANDS)
YEARS ENDED JUNE 30, 1996 1995 1994
------------------------------------
Proceeds from sales of securities held for trading $285,835 $419,340 $66,433
Proceeds from sales of securities available for sale 89,101
Gross gains on sales of securities held for trading 30,492 12,761 34
Gross losses on sales of securities held for trading 28,658 12,695 2,203
Gross gains on sales of securities available for sale 2,593
Gross losses on sales of securities available for sale 2,201
Declines in the value of a non-agency participation certificate which is
included in the available for sale portfolio which are considered to be other
than temporary totaling $414,000 and $253,000 were recorded in the statements of
income for the years ended June 30, 1995 and 1994, respectively. In addition, an
other than temporary decline totaling $357,000 from certain mortgage derivatives
which were included in the available for sale portfolio was recorded in the
statement of income for the year ended June 30, 1994.
41
3. LOANS RECEIVABLE
Approximately 94% of the Bank's loans are to customers in Wayne and Hamilton
counties in Indiana or surrounding counties. The portfolio consists primarily of
owner-occupied single-family residential mortgages.
Loans receivable are summarized as follows:
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
----------------------
Loans secured by one to
four family residences:
Real estate mortgage $64,537 $34,740
Participation loans purchased 305 1,198
Commercial 441 711
Property improvement 315 166
Loans on savings accounts 267 255
Consumer 417 332
Real estate sold on contract 57 60
----------------------
Subtotal 66,339 37,462
Unamortized push-down
accounting adjustment (182) (350)
Undisbursed loan proceeds (420) (43)
Net deferred loan fees,
premiums and discounts 308 62
Allowance for loan losses (120) (121)
----------------------
LOANS RECEIVABLE, NET $65,925 $37,010
----------------------
----------------------
The principal balance of loans on nonaccrual status totaled approximately
$261,000 and $350,000 at June 30, 1996 and 1995, respectively. For the years
ended June 30, 1996, 1995 and 1994, gross interest income which would have been
recorded had the Bank's non-accruing loans been current with their original
terms amounted to $6,000, $13,000 and $26,000, respectively.
The Bank had commitments to originate or purchase loans consisting primarily of
real estate mortgages secured by one to four family residences approximating
$1,041,000 and $5,071,000 excluding undisbursed portions of loans in-process at
June 30, 1996 and 1995, respectively.
The Bank has transactions in the ordinary course of business with directors,
officers and employees. Loans to such individuals totaled $293,000 and $45,000
at June 30, 1996 and 1995, respectively.
The amount of loans serviced for others totaled $5,587,000, $6,820,000 and
$7,540,000 at June 30, 1996, 1995 and 1994, respectively. Servicing loans for
others generally consists of collecting mortgage payments, maintaining escrow
amounts, disbursing payments to investors and foreclosure processing. In
connection with loans serviced for others, the Bank held borrower's escrow
balances of $44,000 and $59,000 at June 30, 1996 and 1995, respectively.
Loan servicing fee income included in other income for the years ended June 30,
1996, 1995 and 1994 was $23,000, $27,000 and $32,000, respectively.
An analysis of the allowance for loan losses is as follows:
(DOLLARS IN THOUSANDS)
YEARS ENDED
JUNE 30, 1996 1995 1994
----------------------------------
Beginning balance $121 $106 $156
Provision for
loan losses (1) 15 (3)
Recoveries 1
Charge-offs (48)
----------------------------------
ENDING BALANCE $120 $121 $106
----------------------------------
----------------------------------
As a federally-chartered savings bank, aggregate commercial real estate loans
may not exceed 400% of capital as determined under the capital standards
provisions of FIRREA. This limitation was approximately $104 million and $74
million at June 30, 1996 and 1995, respectively. Also under FIRREA, the loans-
to-one borrower limitation is generally 15% of unimpaired capital and surplus
which, for the Bank, was approximately $4 million and $3 million at June 30,
1996 and 1995, respectively. Management believes the Bank was in compliance with
all of these requirements at June 30, 1996 and 1995.
42
4. INTEREST RECEIVABLE
Interest receivable is summarized as follows:
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
---------------------
Loans (less allowance for
uncollectibles - $6 and $13) $328 $180
Interest-bearing deposits 26 23
Securities held for trading 1,403 1,090
Securities available for sale 50 60
---------------------
INTEREST RECEIVABLE, NET $1,807 $1,353
---------------------
---------------------
5. PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows:
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
----------------------
Land $ 395 $ 395
Buildings and leasehold
improvements 2,631 1,985
Parking lot improvements 148 148
Furniture, fixtures and equipment 844 578
----------------------
Total 4,018 3,106
Less accumulated depreciation (913) (714)
----------------------
PREMISES AND EQUIPMENT, NET $3,105 $2,392
----------------------
----------------------
Depreciation expense included in operations during the years ended June 30,
1996, 1995 and 1994 totaled $210,000, $176,000 and $141,000, respectively.
(DOLLARS IN THOUSANDS)
JUNE 30,
1996 1995
-------------------------------------------------------
Weighted Weighted
Average Average
Amount Rate Amount Rate
-------------------------------------------------------
NOW and Super NOW accounts $ 4,529 3.04% $ 3,266 2.77%
Savings accounts 17,342 3.96 15,183 3.71
Money market deposit accounts 1,576 4.05 1,976 4.36
-------------------------------------------------------
23,447 20,425
-------------------------------------------------------
Certificates of deposit:
1 year and less 75,343 57,304
1 to 2 years 19,890 17,890
2 to 3 years 8,093 6,844
3 to 4 years 2,636 5,352
Over 4 years 5,734 7,497
-------------------------------------------------------
111,696 5.98 94,887 6.17
-------------------------------------------------------
TOTAL DEPOSITS $135,143 $115,312
-------------------------------------------------------
-------------------------------------------------------
Certificates of deposit in the amount of $100,000 or more totaled approximately
$20 million and $18 million at June 30, 1996 and 1995, respectively. A summary
of certificate accounts by scheduled fiscal year maturities at June 30, 1996, is
as follows:
(DOLLARS IN THOUSANDS)
1997 1998 1999 2000 2001 THEREAFTER TOTAL
-------------------------------------------------------------------------------------------------
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 1,571 $ 441 2,102 91,769
7.01% - 9.00% 5,374 1,210 2,491 988 113 2,391 12,567
9.01% or greater 95 295 6 674 1,070
-------------------------------------------------------------------------------------------------
TOTALS $75,343 $19,890 $8,093 $2,636 $1,228 $4,506 $111,696
-------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------
43
Interest expense on deposits is as follows:
(DOLLARS IN THOUSANDS)
YEARS ENDED JUNE 30, 1996 1995 1994
NOW and Super NOW accounts $ 110 $ 94 $ 83
Savings accounts 613 568 598
Money market deposit accounts 77 88 184
Certificates of deposit 6,351 5,904 3,651
----------------------------------------
Total $ 7,151 $ 6,654 $ 4,516
----------------------------------------
----------------------------------------
Interest expense on certificates of deposit is net of interest income on
interest rate contracts of $129,000, $158,000 and $596,000 in 1996, 1995 and
1994, respectively.
For a complete discussion of the Bank's Risk Management Activities, see Note 13.
7. SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
---------------------------
Securities sold under
agreements to repurchase:
Same securities $ 98,724 $ 29,696
Substantially identical securities 120,343 100,521
---------------------------
Total $ 219,067 $ 130,217
---------------------------
---------------------------
At June 30, 1996, securities sold under agreements to repurchase mature within
one month.
An analysis of securities sold under agreements to repurchase is as follows:
(DOLLARS IN THOUSANDS)
YEARS ENDED
JUNE 30, 1996 1995 1994
----------------------------------------
Maximum amount
outstanding at
any month-end $219,067 $130,217 $78,545
Daily average amount
outstanding 148,524 68,277 66,813
Weighted average
interest rate at end
of year 5.21% 6.01% 4.05%
----------------------------------------
----------------------------------------
Assets pledged to secure securities sold under agreements to repurchase are
concentrated among six dealers and the Bank exercises control over the
securities pledged when the same security is repurchased. Assets pledged are as
follows:
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
-------------------------
Mortgage-backed securities:
At amortized cost $226,091 $127,991
At fair value $225,161 $130,964
8. FEDERAL HOME LOAN BANK ADVANCES
Advances from the Federal Home Loan Bank of Indianapolis are as follows:
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
-------------------------------------------------------
Variable Variable
Weighted Weighted
Average Average
Fiscal Year Maturity Amount Rate Amount Rate
1996 $15,000 6.02%
1998 $26,000 5.41% 16,000 6.12%
-------------------------------------------------------
Total $26,000 $31,000
-------------------------------------------------------
-------------------------------------------------------
As of June 30, 1996, the Bank had a blanket collateral agreement for the
advances instead of utilizing specific securities as collateral. Mortgage-backed
securities with a total amortized cost of $37,124,000 and a total fair value of
$37,605,000 were pledged as collateral for the advances outstanding as of
June 30, 1995.
44
9. NOTE PAYABLE
At June 30, 1996 HFG has a $10,000,000 loan facility from Mark Twain Kansas Bank
consisting of a non-revolving line of credit of $800,000 and a $9,200,000 term
loan of which $1,002,000 had been repaid under the term loan at June 30, 1996.
Interest is payable quarterly at 1/2% over the prime rate published in the Wall
Street Journal (8.25% at June 30, 1996). Quarterly principal and interest
payments of $470,000 are payable during the term July 1, 1995 through March 31,
2000.
As of June 30, 1996, the loan was secured by the Harrington Bank, FSB stock held
by HFG, a personal guarantee from a stockholder of HFG, a blanket security
interest in all of HFG's assets, a corporate guarantee of Smith Breeden
Associates, Inc., a related party, and the assignment of certain life insurance
policies owned by HFG. Under the terms of the agreement, HFG is bound by certain
restrictive debt covenants. As of June 30, 1996, HFG was in compliance with all
such debt covenants. Following is a schedule of principal payments as of June
30, 1996:
(DOLLARS IN THOUSANDS)
YEARS ENDING JUNE 30,
1997 $1,129
1998 1,231
1999 1,343
2000 5,295
--------
$8,998
--------
--------
During July 1996, the Company amended its loan facility agreement with Mark
Twain Kansas Bank and increased its non-revolving line of credit to $3,000,000
with a total loan facility of approximately $12,263,000. Under the terms of the
amended loan agreement, the Company will make quarterly principal and interest
payments of $500,000 commencing October 1, 1996 which increases to $585,000 on
October 1, 1997 through June 30, 2000. The amended loan agreement also removed
the corporate guarantee of Smith Breeden Associates, Inc. and the personal
guarantee from a stockholder of HFG.
10. INCOME TAXES
An analysis of the income tax provision is as follows:
(DOLLARS IN THOUSANDS)
YEARS ENDED JUNE 30, 1996 1995 1994
----------------------------------
Current:
Federal $1,203 $ 372 $245
State 358 126 60
Deferred:
Federal (776) 572 47
State (137) 101 39
----------------------------------
TOTAL INCOME TAX PROVISION $ 648 $1,171 $391
----------------------------------
----------------------------------
The difference between the financial statement provision and amount computed by
using the statutory rate of 34% is reconciled as follows:
(DOLLARS IN THOUSANDS)
YEARS ENDED JUNE 30, 1996 1995 1994
--------------------------------
Federal statutory income
tax at 34% $636 $1,028 $475
Tax exempt interest and dividends (29) (32) (32)
State income taxes,
net of federal tax benefit 129 83 65
Amortization of fair value adjustments (53) (19) (54)
Other, net (35) 111 (63)
--------------------------------
Total income tax provision $648 $1,171 $391
--------------------------------
--------------------------------
The Company adopted SFAS No. 109 effective July 1, 1993. The cumulative effect
of adopting SFAS No. 109 on the Company's consolidated financial statements was
to decrease income by $79,000 for the year ended June 30, 1994.
45
The Company's deferred income tax assets and liabilities are as follows:
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
------------------
Deferred tax assets:
Permanent impairment on securities
available for sale $205
Deferred compensation $ 48 61
Deferred loan fees/costs, net 6
Differences in depreciation methods 16
Unrealized loss on securities
available for sale 4
Other 31 14
------------------
105 280
------------------
Deferred tax liabilities:
Differences in depreciation methods 2
Bad debt reserves, net 79 150
Unrealized gain on securities
held for trading 114 898
Differences in income recognition
on investments 575 740
Unrealized gain on securities
available for sale 36
Deferred loan fees/costs, net 30
------------------
768 1,856
------------------
Deferred income taxes, net $663 $1,576
------------------
------------------
Retained earnings at June 30, 1996 and 1995 includes approximately $3 million of
income that has not been subject to tax because of deductions for bad debts
allowed for Federal income tax purposes. 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 IRC. 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.
46
11. REGULATORY CAPITAL REQUIREMENTS
Effective December 7, 1989, the Office of Thrift Supervision ("OTS") set forth
capital standards applicable to all thrifts. These standards include a core
capital requirement, a tangible capital requirement and a risk-based capital
requirement, as defined. The tables below present the Bank's position relative
to the three capital requirements. The Bank exceeds all of the requirements at
June 30, 1996 and 1995.
The Bank's capital ratios are as follows:
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
--------------------------------------------------------------------------
Actual Actual
Required Capital Capital
Capital Actual as a % of Required Actual as a % of Required
Ratio Capital Assets (1) Capital Capital Assets (1) Capital
--------------------------------------------------------------------------
Total Bank capital $26,038 $18,375
Unrealized (gains) losses on certain
securities available for sale 8 (61)
------- -------
Total Bank tangible capital 1.50% 26,046 6.27% $ 6,228 18,314 6.12% $4,489
------- -------
Total Bank core capital
(Tier 1 capital) 3.00% 26,046 6.27% $12,456 18,314 6.12% $8,978
General allowance for loan losses 115 115
------- -------
Total Bank risk-based capital 8.00% $ 26,161 30.10% $ 6,953 $18,429 24.62% $5,989
------- -------
(1) Tangible capital and core capital are computed as a percentage of Bank
adjusted total assets of $415,212,000 and $299,253,000 as of June 30, 1996
and 1995, respectively. Risk-based capital is computed as a percentage of
bank adjusted risk-weighted assets of $86,909,000 and $74,865,000 as of
June 30, 1996 and 1995, respectively.
47
The various federal banking agencies recently adopted the final Prompt
Corrective Action regulations that are required by the Federal Deposit Insurance
Corporation Improvement Act of 1991 ("FDICIA"). Such regulations require
specific supervisory actions as capital levels decrease.
The specifications of the capital categories are shown below. The most recent
notification from the OTS categorized the Bank as well capitalized under the
regulatory frame work for prompt corrective action. As of the report date, there
are no conditions or events since that notification that management believes
have changed the institution category.
Total Tier 1 Tier 1
Risk-based Risk-based Leverage
(DOLLARS IN THOUSANDS) Ratio Ratio (1) Ratio
------------------------------------------
Capital Category:
Well-capitalized (greater than or equal to) 10% 6% 5%
Adequately capitalized (greater than or equal to) 8% 4% 4%
Under-capitalized (less than) 8% 4% 4%
Significantly under-capitalized (less than) 6% 3% 3%
Critically under-capitalized N/A N/A N/A
Bank actual capital at June 30, 1996 $26,161 $26,046 $26,046
Bank actual capital at June 30, 1995 $18,429 $18,314 $18,314
As a percentage of adjusted assets:
June 30, 1996 30.10% 29.97% 6.27%
June 30, 1995 24.62% 24.46% 6.12%
(1) The Tier 1 Risked-based ratio is defined as total core capital
(Tier 1 capital) divided by adjusted risk-weighted assets.
12. EMPLOYEE BENEFIT PLANS
PROFIT-SHARING PLAN - The Bank has a qualified noncontributory profit-sharing
plan for all eligible employees. The plan provides for contributions by the Bank
in such amounts as its Board of Directors may annually determine. Contributions
charged to expense for the years ended June 30, 1996, 1995 and 1994 were
$39,000, $79,000 and $69,000, respectively.
DEFERRED COMPENSATION PLAN - On September 30, 1988, three senior officers of the
Bank entered into consulting agreements with the Bank to take effect at their
retirement. The agreements obligate the Bank to make monthly payments to these
individuals for the remainder of their lives. At September 30, 1988, the Bank
recorded a liability for this deferred compensation calculated as the present
value of the estimated future cash payments. The amount of benefit expense for
fiscal years 1996, 1995 and 1994 was $29,000, $26,000 and $23,000, respectively.
48
STOCK OPTIONS - The Company has granted stock options to existing stockholders,
officers, directors and other affiliated individuals to purchase shares of the
Company's stock. At June 30, 1996, all outstanding stock options were
exercisable between December 1997 and January 1998. The options are
nontransferable and are forfeited upon termination of employment, as applicable.
The following is an analysis of stock option activity for each of the three
years in the period ended June 30, 1996, and the stock options outstanding at
the end of the respective years:
Weighted
Average
Options Shares Price
- --------------------------------------------------------
Outstanding July 1, 1993 161,200 $7.50
Forfeited or expired (6,000) 7.50
--------------------------
Outstanding June 30, 1994 155,200 7.50
Granted 41,000 5.04
Exercised (21,600) 4.66
Forfeited or expired (11,400) 6.66
--------------------------
Outstanding June 30, 1995 163,200 7.32
Granted 14,112 5.32
Exercised (30,112) 5.48
Forfeited or expired (4,000) 7.50
--------------------------
Outstanding June 30, 1996 143,200 $7.50
---------------------------
---------------------------
The Company also adopted a new Stock Option Plan during fiscal 1996 which
authorized 126,500 shares of common stock to be granted. At June 30, 1996, no
shares were granted under the Stock Option Plan.
EMPLOYEE STOCK OWNERSHIP PLAN - The Company established an Employee Stock
Ownership Plan (ESOP) on February 5, 1996 for employees of the Company and the
Bank. Full-time employees of the Company and the Bank who have been credited
with at least 1,000 hours of service during a twelve month period and who have
attained age 21 are eligible to participate in the ESOP. The ESOP purchased
7,000 shares in the initial public offering at $10.00 per share which were
allocated to eligible employees based on their eligible compensation as defined
in the ESOP Agreement. Gross compensation expense (i.e. the value of shares
contributed to the ESOP by the Company) was $70,000 for the year ended June 30,
1996.
13. RISK MANAGEMENT ACTIVITIES
The Bank closely monitors the sensitivity of its balance sheet and income
statement to potential changes in the interest rate environment. Derivative
financial instruments such as interest rate swaps, caps, floors, collars,
futures and options are used on an aggregate basis to protect the trading
portfolio and certain liabilities from adverse rate movements. The Bank's
objective, with regard to managing interest rate risk, is to maintain at an
acceptably low level the sensitivity to rising or falling rates of its market
value of portfolio equity.
Interest rate swaps are contracts in which the parties agree to exchange fixed
and floating rate payments for a specified period of time on a specified
(notional) amount. The notional amount is only used to calculate the amount of
the periodic interest payments to be exchanged, and does not represent the
amount at risk. The Bank uses swaps to modify the effective duration of various
assets and liabilities. The floating rates are generally indexed to the three-
month London Interbank Offered Rates (LIBOR).
Interest rate caps and floors are instruments in which the writer (seller)
agrees to pay the holder (purchaser) the amount that an agreed-upon index is
above or below the specified cap or floor rate, respectively, times the notional
amount. In return for this promise of future payments, the purchaser pays a
premium to the seller. The notional amount is never exchanged between the two
parties and does not represent the amount at risk. The Bank purchases interest
rate caps and floors to reduce the impact of rising or falling interest rates on
the fair value of its trading portfolio. The interest rate caps and floors
generally have indexes equal to one or
49
three month LIBOR, except for one interest rate cap which is tied to the five
year Constant Maturity Treasury.
The Bank is a party to an interest rate collar which also is used to manage
interest rate risk in the trading portfolio. The interest rate collar consists
of an interest rate cap held by the Bank and an interest rate floor written by
the Bank. The notional amount of the interest rate collar is based on the
balance in the collection accounts of certain Merrill Lynch collateralized
mortgage obligation trusts.
Interest rate futures contracts are commitments to either purchase or sell
designated instruments at a future date for a specified price. Initial margin
requirements are met in cash or other instruments, and changes in the contract
values are settled in cash daily. The Bank enters into futures contracts when
these instruments are economically advantageous to interest rate swaps, caps and
floors. The Bank uses primarily Eurodollar contracts which are structured in
calendar quarter increments and therefore result in a much larger notional
amount than longer maturity swap, cap or floor contracts which represent a
series of quarterly repricing.
Financial options are contracts which grant the purchaser, for a premium
payment, the right to either purchase from or sell to the writer a specified
financial instrument under agreed-upon terms. Financial options to buy or sell
securities are typically traded in standardized contracts on organized
exchanges. The Bank purchases financial options to reduce the risk of the
written financial options embedded in mortgage related assets.
CASH RESTRICTIONS - The Bank maintained $1,548,000 and $399,000 at June 30, 1996
and 1995, respectively, in U.S. Treasury Securities, which are considered cash
equivalents, as a deposit with a broker for its futures activities.
CREDIT RISK - The Bank is dedicated to managing credit risks associated with
trading activities. The Bank maintains trading positions with a variety of
counterparts or obligors (counterparts). To limit credit exposure arising from
such transactions, the Bank evaluates the credit standing of counterparts,
establishes limits for the total exposure to any one counterparty, monitors
exposure against the established limits and monitors trading portfolio
composition to manage concentrations. In addition, the Bank maintains qualifying
netting agreements with its counterparts and records gains and losses on
derivative financial instruments net in the trading portfolio.
The Bank's exposure to credit risk from derivative financial instruments is
represented by the fair value of instruments. Credit risk amounts represent the
replacement cost the Bank could incur should counterparts with contracts in a
gain position completely fail to perform under the terms of those contracts and
any collateral underlying the contracts proves to be of no value to the Bank.
Counterparts are subject to the credit approval and credit monitoring policies
and procedures of the Bank. Certain instruments require the Bank or the
counterparty to maintain collateral for all or part of the exposure. Limits for
exposure to any particular counterparty are established and monitored. Notional
or contract amounts indicate the total volume of transactions and significantly
exceed the amount of the Bank's credit or market risk associated with these
instruments.
50
The following off balance sheet positions are included in the Bank's trading
portfolio and are thus reported in the financial statements at current fair
value.
(DOLLARS IN THOUSANDS)
JUNE 30, 1996
Estimated
Contract or Fair Value Weighted Average Interest Rate
Notional ---------------------------------------------------------------------------------
Amount Asset Liability Payable Receivable Cap Floor
-------------------------------------------------------------------------------------------------
Interest rate swaps:
Pay fixed rate $ 63,500 $ 620 5.56% 5.52% NA NA
Interest rate caps 158,000 3,074 NA NA 7.46% NA
Interest rate floors 165,000 2,970 NA NA NA 6.41%
Interest rate collar 6,484 $ 8 NA NA 10.25% 5.25%
Futures 1,361,900 784 NA NA NA NA
Options 13,000 65 NA NA NA NA
------------------------------------------------------------------------------------------------
$1,767,884 $6,729 $792
------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------
(DOLLARS IN THOUSANDS)
JUNE 30, 1995
Estimated
Contract or Fair Value Weighted Average Interest Rate
Notional ---------------------------------------------------------------------------------
Amount Asset Liability Payable Receivable Cap Floor
-------------------------------------------------------------------------------------------------
Interest rate swaps:
Pay fixed rate $124,500 $ 827 $1,539 5.87% 6.10% NA NA
Pay floating rate 10,000 493 6.06% 7.23% NA NA
Interest rate caps 123,000 1,995 NA NA 7.00% NA
Interest rate floors 95,000 3,409 NA NA NA 6.55%
Interest rate collar 117,972 71 NA NA 10.25% 5.25%
Futures 455,800 3 137 NA NA NA NA
Options 51,500 200 NA NA NA NA
-------------------------------------------------------------------------------------------------
$977,772 $6,927 $1,747
-------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------
(DOLLARS IN THOUSANDS)
YEAR ENDED JUNE 30, 1996 1995
----------------------------------------------------------
Monthly Monthly
Average Average
Fair Value Fair Value
------------------------------------------------------------
Asset Liability Asset Liability
------------------------------------------------------------
Interest rate swaps:
Pay fixed rate $ 534 $1,469 $3,280 $180
Pay floating rate 59
Interest rate caps 3,228 3,779
Interest rate floors 4,370 2,467
Interest rate collar 48 49
Futures 134 8
Options 136 73
------------------------------------------------------------
$8,268 $1,651 $9,648 $247
------------------------------------------------------------
------------------------------------------------------------
51
The following table shows the various components of the Company's recorded net
gain (loss) on its trading portfolio. All realized and unrealized gains and
losses are reported as other income in the statement of income. The periodic
exchanges of interest payments and the amortization of premiums paid for
contracts are accounted for as adjustments to the yields, and are reported on
the statement of income as interest income.
(DOLLARS IN THOUSANDS)
YEAR ENDED JUNE 30, 1996
Realized Unrealized Net Trading
Gains/ Gains/ Gains/
(Losses) (Losses) (Losses)
-----------------------------------------
Interest rate contracts:
Swaps $(1,116) $839 $(277)
Caps (316) (316)
Floors (1,430) (1,430)
Collar 135 135
Futures 2,522 (650) 1,872
Options 256 76 332
------------------------------------------
Total 1,662 (1,346) 316
MBS and other trading assets 172 (614) (442)
-----------------------------------------
Total trading portfolio $1,834 $(1,960) $(126)
-----------------------------------------
-----------------------------------------
(DOLLARS IN THOUSANDS)
YEAR ENDED JUNE 30, 1995
Realized Unrealized Net Trading
Gains/ Gains/ Gains/
(Losses) (Losses) (Losses)
------------------------------------------
Interest rate contracts:
Swaps $ (651) $ (3,577) $ (4,228)
Caps (110) (1,783) (1,893)
Floors 42 2,737 2,779
Collar (14) (14)
Futures (1,854) (134) (1,988)
Options 135 (65) 70
-----------------------------------------
Total (2,438) (2,836) (5,274)
MBS and other trading assets 2,504 4,371 6,875
-----------------------------------------
Total trading portfolio $ 66 $ 1,535 $ 1,601
-----------------------------------------
-----------------------------------------
52
The following table sets forth the maturity distribution and weighted average
interest rates of financial instruments used on an aggregate basis to protect
the trading portfolio from adverse rate movements at June 30, 1996.
(DOLLARS IN THOUSANDS)
MATURITIES DURING FISCAL
YEARS ENDING JUNE 30, 1997 1998 1999 2000 2001 Thereafter
------- ------- ------ ------- ------- ----------
Interest rate swaps-Pay fixed rate
Notional amount $16,000 $26,500 $16,000 $5,000
Weighted average payable rate 5.15% 5.20% 6.27% 6.58%
Weighted average receivable rate 5.50% 5.51% 5.54% 5.54%
Interest rate caps
Notional amount 25,000 37,000 10,000 $86,000
Weighted average cap rate 5.00% 8.09% 6.50% 8.01%
Interest rate floors
Notional amount 35,000 $60,000 40,000 30,000
Weighted average floor rate 7.50% 6.42% 6.50% 5.00%
Interest rate collar
Notional amount 6,484
Weighted average cap rate 10.25%
Weighted average floor rate 5.25%
Futures
Notional amount 196,900 226,000 217,000 162,000 238,000 322,000
Options
Notional amount 13,000
The following interest rate hedges are not included in the Bank's trading
portfolio. Interest rate swaps are used to modify the interest rate sensitivity
of certain certificates of deposit issued by the Bank. These certificates of
deposit, called inverse variable rate CDs, adjust according to a formula in such
a way as to pay a higher rate of interest when the index falls, and a lower rate
of interest when the index rises. As of June 30, 1996 and 1995, the Bank held
approximately $8.4 million and $10 million of inverse variable rate CDs, with
original terms to maturity ranging from three to ten years. The Bank utilizes
interest rate swaps with the same notional amount as the inverse variable rate
CDs to convert such certificates of deposit effectively to fixed rate deposits.
A similar notional amount of interest rate swaps are then utilized to convert
such certificates from fixed rate to variable rate deposits. Consequently, the
notional amount of interest rate swaps is approximately twice that of the
inverse variable rate CDs. The swaps protect the Bank against the exposure to
falling interest rates inherent in these CDs.
The Bank also has a 7% interest rate cap which is used to effectively cap the
interest rate on the Company's floating-rate Federal Home Loan Bank advances. As
of June 30, 1996, the Bank held two advances totaling $26 million that reprice
based on the three month LIBOR quarterly. The interest rate cap has a notional
amount of $30 million and reprices based on the three month LIBOR quarterly
within a few days of the advances. The cap matures May 2001 and the advances
mature October and November 1997, however, it is the Bank's intent to replace
the advances when they mature with additional floating rate liabilities, which
will be designated against the cap.
53
The fair values of the following swaps and cap are not reflected in the
Company's financial statements. The periodic exchanges of interest payments and
the net expense of the cap are included in interest expense in the statements of
income.
(DOLLARS IN THOUSANDS)
JUNE 30, 1996
CONTRACT OR ESTIMATED FAIR VALUE WEIGHTED AVERAGE INTEREST RATE
NOTIONAL --------------------------------------------------------------------
AMOUNT ASSET LIABILITY PAYABLE RECEIVABLE
-------------------------------------------------------------------------------------
Interest rate swaps:
Pay floating rate $17,500 $110 5.57% 6.48%
Interest rate cap $30,000 $747 N/A N/A
(DOLLARS IN THOUSANDS)
JUNE 30, 1995
CONTRACT OR ESTIMATED FAIR VALUE WEIGHTED AVERAGE INTEREST RATE
NOTIONAL -------------------------------------------------------------------
AMOUNT ASSET LIABILITY PAYABLE RECEIVABLE
-------------------------------------------------------------------------------------
Interest rate swaps:
Pay floating rate $22,500 $403 6.46% 6.59%
The following table sets forth the maturity distribution and weighted average
interest rates of the interest rate swaps used to protect the inverse variable
rate CDs from adverse rate movements and the interest rate cap used to cap the
Federal Home Loan Bank advances at 7% as of June 30, 1996:
(DOLLARS IN THOUSANDS)
MATURITIES DURING FISCAL
YEARS ENDING JUNE 30, 1997 1998 1999 2000 2001 THEREAFTER
-------- ------ ------ ------- -------- ------------
Interest rate swaps-Pay floating rate
Notional amount $10,000 $7,500
Weighted average payable rate 5.53% 5.63%
Weighted average receivable rate 6.12% 6.96%
Interest rate cap
Notional amount $30,000
Weighted average cap rate 7.0%
14. CREDIT COMMITMENTS
The Bank is a party to commitments to extend credit as part of its normal
business operations to meet the financing needs of its customers. These
commitments involve, to varying degrees, elements of credit and interest rate
risk in excess of the amount recognized in the balance sheet. Exposure to credit
loss in the event of nonperformance by the other party to the financial
instrument for commitments to extend credit is represented by the contract
amount of those instruments. The Bank uses the same credit policies in making
commitments as it does for on-balance-sheet instruments. Unless noted otherwise,
the Bank does not require collateral or other security to support financial
instruments with credit risk.
Real estate loan commitments whose contract amounts represent credit risk were
approximately $1,041,000 and $5,071,000 at June 30, 1996 and 1995, respectively.
54
15. RELATED PARTY TRANSACTIONS
The Company has contracted with Smith Breeden Associates Inc. ("SBA") to provide
investment advisory services and interest rate risk analysis. Certain
stockholders of HFG are also principals of SBA. The amount of consulting expense
relating to SBA for fiscal years ending June 30, 1996, 1995 and 1994 was
$232,000, $194,000 and $183,000, respectively.
16. STOCKHOLDERS' EQUITY AND REGULATORY MATTERS
EQUITY OFFERING - Under the terms of an offering memorandum the Company offered
up to 555,556 shares of stock to certain stockholders, directors and officers of
the Company and the Bank during fiscal 1995. The shares of common stock were
offered at $4.50 per share beginning on November 1, 1994; however, the purchase
price increased each day thereafter at a rate of prime plus 2% until the closing
of the equity offering on January 31, 1995.
LIQUIDATION ACCOUNT - On July 10, 1985, the Bank converted from a federally
chartered mutual association to a federally chartered stock association through
the issuance of 463,173 shares of common stock ($1 par value) at a price of $8
per share. From the proceeds, $463,000 was allocated to capital stock at the par
value of $1 per share and $2,919,000, which is net of conversion costs of
$324,000, was allocated to additional paid-in-capital.
The Bank established a special liquidation account (in memorandum form) in an
amount equal to its total retained earnings as of June 1, 1984 for the purpose
of granting to eligible savings account holders a priority in the event of
future liquidation. In the event of future liquidation of the converted
institution (and only in such event), an eligible account holder who continues
to maintain his savings account shall be entitled to receive a distribution from
the liquidation account. The total amount of the liquidation account will be
decreased in an amount proportionately corresponding to decreases in the savings
accounts of eligible account holders on each subsequent annual determination
date.
DIVIDEND RESTRICTIONS - Regulations provide that the Bank may not declare or pay
a cash dividend on or repurchase any of its stock if the result thereof would be
to reduce the consolidated stockholders' equity of the Bank below the amount
required for the liquidation account (as defined by regulations). Under the
capital distribution regulations of the OTS, the Bank, as a "Tier 1"
institution, is permitted to make capital distributions during a calendar year
up to one hundred percent of its net income to date during the calendar year
plus the amount that would reduce by one-half its surplus capital ratio, as
defined, at the beginning of the calendar year. Under this limitation,
$5,739,000 was available for dividends at June 30, 1996.
Recapitalization of SAIF and Related Legislative Proposals - The deposits of the
Company are currently insured by the Savings Association Insurance Fund ("SAIF")
of the FDIC. Both the SAIF and the Bank Insurance Fund ("BIF"), the federal
deposit insurance fund that covers commercial bank deposits, are required by law
to attain and thereafter maintain a reserve ratio of 1.25% of insured deposits.
The BIF has achieved a fully funded status in contrast to the SAIF and,
therefore, as discussed below, the FDIC has substantially reduced the average
deposit insurance premium paid by commercial banks to a level approximately 75%
below the average premium paid by savings institutions.
On November 14, 1995, the FDIC approved a final rule regarding deposit insurance
premiums. The final rule will reduce deposit insurance premiums for BIF member
institutions to zero basis points (subject to a $2,000 minimum) for institutions
in the lowest risk category, while holding deposit insurance premiums for SAIF
members at their current levels (23 basis points for institutions in the lowest
risk category). The reduction was effective with respect to the semiannual
premium assessment beginning January 1, 1996. Accordingly, in the absence of
further legislative action, SAIF members such as the Bank will be competitively
disadvantaged as
55
compared to commercial banks by the resulting premium differential.
The U.S. House of Representatives and Senate have actively considered
legislation which would eliminate the premium differential between SAIF-member
institutions provided that all SAIF-member institutions pay a special one-time
assessment to recapitalize the SAIF, which in the aggregate would have been
sufficient to bring the reserve ratio in the SAIF to 1.25% of insured deposits.
Based on the current level of reserves maintained by the SAIF it was anticipated
that the amount of the special assessment required to recapitalize the SAIF
would have been approximately 80 to 85 basis points of the SAIF-assessable
deposits. It was anticipated that after the recapitalization of the SAIF,
premiums paid by SAIF-insured institutions would be reduced to match those
currently being assessed BIF-insured commercial banks. The legislation also
provided for the merger of the BIF and the SAIF, with such merger being
conditioned upon the prior elimination of the thrift charter.
The legislation discussed above had been, for some time, included as part of a
fiscal 1996 federal budget bill, but was eliminated prior to the bill being
enacted on April 26, 1996. If legislation were to be enacted in the future which
would assess a one-time special assessment of 85 basis points, the Bank would
(based upon the Bank's SAIF deposits as of March 31, 1995) pay approximately
$700,000, net of related tax benefits. In addition, the enactment of such
legislation may have the effect of immediately reducing the capital of SAIF-
member institutions by the amount of the special assessment. Nevertheless,
management does not believe that this one-time charge to the Bank, if incurred,
will have a material adverse effect on the Company's consolidated financial
condition.
In light of the different proposals currently under consideration and the
uncertainty of the legislative process generally, management cannot predict
whether legislation reducing SAIF premiums and/or imposing a special one-time
assessment will be adopted, or, if adopted, the amount of the assessment, if
any, that would be imposed on the Company.
56
17. FAIR VALUES OF FINANCIAL INSTRUMENTS
The following disclosure of the estimated fair value of financial instruments is
made in accordance with the requirements of SFAS No. 107, DISCLOSURES ABOUT FAIR
VALUE OF FINANCIAL INSTRUMENTS:
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
--------------------------------------------------------
CARRYING FAIR CARRYING FAIR
VALUE VALUE VALUE VALUE
-------------------------------------------------------
Assets:
Cash $ 1,036 $ 1,036 $ 773 $ 773
Interest-bearing deposits 16,107 16,107 4,932 4,932
Securities held for trading 324,221 324,221 246,733 246,733
Securities available for sale 2,050 2,050 2,541 2,541
Loans receivable, net 65,925 65,900 37,010 38,443
Interest receivable 1,807 1,807 1,353 1,353
Federal Home Loan Bank stock 2,645 2,645 2,500 2,500
Liabilities:
Deposits 135,143 134,951 115,312 116,415
Securities sold under agreements
to repurchase 219,067 218,967 130,217 130,235
Federal Home Loan Bank advances 26,000 26,000 31,000 31,000
Interest payable 1,970 1,970 1,692 1,692
Note payable 8,998 8,998 9,200 9,200
Advance payments by borrowers for
taxes and insurance 392 392 264 264
Off Balance Sheet Hedging
Instruments:
Interest rate swaps 110 403
Interest rate cap 863 747
The estimated fair value amounts are determined by the Company, using available
market information and appropriate valuation methodologies. However,
considerable judgment is required in interpreting market data to develop the
estimates of fair value. Accordingly, the estimates presented herein are not
necessarily indicative of the amounts the Company could realize in a current
market exchange. The use of different market assumptions and/or estimation
methodologies may have a material effect on the estimated fair value amounts.
CASH, INTEREST-BEARING DEPOSITS, INTEREST RECEIVABLE AND PAYABLE, ADVANCE
PAYMENTS BY BORROWERS FOR TAXES AND INSURANCE AND NOTE PAYABLE - The carrying
amounts of these items are a reasonable estimate of their fair value.
LOANS RECEIVABLE - The fair value of loans receivable is estimated by
discounting future cash flows at market interest rates for loans of similar
terms and maturities, taking into consideration repricing characteristics and
prepayment risk.
Securities held for trading consist of mortgage-backed securities,
collateralized mortgage obligations, residuals, interest-only strips, a
principal-only strip, interest rate swaps, an interest rate collar, interest
rate caps, interest rate floors, options, futures and equity securities.
57
Fair values are based on quoted market prices or dealer quotes. Where such
quotes are not available, fair value is estimated by using quoted market prices
for similar securities or by discounting future cash flows at a risk adjusted
spread to Treasury.
Securities available for sale consist of municipal bonds and a non-agency
participation certificate. Fair values for the municipal bonds are based on
quoted market prices. The non-agency participation certificate fair value is
based on projected future cash flows using a published analysis of the
underlying credit risks.
FEDERAL HOME LOAN BANK STOCK - The fair value is estimated to be the carrying
value which is par. All transactions in the capital stock of the Federal Home
Loan Bank of Indianapolis are executed at par.
DEPOSITS - The fair value of deposits is calculated by discounting the future
cash flows at a market interest rate.
SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE - Fair values are based on the
discounted value of contractual cash flows using dealer quoted rates for
agreements of similar terms and maturities.
FEDERAL HOME LOAN BANK ADVANCES - The fair value is estimated by discounting
future cash flows using rates currently available to the bank for advances of
similar maturities.
Off balance sheet hedging instruments consist of interest rate swaps and an
interest rate cap used to modify the interest rate sensitivity of certain
certificates of deposits and Federal Home Loan Bank advances, respectively. Fair
values are based on quoted market prices or dealer quotes. Where such quotes are
not available, fair value is estimated by using quoted market prices for similar
securities or by discounting future cash flows at a risk adjusted spread to
Treasury.
COMMITMENTS - The estimated fair value of commitments to originate fixed-rate
loans is determined based on the fees currently charged to enter into similar
agreements and the difference between current levels of interest rates and the
committed rates. Based on that analysis, the estimated fair value of such
commitments is a reasonable estimate of the loan commitments at par.
The fair value estimates presented herein are based on information available to
management as of June 30, 1996 and 1995. Although management is not aware of any
factors that would significantly affect the estimated fair value amounts, such
amounts have not been comprehensively revalued for purposes of these
consolidated financial statements since that date, and therefore, current
estimates of fair value may differ significantly from the amounts presented
herein.
58
18. HARRINGTON FINANCIAL GROUP, INC.
FINANCIAL INFORMATION (PARENT COMPANY ONLY)
The following condensed balance sheets as of June 30, 1996 and 1995, and
condensed statements of income and cash flows for the three years in the period
ended June 30, 1996 for Harrington Financial Group, Inc. should be read in
conjunction with the consolidated financial statements and notes thereto.
CONDENSED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
--------------------------
Cash and cash equivalents $ 5,271 $ 434
Securities held for trading 550 249
Other assets 82 90
Intercompany receivable 70
Investment in subsidiary 26,039 18,376
-------------------------
Total assets $32,012 $19,149
-------------------------
-------------------------
Note payable $ 8,998 $ 9,200
Deferred income taxes, net 10 (5)
Accrued income taxes (210) (421)
Accrued expenses payable
and other liabilities 97 14
-------------------------
Total liabilities 8,895 8,788
-------------------------
Common stock 407 245
Additional paid-in capital 15,623 4,183
Unrealized gain (loss)
on securities available
for sale (8) 61
Retained earnings 7,095 5,872
-------------------------
Total stockholders' equity 23,117 10,361
-------------------------
Total liabilities and
stockholders' equity $32,012 $19,149
-------------------------
-------------------------
CONDENSED STATEMENTS OF INCOME
(DOLLARS IN THOUSANDS)
YEARS ENDED
JUNE 30, 1996 1995 1994
-----------------------------------
Dividends from subsidiary $ 855 $1,455
Interest income from securities
held for trading 8 $ 18 17
Interest on deposits 12 12 6
Gain on sale of securities
held for trading 42 24
Unrealized gain on securities
held for trading 28 26
-----------------------------------
Total income 945 80 1,478
-----------------------------------
Interest expense on
long-term borrowings 905 749 577
Salaries and employee benefits 98 29
Other expenses 19 48 3
------------------------------------
Total expenses 1,022 826 580
------------------------------------
Income (loss) before equity in
undistributed earnings (77) (746) 898
Income tax benefit (359) (296) (195)
Equity in undistributed earnings
of subsidiary 941 2,303 (166)
------------------------------------
Net income $1,223 $1,853 $ 927
------------------------------------
------------------------------------
59
CONDENSED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
YEARS ENDED JUNE 30, 1996 1995 1994
-------------------------------------
Cash flows from operating activities:
Net income $1,223 $1,853 $927
Adjustments to reconcile net income to net
cash provided by (used in) operating activities:
Decrease (increase) in other assets 8 23 27
Increase in intercompany receivable (70)
Increase (decrease) in accrued expenses
and other liabilities 83 14 (42)
Gain on sale of securities held for trading (42) (24)
Unrealized gain on securities held for trading (28) (26)
Purchases of securities held for trading (545) (880)
Proceeds from sales of securities held for trading 314 1,081
Deferred income tax provision 16 (4) 29
Increase (decrease) in accrued income taxes 211 (189) (36)
Increase in undistributed earnings of subsidiary (941) (2,303) 166
--------------------------------------
Net cash provided by (used in)
operating activities 229 (455) 1,071
---------------------------------------
Cash flows from investing activities:
Capital contributions to subsidiary (6,792) (3,250) (1,000)
Purchase of securities available for sale (401)
Proceeds from sales of securities available for sale 219
---------------------------------------
Net cash used in investing activities (6,792) (3,250) (1,182)
---------------------------------------
Cash flows from financing activities:
Proceeds from issuance of common stock under
equity offering 2,421
Proceeds from issuance of common stock
under initial public offering 11,437
Proceeds from stock options exercised 165 101
Proceeds from note payable 800 1,900 8,000
Principal repayments on note payable (1,002) (600) (7,631)
---------------------------------------
Net cash provided by financing activities 11,400 3,822 369
---------------------------------------
Net increase in cash and equivalents 4,837 117 258
Cash and cash equivalents
beginning of year 434 317 59
---------------------------------------
Cash and cash equivalents
end of year $5,271 $434 $317
---------------------------------------
---------------------------------------
60
TO THE BOARD OF DIRECTORS AND STOCKHOLDERS OF HARRINGTON FINANCIAL GROUP, INC.:
We have audited the accompanying consolidated balance sheets of Harrington
Financial Group, Inc. and its subsidiary (the "Company") as of June 30, 1996 and
1995, and the related consolidated statements of income, changes in
stockholders' equity and cash flows for the years then ended. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits. The financial statements of Harrington Financial Group, Inc. and its
subsidiary for the year ended June 30, 1994 were audited by other auditors whose
report, dated August 9, 1994, on those statements included an explanatory
paragraph concerning a change in accounting for income taxes discussed in Note 1
to the financial statements.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such 1996 and 1995 consolidated financial statements present
fairly, in all material respects, the financial position of Harrington Financial
Group, Inc. and its subsidiary as of June 30, 1996 and 1995, and the results of
their operations and their cash flows for the years then ended, in conformity
with generally accepted accounting principles.
/s/ DELOITTE & TOUCHE LLP
DELOITTE & TOUCHE LLP
Indianapolis, Indiana
August 12, 1996
61