Exhibit 13
1998 Annual Report to Stockholders
FINANCIAL HIGHLIGHTS
(Dollars in thousands except per share amounts)
For the Years Ended June 30, 1998 1997
- ------------------------------------------------------------------------------------------------------
Net interest income ............................................. $ 4,924 $ 8,066
Income (loss) before tax provision and gain (loss) on securities (1,388) 2,769
Net realized and unrealized gain (loss) on securities ........... (1,705) 494
Special SAIF assessment ......................................... 830
Net income (loss) ............................................... (1,859) 2,002
Return on average assets before special SAIF assessment ...... (0.34%) 0.50%
Return on average assets after special SAIF assessment .......... (0.34%) 0.39%
Return on average equity before special SAIF assessment ......... (7.56%) 10.52%
Return on average equity after special SAIF assessment .......... (7.56%) 8.34%
At June 30
Total assets .................................................... $ 484,397 $ 446,797
Total loans ..................................................... 163,546 93,958
Total securities ................................................ 291,531 318,480
Total deposits .................................................. 178,311 136,175
Stockholders' equity ............................................ 22,664 24,994
Common shares outstanding ....................................... 3,275,886 3,256,738
Average Balances
Assets .......................................................... $ 538,981 $ 507,407
Loans ........................................................... 116,982 78,545
Core retail deposits ............................................ 136,594 116,210
Other deposits .................................................. 15,168 20,592
Total deposits .................................................. 151,762 136,802
Per Share
Basic earnings (loss) per share ................................. $ (0.57) $ 0.61
Diluted earnings (loss) per share ............................... (0.57) 0.61
After tax basic earnings (loss) excluding special SAIF assessment (0.57) 0.78
Book value, fiscal year end Market price, fiscal year end ....... 6.92 7.67
11.250 12.125
Asset Quality at June 30
Non-performing assets to total assets ........................ 0.18% 0.25%
Loan loss reserves to non-performing loans ..................... 126.32% 63.39%
Capital Ratios at June 30 (Harrington Bank)
Tangible capital ................................................ 6.88% 6.96%
Core capital .................................................... 6.88% 6.96%
Risk-based capital .............................................. 21.92% 31.14%
Financial Review
- ----------------
14 Selected Consolidated Financial Data
15 Management's Discussion and Analysis
of Financial Condition and Results of Operations
29 Consolidated Balance Sheets
30 Consolidated Statements of Operations
31 Consolidated Statements of Changes in
Stockholders' Equity
32 Consolidated Statements of Cash Flows
34 Notes to Consolidated Financial Statements
56 Independent Auditors' Report
Selected Consolidated Financial Data
The following table presents selected consolidated financial and other data of
the Company for the five years in the period ended June 30, 1998. 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 Years Ended June 30, 1998 1997 1996 1995 1994
--------- --------- --------- --------- ---------
Balance Sheet Data
Securities held for trading and available for sale ......... $ 291,531 $ 318,480 $ 321,897 $ 249,274 $ 174,347
Loans receivable-net ....................................... 163,546 93,958 65,925 37,010 20,682
Total assets ............................................... 484,397 446,797 418,196 300,174 211,688
Deposits ................................................... 178,311 136,175 135,143 115,312 108,300
Securities sold under agreements to repurchase ............. 240,396 245,571 219,067 130,217 54,651
Federal Home Loan Bank advances ............................ 26,000 26,000 26,000 31,000 31,000
Note payable ............................................... 13,495 9,995 8,998 9,200 7,880
Stockholders' equity ....................................... 22,664 24,994 23,117 10,361 5,926
Stockholders' equity per share ............................. 6.92 7.67 7.10 5.28 4.20
Income Statement Data
Interest income ............................................ $ 33,956 $ 34,474 $ 23,484 $ 17,560 $ 13,607
Interest expense ........................................... 29,032 26,408 18,004 12,779 8,284
--------- --------- --------- --------- ---------
Net interest income ...................................... 4,924 8,066 5,480 4,781 5,323
Provision for loan losses .................................. 147 92 (1) 15 (3)
--------- --------- --------- --------- ---------
Net interest income after provision for loan losses ........ 4,777 7,974 5,481 4,766 5,326
Retail banking fees and other income ....................... 295 239 256 238 267
--------- --------- --------- --------- ---------
Total net revenue .......................................... 5,072 8,213 5,737 5,004 5,593
Operating expenses ......................................... 6,460 5,444 3,740 3,167 2,519
--------- --------- --------- --------- ---------
Income before tax provision and gain (loss) on securities .. (1,388) 2,769 1,997 1,837 3,074
Gain (loss) on sale of securities held for trading ......... (775) (1,623) 1,834 66 (2,169)
Gain on sale of securities available for sale .............. 392
Unrealized gain (loss) on securities held for trading ...... (930) 2,117 (1,960) 1,535 710
Permanent impairment of securities available for sale ...... (414) (610)
--------- --------- --------- --------- ---------
Net gain (loss) on securities ............................ (1,705) 494 (126) 1,187 (1,677)
--------- --------- --------- --------- ---------
Income before income tax provision and cumulative effect
of change in accounting for deferred income taxes ........ (3,093) 3,263 1,871 3,024 1,397
Income tax provision ....................................... (1,234) 1,261 648 1,171 391
Income (loss) before cumulative effect of change in
accounting for deferred income taxes ..................... (1,859) 2,002 1,223 1,853 1,006
--------- --------- --------- --------- ---------
Cumulative effect of change in accounting for deferred
income taxes (2) ......................................... (79)
Net income (loss) .......................................... $ (1,859) $ 2,002 $ 1,223 $ 1,853 $ 927
--------- --------- --------- --------- ---------
Basic earnings (loss) per share ............................ $ (0.57) $ 0.61 $ 0.57 $ 1.20 $ 0.66
--------- --------- --------- --------- ---------
Diluted earnings (loss) per share .......................... $ (0.57) $ 0.61 $ 0.56 $ 1.20 $ 0.66
--------- --------- --------- --------- ---------
Cash dividends per share ................................... $ 0.12 $ 0.03 N/A N/A N/A
--------- --------- --------- --------- ---------
Performance Ratios
Return on average assets (3) ............................... (0.34%) 0.50% 0.37% 0.76% 0.44%
Return on average equity (3) ............................... (7.56) 10.52 9.49 22.24 14.98
Interest rate spread ....................................... 0.79 1.43 1.64 2.13 2.63
Net interest margin ........................................ 0.94 1.62 1.73 2.10 2.64
Average interest-earning assets to average interest
bearing liabilities ...................................... 102.73 103.67 101.55 99.57 100.25
Net interest income after provision for loan losses to total
other expenses (3) ....................................... 73.95 172.82 146.55 150.49 211.43
Total other expenses to average total assets (3) ........... 1.20 0.91 1.13 1.30 1.19
Full service offices ....................................... 7 4 3 2 2
Asset Quality Ratios (at end of period)
Non-performing loans to total loans (4) .................... 0.17 0.36 0.40 0.95 2.70
Non-performing assets to total assets (4) .................. 0.18 0.25 0.32 0.59 1.34
Allowance for loan losses to total loans ................... 0.22 0.23 0.18 0.33 0.51
Allowance for loan losses to total non-performing loans .... 126.32 63.39 45.98 34.57 18.96
Capital Ratios (5)
Tangible capital ratio ..................................... 6.88 6.96 6.27 6.12 6.07
Core capital ratio ......................................... 6.88 6.96 6.27 6.12 6.07
Risk-based capital ratio ................................... 21.92 31.14 30.10 24.62 21.40
Equity to assets at end of period .......................... 4.68 5.59 5.53 3.45 2.80
(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) Reflects the Company's adoption of Statement of Financial Accounting
Standards ("SFAS") No. 109, "Accounting for Income Taxes," effective July
1, 1993.
(3) For comparability purposes, the 1997 fiscal year ratios exclude the effect
of the special SAIF assessment of $830,000.
(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 (1) expanding its banking locations and product offerings in order
to build a strong community banking franchise through de novo branching and the
pursuit of acquisition opportunities; (2) controlling interest rate risk by
matching the interest rate sensitivity of its assets to that of its liabilities;
(3) controlling credit risk by maintaining a substantial portion of the
Company's assets in mortgage-backed securities and single-family residential
loans and by applying conservative underwriting standards and credit risk
monitoring; and (4) utilizing excess capital balances through the management of
a hedged investment portfolio.
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 Indiana and the Kansas City
metropolitan area. While Harrington has greatly expanded its portfolio of
originated mortgage loans, approximately 60% of its assets currently consist of
purchased mortgage-backed and related securities that are hedged to reduce
interest rate risk. 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. The funds invested
in the securities portfolio can be quickly redeployed to pursue retail expansion
opportunities as they arise. Furthermore, in March 1998, the Company commenced
the origination of commercial mortgage and commercial and industrial loans
through a newly developed commercial loan division. This activity provides
further diversification of business lines and fulfills a critical component of
the Company's community banking strategy.
Harrington's funding strategy focuses on accessing cost-efficient funding
sources, including securities sold under agreements to repurchase, retail and
non-retail deposits and Federal Home Loan Bank ("FHLB") advances. The Company
continues to build a community-oriented banking operation in order to sustain
loan originations and deposit growth, benefit from economies of scale, 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 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.
"Safe Harbor" Statement under the Private Securities Litigation Reform Act of
1995
In addition to historical information, forward-looking statements contained in
this annual report are subject to risks and uncertainties that could cause
actual results to differ materially from those reflected in the forward-looking
statements. Factors that could cause future results to vary from current
expectations include, but are not limited to, the impact of economic conditions
(both generally and more specifically in the markets in which Harrington
operates), the impact of competition for Harrington's customers from other
providers of financial services, the impact of government legislation and
regulation (which changes from time to time and over which Harrington has no
control), and other risks detailed in the Annual Report and in Harrington's
other Securities and Exchange Commission ("SEC") filings. Readers are cautioned
not to place undue reliance on these forward-looking statements, which reflect
management's analysis only as of the date hereof. Harrington undertakes no
obligation to publicly revise these forward-looking statements to reflect events
or circumstances that arise after the date hereof. Readers should carefully
review the risk factors described in other documents Harrington files from time
to time with the SEC, including the Quarterly Reports on Form 10-Q to be filed
by Harrington in 1998 and 1999 and any Current Reports on Form 8-K filed by
Harrington.
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 the cashflows from 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 MVPE in times of declining interest rates,
such an asset/liability mismatch is generally detrimental during periods of
rising interest rates.
The Company's management 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 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,
investment opportunities and the performance of the investment portfolios, and
the past month's purchase and sale activity of securities. The Committee also
provides guidance to management on reducing interest rate risk and on investment
strategy and 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, Smith Breeden's mutual funds, and
government agencies nationally. Certain directors of the Company and the Bank
are principals 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 MVPE. 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.
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 and
origination of 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
16
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 or less sensitive non-defined maturity
(transaction) 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 necessarily
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 could 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 or money center bank) 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, 1998, Harrington was a party to four interest rate swap agreements
held in its trading portfolio. The agreements had an aggregate notional amount
of $121.0 million and maturities from January 1999 to April 2001. With respect
to these agreements, Harrington makes fixed interest payments ranging from 6.12%
to 6.58% and receives payments based upon the three-month London Interbank
Offered Rate ("LIBOR").
The net expense (income) relating to Harrington's interest rate swaps held in
the trading portfolio was $313,000, $330,000 and $(168,000) during the years
ended June 30, 1998, 1997 and 1996, respectively. The approximate market value
of the interest rate swaps which are maintained in the trading portfolio was
$(397,000) and $581,000 as of June 30, 1998 and 1997, respectively.
The Company also has one swap whereby it pays a floating rate (based on
three-month LIBOR) and receives a fixed rate of 6.96%. Harrington's floating-pay
swap, which has a notional amount of $7.5 million, is not included in the
Company's trading portfolio. This swap is used to modify the interest rate
sensitivity of certain certificates of deposit issued by the Bank.
The net income relating to Harrington's floating-pay swap was $70,000, $130,000
and $129,000 during the years ended June 30, 1998, 1997 and 1996, 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 swap (which is not reflected in the Company's financial
statements) was $137,000 and $91,000 as of June 30, 1998 and 1997, 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, 1998, Harrington held seven interest rate cap agreements, twelve
interest rate floor agreements and one interest rate collar in its trading
portfolio. These contracts, which expire from October 1998 to June 2004, have an
aggregate notional amount of approximately $391.1 million. The interest rate cap
agreements provide for a payment, depending on the particular contract, whenever
the defined floating rate exceeds 6.50% to 9.00%. The interest rate floor
agreements provide for a payment, depending on the particular contract, whenever
the defined floating rate is less than 5.00% to 7.00%. The interest rate collar
provides for a payment whenever the defined floating rate is greater than 10.25%
or less than 5.25%.
17
The aggregate net expense (income) relating to the Company's interest rate caps,
collars and floors held in the trading portfolio was $223,000, $(370,000) and
$(220,000) during the years ended June 30, 1998, 1997 and 1996, respectively.
The approximate market value of Harrington's interest rate caps, collars and
floors which are maintained in the trading portfolio was $4.6 million and $5.1
million as of June 30, 1998 and 1997, respectively.
Harrington also has four interest rate caps with aggregate notional amounts of
$90.0 million which are not held in the Company's trading portfolio. These caps,
which mature from May 2001 to May 2008, provide for a payment, depending on the
particular contract, whenever the defined floating rate exceeds 6.00% to 7.00%.
The instruments are used to effectively cap the interest rate on a portion of
the Company's securities sold under agreements to repurchase and the Company's
floating-rate borrowing from the FHLB. Net expense on the caps was $257,000,
$178,000 and $25,000 for the years ended June 30, 1998, 1997 and 1996,
respectively. The approximate market value of the caps, which is not reflected
in the Company's financial statements, was $2.5 million and $351,000 at June 30,
1998 and 1997, respectively.
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 are 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 and Bond 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, 1998, Harrington had sold Eurodollar and
Treasury Note futures contracts with an aggregate notional amount of
approximately $2.8 billion. The Company had total gains (losses) on its futures
contracts of $(8.6) million, $(3.9) million and $1.9 million for the fiscal
years ended June 30, 1998, 1997 and 1996, 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, 1998, Harrington had 660 purchased
options contracts with an aggregate notional amount of approximately $66.0
million. The net expense relating to the Company's options contracts was
$943,000, $770,000 and $640,000 during the years ended June 30, 1998, 1997 and
1996, respectively. The approximate market value of the Company's options
contracts which are maintained in the trading portfolio was $50,000 and $24,000
as of June 30, 1998 and 1997, 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)
Years Ended June 30, 1998 1997 1996
------ ------ ------
Interest rate contract
(income) expense:
Swaps ........................... $ 313 $ 330 $ (168)
Caps, floors, and collars ....... 223 (370) (220)
Options ......................... 943 770 640
------ ------ ------
Net interest expense on
interest rate contracts ........ $1,479 $ 730 $ 252
====== ====== ======
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 Operations.
Harrington is subject to the risk that its counter-parties with respect to
various interest rate contracts (such as swaps, collar, 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.
18
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. The Company retains Smith Breeden to assist in
performing the required calculation of the sensitivity of its market value to
changes in interest rates.
In estimating the market value of mortgage loans and mortgage-backed securities,
the Company utilizes various prepayment assumptions which vary, in accordance
with historical experience, based upon the term, interest rate and other factors
with respect to the underlying loans. At June 30, 1998, these prepayment
assumptions varied from 5% to 36% for fixed-rate mortgages and mortgage-backed
securities and varied from 14% to 31% for adjustable rate mortgages and
mortgage-backed securities.
The following table sets forth at June 30, 1998 the estimated sensitivity of the
Bank's MVPE to parallel yield curve shifts using Harrington's internal market
value calculation. The table demonstrates the sensitivity of the Bank's assets
and liabilities both before and after the inclusion of its interest rate
contracts.
The table set forth below 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 (1) to the extent the affected instruments are marked to market, and (2)
over the life of the instruments as an impact on recorded yields.
(Dollars in thousands)
Change in
Interest Rates (In Basis Points)(1) .... -400 -300 -200 -100 -- +100 +200
Market value gain (loss) of assets ..... $ 34,498 $ 25,182 $ 17,057 $ 10,498 -- $(17,232) $(38,546)
Market value gain (loss) of liabilities (4,698) (3,576) (2,451) (1,279) -- 1,436 3,064
-------- -------- -------- -------- ---- -------- --------
Market value gain (loss) of net
assets before interest rate contracts 29,800 21,606 14,606 9,219 -- (15,796) (35,482)
Market value gain (loss)
of interest rate contracts ......... (22,328) (18,097) (13,535) (8,070) -- 12,845 30,307
-------- -------- -------- -------- ---- -------- --------
Total change in MVPE(2) ................ $ 7,472 $ 3,509 $ 1,071 $ 1,149 -- $ (2,951) $ (5,175)
-------- -------- -------- -------- ---- -------- --------
Change in MVPE as a percent of:
MVPE(2) ............................. 21.2% 9.9% 3.0% 3.3% -- (8.4)% (14.7)%
Total assets of the Bank ............ 1.5% 0.7% 0.2% 0.2% -- (0.6)% (1.1)%
Change in
Interest Rates (In Basis Points)(1) .... +300 +400
Market value gain (loss) of assets ..... $(61,294) $(83,934)
Market value gain (loss) of liabilities 4,825 6,624
Market value gain (loss) of net
assets before interest rate contracts (56,469) (77,310)
Market value gain (loss)
of interest rate contracts ......... 49,820 69,985
Total change in MVPE(2) ................ $ (6,649) $ (7,325)
Change in MVPE as a percent of:
MVPE(2) ............................. (18.8)% (20.8)%
Total assets of the Bank ............ (1.4)% (1.5)%
(1) Assumes an instantaneous parallel change in interest rates at all
maturities.
(2) Based on the Bank's pre-tax MVPE of $35.3 million at June 30, 1998.
19
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 instantaneous, parallel shifts in the yield curve, and constant option
adjusted spreads on assets and liabilities. 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 39.0%.
(Dollars in thousands)
Change in
Interest Rates (In Basis Points) -400 -300 -200 -100 -- +100 +200
- ------------------------------------------------------------------------------------------------------------------------------------
After tax market value gain (loss) of assets $ 16,770 $ 12,180 $ 8,161 $ 4,788 -- $ (7,051) $(15,600)
After tax market value gain (loss) of interest (12,283) (9,681) (6,998) (4,050) -- 6,287 14,889
rate contacts --------- --------- --------- --------- -------- --------
After tax gain (loss) in equity $ 4,487 $ 2,499 $ 1,163 $ 738 -- $ (764) $ (711)
--------- --------- --------- --------- -------- --------
After tax gain (loss) in equity as a percent of
the Company's equity at June 30, 1998 19.8% 11.0% 5.1% 3.3% -- (3.4)% (3.1)%
Change in
Interest Rates (In Basis Points) +300 +400
- ---------------------------------------------------------------------------
After tax market value gain (loss) of assets $ (24,792) $ (34,012)
After tax market value gain (loss) of interest 24,588 34,729
rate contacts --------- ---------
After tax gain (loss) in equity $ (204) $ 717
--------- ---------
After tax gain (loss) in equity as a percent of
the Company's equity at June 30, 1998 (0.9)% 3.2%
Changes in Financial Condition
General. At June 30, 1998, Harrington's total assets amounted to $484.4 million,
as compared to $446.8 million at June 30, 1997. The increase in total assets was
primarily due to a $70.0 million increase in the Bank's loan portfolio which was
partially offset by a $38.3 million decrease in the securities portfolio and due
from broker account.
Cash and Interest-Bearing Deposits. Cash and interest-bearing deposits amounted
to $11.8 million and $9.5 million at June 30, 1998 and 1997, 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 in 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, to enhance balance sheet liquidity, and to
utilize excess capital balances, Harrington maintains a substantial portion of
its assets in a hedged mortgage-backed and related securities portfolio, the
securities of 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 $290.6 million and $317.4 million at June 30, 1998 and
1997, respectively. Securities classified as available for sale (consisting of a
non-agency mortgage-backed security and municipal bonds) declined from $1.1
million at June 30, 1997 to $922,000 at June 30, 1998.
Loans Receivable. At June 30, 1998, loans receivable (net of the Company's
allowance for loan losses) amounted to $163.5 million, an increase of 74.1% over
the June 30, 1997 total of $94.0 million. Harrington has significantly increased
its community banking operations, particularly the origination (both directly
and through correspondent mortgage banking companies) of single-family
residential loans. Loans originated through correspondents must meet the same
pricing and underwriting standards as loans originated internally.
Allowance for Loan Losses. At June 30, 1998, Harrington's allowance for loan
losses totaled $360,000, compared to $213,000 at June 30, 1997. At June 30,
1998, the Company's allowance represented approximately 0.2% of the total loan
portfolio and 126.3% of total non-performing loans, as compared to 0.2% and
63.4% at June 30, 1997. The ratio of total non-performing loans to total loans
amounted to 0.2% at June 30, 1998 compared to 0.4% at June 30, 1997, which
reflects Harrington's emphasis on maintaining low credit risk with respect to
its operations.
20
Although Harrington management believes that its allowance for loan losses at
June 30, 1998 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, 1998, deposits totaled $178.3 million, as compared to
$136.2 million as of June 30, 1997. Retail deposits increased $43.3 million,
from $123.5 million at June 30, 1997 to $166.8 million at June 30, 1998,
primarily due to Harrington's strategy of rapidly building a community banking
franchise. Non-retail deposits declined by $1.2 million during the same period,
for a total increase in deposits of $42.1 million.
Borrowings. At June 30, 1998, reverse repurchase agreements and dollar rolls
(both of which are securities sold under agreements to repurchase and are
accounted for as a financing) totaled $240.4 million, as compared to $245.6
million as of June 30, 1997.
Advances from the FHLB of Indianapolis remained stable at $26.0 million as of
June 30, 1998 and 1997. At June 30, 1998, the FHLB advance was scheduled to
mature in fiscal 1999, with an average interest rate thereon of 5.6%, as
compared to 5.8% at June 30, 1997.
The Company's note payable amounted to $13.5 million and $10.0 million at June
30, 1998 and 1997, 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.
Stockholders' Equity. Stockholders' equity decreased from $25.0 million at June
30, 1997 to $22.7 million at June 30, 1998. This decrease was due primarily to
the $1.9 million of net loss recognized during fiscal 1998, the purchase of
treasury stock amounting to $1.5 million and the payment of the Company's
quarterly dividends of $.03 per share, or $395,000 in total. This decrease was
partially offset by the $1.1 million raised in connection with the exercise of
existing stock options during fiscal 1998 and the $283,000 tax benefit from the
exercise of non-qualified stock options.
Results of Operations
Summary of Operations. Harrington reported net loss of $1.9 million or $0.57
basic loss per share for the year ended June 30, 1998 compared to net income of
$2.0 million or $0.61 basic earnings per share for the year ended June 30, 1997.
This $3.9 million or 192.9% decrease in net income was due primarily to a $3.1
million decrease in net interest income, a $2.1 million decrease in other income
(loss) and a $1.0 million increase in operating expenses, which was partially
offset by a $2.5 million decrease in the income tax provision.
Net income for the year ended June 30, 1997 was $2.0 million or $0.61 basic
earnings per share, compared to $1.2 million or $0.57 basic earnings per share
for the year ended June 30, 1996. The $779,000 or 63.7% increase in net income
was due primarily to a $2.6 million increase in net interest income, which was
partially offset by a $1.7 million increase in operating expenses which includes
the Savings Association Insurance Fund ("SAIF") special assessment of $830,000,
and a $613,000 increase in the income tax provision.
21
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)
Years Ended June 30, 1998 1997
- --------------------------------------------------------------------------------------------------------------
Average Yield/ Average Yield/
Interest Rate (1) Balance Interest Rate Balance Interest Rate
- --------------------------------------------------------------------------------------------------------------
Interest-Earning Assets:
Interest-bearing deposits ................ $ 14,590 $ 792 5.43% $ 22,727 1,197 5.27%
Securities held for trading (2) .......... 386,640 23,947 6.19 390,867 26,808 6.86
Securities available for sale (3) ........ 1,039 91 8.76 1,375 133 9.67
Loans receivable, net (4) ................ 116,982 8,734 7.47 78,545 6,087 7.75
Federal Home Loan Bank stock ............. 4,858 392 8.07 3,179 249 7.83
-------- ------- ------ --------- ------- ------
Total interest-earning assets ............ 524,109 33,956 6.48% 496,693 34,474 6.94%
-------- ------- ------ --------- ------- ------
Non-interest-earning assets ................. 14,872 10,714
-------- --------
Total assets ............................. $538,981 $507,407
-------- --------
Interest-Bearing Liabilities:
Deposits:
NOW and checking accounts .............. $ 6,788 166 2.45% $ 4,697 124 2.64%
Savings accounts ....................... 25,666 1,117 4.35 20,463 844 4.12
Money market deposit accounts .......... 2,235 101 4.52 1,886 82 4.35
Certificates of deposit ................ 117,073 6,919 5.91 109,756 6,416 5.85
-------- ------- ---- -------- ------ ------
Total deposits .......................... 151,762 8,303 5.47 136,802 7,466 5.46
Securities sold under agreements
to repurchase ........................ 319,578 17,905 5.60 306,034 16,391 5.36
Federal Home Loan Bank advances ......... 27,488 1,843 6.70 26,089 1,644 6.30
Note payable ............................ 11,355 981 8.64 10,168 907 8.92
-------- ------- ---- -------- ------ ------
Total interest-bearing liabilities ....... 510,183 29,032 5.69% 479,093 26,408 5.51%
-------- ------- ----- -------- ------ ------
Non-interest bearing liabilities ............ 4,200 4,307
-------- --------
Total liabilities ........................... 514,383 483,400
Stockholders' equity ........................ 24,598 24,007
-------- --------
Total liabilities and stockholders' equity .. $538,981 $507,407
-------- --------
Net interest income; interest rate spread (5) $ 4,924 0.79% $ 8,066 1.43%
-------- ------ -------- ------
Net interest margin (5)(6) .................. 0.94% 1.62%
Average interest-earning assets to ------ ------
average interest-bearing liabilities ..... 102.73% 103.67%
1996
------------------------------------
Average Yield/
Balance Interest Rate
------------------------------------
Interest-Earning Assets:
Interest-bearing deposits ................ $ 14,520 $ 780 5.37%
Securities held for trading (2) .......... 243,862 18,034 7.40
Securities available for sale (3) ........ 2,672 194 7.26
Loans receivable, net (4) ................ 52,399 4,276 8.16
Federal Home Loan Bank stock ............. 2,533 200 7.90
--------- --------- ------
Total interest-earning assets ............ 315,986 23,484 7.43%
--------- --------- ------
Non-interest-earning assets ................. 13,952
Total assets ............................. $ 329,938
--------- --------- ------
Interest-Bearing Liabilities:
Deposits:
NOW and checking accounts .............. 3,813 110 2.88%
Savings accounts ....................... 15,922 613 3.85
Money market deposit accounts .......... 1,777 77 4.33
Certificates of deposit ................ 103,981 6,351 6.11
--------- --------- ------
Total deposits .......................... 125,493 7,151 5.70
Securities sold under agreements
to repurchase ........................ 148,523 8,352 5.62
Federal Home Loan Bank advances ......... 27,586 1,596 5.79
Note payable ............................ 9,553 905 9.47
--------- --------- ------
Total interest-bearing liabilities ....... 311,155 18,004 5.79%
Non-interest bearing liabilities ............ 5,894
--------- --------- ------
Total liabilities ........................ 317,049
Stockholders' equity ........................ 12,889
--------- --------- ------
Total liabilities and stockholders' equity .. $329,938
--------- --------- ------
Net interest income; interest rate spread (5) $ 5,480 1.64%
--------- --------- ------
Net interest margin (5)(6) .................. 1.73%
--------- --------- -------
Average interest-earning assets to
average interest-bearing liabilities ..... 101.55%
--------- --------- -------
(1) At June 30, 1998, the yields earned and rates paid were as follows:
interest-bearing deposits, 5.34%; securities held for trading, 6.10%;
securities available for sale, 7.77%; loans receivable, net 7.37%; FHLB
stock, 8.00%; total interest-earning assets, 6.55%; deposits, 5.50%;
securities sold under agreements to repurchase, 5.65%; FHLB advances,
5.64%; note payable, 8.64%; total interest-bearing liabilities, 5.68%;
interest rate spread, 0.87%.
(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, 1998, 1997 and 1996, the net
costs of hedging the Company's interest rate exposure with respect to its
securities held for trading amounted to $1.5 million or 0.77%, $730,000 or
0.37% and $252,000 or 0.21%, respectively.
(3) The average balance reflects the carrying value of available for sale
investments net of the average valuation allowance related to a single
non-agency participation certificate of $155,000, $276,000 and $447,000 for
the years ended June 30, 1998, 1997 and 1996, 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 1.07%, 1.58% and
1.72%, and the Company's net interest margin amounted to 1.22%, 1.77% and
1.81% for the years ended June 30, 1998, 1997 and 1996, respectively.
(6) Net interest margin is net interest income divided by average
interest-earning assets.
22
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
(1) changes in volume (change in volume multiplied by prior year rate), (2)
changes in rate (change in rate multiplied by prior year volume), and (3) 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)
Years Ended June 30, 1998 vs. 1997 1997 vs. 1996
- --------------------------------------- ----------------------------------- ----------------------------------
Increase Increase
(Decrease) Total (Decrease)
Due to Increase Due to Total
Rate Volume (Decrease) Rate Volume Increase
---- ------ ---------- ---- ------ --------
Interest-earning assets:
Interest-bearing deposits ........... $ 36 $ (441) $ (405) $ (16) $ 433 $ 417
Securities held for trading and
securities available for sale .... (2,593) (310) (2,903) (1,377) 10,090 8,713
Loans receivable, net ............... (230) 2,877 2,647 (225) 2,036 1,811
Federal Home Loan Bank stock ........ 8 135 143 (2) 51 49
-------- -------- ---- -------- -------- ------
Total interest-earning assets .... $ (2,779) $ 2,261 (518) $ (1,620) $ 12,610 10,990
-------- -------- ---- -------- -------- ------
Interest-bearing liabilities:
NOW and checking accounts .......... $ (10) $ 52 42 $ (10) $ 24 14
Savings accounts ................... 49 224 273 46 185 231
Money market deposit accounts ...... 3 16 19 -- 5 5
Certificates of deposit ............ 71 432 503 (279) 344 65
-------- -------- ---- -------- -------- ------
Total deposits ................... 113 724 837 (243) 558 315
Securities sold under agreements
to repurchase .................... 772 742 1,514 (415) 8,454 8,039
Federal Home Loan Bank advances .... 108 91 199 138 (90) 48
Note payable ....................... (29) 103 74 (54) 56 2
-------- -------- ---- -------- -------- ------
Total interest-bearing liabilities $ 964 $ 1,660 2,624 $ (574) $ 8,978 8,404
-------- -------- ---- -------- -------- ------
Increase (decrease) in net
interest income .................. $ (3,142) $ 2,586
-------- --------
Interest Income. For the year ended June 30, 1998, Harrington's interest income
decreased by $518,000 or 1.5% to $34.0 million, compared to the year ended June
30, 1997. This decrease was primarily due to a $2.9 million decrease in interest
income on the Company's investment portfolio including the increase in the net
interest expense on interest rate contracts maintained in the trading portfolio.
This decrease was partially offset by a $2.6 million increase in interest income
from the loan portfolio. The 67 basis point decline in interest income from the
investment portfolio was largely a result of the Company's shifting of assets to
low initial rate GNMA one-year adjustable rate mortgage securities and the
shifting of the portfolio's fixed rate mortgage investments to lower coupons
with lower accounting yields but higher option adjusted spreads. The increase in
interest income on the loan portfolio was a direct result of the $38.4 million
increase in the level of the average loan portfolio which was partially offset
by a 28 basis point decline in the interest yield earned caused primarily by an
overall decline in the level of interest rates during fiscal 1998.
For the year ended June 30, 1997, Harrington's interest income increased by
$11.0 million or 46.8% to $34.5 million, compared to the year ended June 30,
1996. This increase was primarily due to an $8.7 million increase in interest
income on the Company's investment portfolio, including the increase in the net
interest expense on interest rate contracts maintained in the trading portfolio,
and a $1.8 million increase in interest income from the loan portfolio. The
increase in interest income
23
from the Company's investment portfolio was a direct result of deploying capital
raised in the Company's initial public offering (IPO) which increased the
average portfolio by $145.7 million which was partially offset by a 53 basis
point decline in the interest yield earned. The increase in interest income on
the loan portfolio was a direct result of the $26.1 million increase in the
level of the average loan portfolio which was partially offset by a 41 basis
point decline in the interest yield earned. The decreases in interest yields
earned were primarily caused by an overall decline in the level of interest
rates during fiscal 1997.
Interest Expense. For the year ended June 30, 1998, Harrington's interest
expense increased by $2.6 million or 9.9% to $29.0 million, compared to the year
ended June 30, 1997. This increase was primarily due to a $31.1 million increase
in the level of average interest-bearing liabilities and an 18 basis point
increase in the cost of interest-bearing liabilities resulting mainly from an
increase in the funding costs for securities sold under agreements to
repurchase.
For the year ended June 30, 1997, Harrington's interest expense increased by
$8.4 million or 46.7% to $26.4 million, compared to the year ended June 30,
1996. This increase was primarily due to a $167.9 million increase in the level
of average interest-bearing liabilities which was partially offset by a 28 basis
point decrease in the cost of interest-bearing liabilities resulting mainly from
an overall decrease in the interest rates during fiscal year 1997.
Net Interest Income. Net interest income decreased by $3.1 million or 39.0% to
$4.9 million during fiscal year 1998 as compared to fiscal year 1997. For the
year ended June 30, 1997, Harrington's net interest income amounted to $8.1
million, compared to $5.5 million for the year ended June 30, 1996.
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
areas, historical loan loss experience and other factors related to the
collectibility 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 $147,000,
$92,000 and $(1,000) during the years ended June 30, 1998, 1997 and 1996,
respectively. During such respective periods, loan charge-offs (net of
recoveries) amounted to $0, $(1,000) and $0, respectively. Although the
Company's non-performing loans remain low, given the growth in the mortgage loan
portfolio and the initial production of commercial related loans, the Company's
analysis of loan reserve requirements indicated that additional reserves were
prudent. The allowance for loan losses as a percentage of total non-performing
loans was 126.3% and 63.4% at June 30, 1998 and 1997, respectively. The
allowance for loan losses as a percentage of total loans was 0.2% at June 30,
1998 and 1997.
Other Income (Loss). Other income (loss) is comprised of two distinct
components: gains and losses on the Company's investment securities and hedging
instruments, and fee and other income from retail bank operations. Gains or
losses on investments and hedges which have been sold are reported as realized
gains or losses, and market value gains or losses on investments 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).
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 and it allows flexibility to
grow or reduce investments as opportunities allow.
The following table sets forth information regarding other income (loss) for the
periods shown.
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- -------------------------------------------------------------------------------
Gain (loss) on sale of
securities held for trading ....... $ (775) $(1,623) $ 1,834
Unrealized gain (loss) on
securities held for trading ....... (930) 2,117 (1,960)
Other (1) ............................ 295 239 256
------- ------- -------
Total other income (loss) ............ $(1,410) $ 733 $ 130
======= ======= =======
(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.
24
Total other income (loss) amounted to $(1.4) million for the year ended June 30,
1998. This total consisted of a net realized and unrealized loss of $1.7 million
on the trading portfolio, plus fee and other retail bank income of $295,000. The
loss on the trading portfolio, net of hedges, reflects only a portion of the
total income (loss) produced from this portfolio in fiscal 1998. Total income
from this portfolio consists of both interest income and net realized and
unrealized gains and losses on the investments and hedges.
The Company seeks to produce a positive spread between the total income of this
portfolio and one month LIBOR, the Company's marginal cost of borrowing. In the
fiscal years 1998, 1997, and 1996, this portfolio produced a net hedged spread
to one month LIBOR of 0.15%, 1.47% and 1.44%, respectively. The weaker
investment performance of the Company's hedged mortgage securities portfolio in
fiscal year 1998 can be attributed to the low interest rate and flat yield curve
environment which, together with the associated prepayment uncertainty, caused
investors to demand a larger spread between the rates on mortgage securities and
comparable duration securities. Management expects that this situation, although
negatively affecting the returns in fiscal 1998, to provide favorable investment
management opportunities for Harrington in future periods.
Total other income amounted to $733,000 for the year ended June 30, 1997. This
total consisted of a net realized and unrealized gain of $494,000 on the trading
portfolio, plus fee and other retail bank income of $239,000. The net gain in
fiscal 1997 can be attributed to such factors as opportunistic trades between
fixed and adjustable rate securities at favorable relative option adjusted
spreads, the general tightening of mortgage spreads to the related hedge
instruments, and the use of a higher mix of interest rate swaps to financial
futures in hedging that shifts a portion of hedge expense from the trading
portfolio gain to net interest income.
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.
Other Expense. In order to enhance the Company's profitability, management
strives to maintain a favorable level of operating expenses relative to its peer
group. During the years ended June 30, 1998, 1997 and 1996, total other expense,
excluding the special SAIF assessment, as a percentage of average total assets
amounted to 1.2%, 0.9% and 1.1%, respectively. The following table sets forth
certain information regarding other expense for the periods shown.
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- --------------------------------------------------------------------------------
Salaries and employee benefits ............. $3,295 $2,174 $1,776
Premises and equipment ..................... 805 532 466
Special SAIF assessment ................... 830
FDIC insurance premiums .................... 86 180 276
Marketing ................................. 183 136 200
Computer services .......................... 243 165 143
Consulting fees ............................ 287 281 232
Other (1) .................................. 1,561 1,146 647
------ ------ ------
Total other expense ..................... $6,460 $5,444 $3,740
====== ====== ======
(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 $1.1 million or 51.6% and $398,000 or 22.4% during
fiscal 1998 and 1997, respectively. A major cause of these increases was the
continuing implementation of Harrington's community bank expansion strategy. A
total of six new banking locations were opened since May 1994, with three being
opened in the third quarter of fiscal year 1998, and the administrative support
at the home office was increased as well. In addition, new employees were hired
in connection with the growth in the Bank's mortgage lending operations and the
development of the Bank's commercial loan department.
Premises and equipment expense increased by $273,000 or 51.3% and $66,000 or
14.2% during fiscal 1998 and 1997, respectively. The increase in premises and
equipment expense during the periods was primarily due to the opening of new
branches during fiscal years 1998 and 1997.
During the year ended June 30, 1997, all SAIF-insured financial institutions
were required to pay a special assessment to recapitalize that fund.
Harrington's special assessment, which was based on the Bank's level of deposits
at March 31, 1995, was $830,000. However, beginning January 1, 1997, the Bank's
Federal Deposit Insurance Corporation ("FDIC") insurance rate dropped from 23
basis points to 6 basis points on its deposits. Excluding the special SAIF
assessment, FDIC insurance premiums decreased $96,000 or 34.8% for fiscal 1997
compared to fiscal 1996. During fiscal 1998, FDIC insurance premiums decreased
$94,000 or 52.2% primarily due to the decrease in the FDIC insurance rate which
was offset by an increase in deposit base.
Harrington incurred marketing expense of $183,000, $136,000 and $200,000 during
the years ended June 30, 1998, 1997 and 1996, 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 1998 and 1997.
25
Computer services expense increased by $78,000 or 47.3% and $22,000 or 15.4%
during fiscal 1998 and 1997, 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. 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, 1998, 1997 and 1996, which are
based on the Company's asset size, amounted to $287,000, $281,000 and $232,000,
respectively.
Income Tax Provision. The Company received an income tax benefit of $1.2 million
during fiscal 1998 as compared to income tax expense of $1.3 million and
$648,000 during the years ended June 30, 1997 and 1996, respectively. The
Company's effective tax rate amounted to 39.9%, 38.6% and 34.6% during the years
ended June 30, 1998, 1997 and 1996, respectively. The Company's effective tax
rate for the year ended June 30, 1996 was lower than the effective rates for
fiscal years 1998 and 1997 primarily due to increased permanent differences
relative to the level of pre-tax income in fiscal 1996.
Liquidity
- ---------
The Bank is required under applicable federal regulations to maintain specified
levels of "liquid" investments as defined by the OTS. As of November 24, 1997,
the required level of such liquid investments was changed from 5% to 4% of
certain liabilities as defined by the OTS. In addition to the change in the
percentage of required level of liquid assets, the OTS also modified its
definition of investments that are considered liquid. As a result of this
change, the level of assets eligible for regulatory liquidity calculations
increased considerably.
The total eligible regulatory liquidity of the Bank was 15.58% at June 30, 1998,
as compared to 5.25% at June 30, 1997. At June 30, 1998, the Bank's liquid
assets as defined by the OTS totaled approximately $82.2 million, which was
$61.1 million in excess of the current OTS minimum requirement.
The Bank maintains liquid assets at a level believed adequate to support its
normal operations, including funding loans and paying deposit withdrawals. Cash
flow projections are regularly reviewed and updated to ensure that adequate
liquidity is maintained. Cash for these purposes is generated through the sale
or maturity of securities, the receipt of loan payments, and increases in
deposits and borrowings. While the level of loan and deposit activity is not
entirely under the control of the Bank, the sale of securities and increases in
borrowings are entirely at the Bank's discretion and thus provide a ready source
of cash when needed.
As a member of the FHLB System, the Bank may borrow from the FHLB of
Indianapolis. FHLB advances may be obtained on very short notice due to the
Bank's blanket collateral agreement with the FHLB. In addition, the Bank can
pledge securities for collateralized borrowings such as reverse repurchase
agreements and quickly obtain cash whenever needed. In the opinion of
management, Harrington has sufficient cash flow and borrowing capacity to meet
current and anticipated funding commitments.
The Bank's liquidity, represented by cash and cash equivalents, is a result of
its operating, investing and financing activities. During the year ended June
30, 1998, there was a net increase of $2.3 million in cash and cash equivalents.
The major sources of cash during the year included $680.8 million in proceeds
from sales and maturities of securities held for trading, a $42.1 million net
increase in deposits and an $11.3 million decrease in amounts due from brokers.
Partially offsetting these sources of cash, the major uses of cash during the
fiscal year were purchases of securities for the trading portfolio of $657.2
million and loan originations, net of repayments, of $70.0 million.
Year 2000
- ---------
The Year 2000 issue is the result of computer programs being written using two
digits rather than four to define the applicable year. The Company's computer
programs and those of third-party computer related providers may recognize a
date using "00" as the year 1900 rather than the year 2000. This situation could
result in system failures or miscalculations causing disruption of operations
that could affect the ability of the Company to operate effectively and service
customers.
The Company's State of Readiness. The company is preparing for the year 2000 by
testing and evaluating both its information technology (IT) and non-information
technology systems. The Company does not have any mission critical processes
that are dependent on non-IT systems. The non-IT systems, such as the telephone
system, are either currently compliant or are expected to be compliant in fiscal
year 1999. The IT systems used by the Company have been or are being tested. The
components of the IT systems being examined are: 1) personal computers (PCs),
hardware and software, 2) data service bureau, and 3) other service providers.
26
Hardware and software on all PCs have been inventoried and tested. The limited
number of PCs and software that were not Year 2000 compliant have been replaced
or are scheduled to be replaced in the fourth quarter of calendar year 1998.
Given the expiration of the Bank's data processing agreement with its current
service provider in early calendar year 1999, the Company has been evaluating
its data processing requirements under its strategic plan and considering
alternative solutions to meet these requirements. The Company has recently
selected another data service provider, FISERV Vision, to replace its current
provider. The conversion to this system is expected to be accomplished in March
of 1999. FISERV has provided the Company with assurances that the Vision product
is Year 2000 compliant, and the Company will be conducting tests on this
software system to confirm this compliance.
If, for some unexpected reason, the Company is unable to accomplish this
conversion to FISERV, then it would retain its current vendor and ensure
compliance with Year 2000 through written assurance from the vendor and adequate
testing of the operating system. The existing data service vendor is making
progress toward making its operating systems Year 2000 complaint and expects
this objective to be achieved in the third quarter of calendar year 1998.
Other service providers, such as the Company's financial advisors or the FHLB of
Indianapolis, are either Year 2000 compliant or are keeping the Company apprised
of their progress towards being Year 2000 compliant. As part of the Company's
Year 2000 compliance program, the Company will be monitoring the vendors'
progress toward compliance and, if necessary, testing systems to help ensure
compliance.
The Costs to Address the Company's Year 2000 Issues. The limited number of PCs
and software that were not Year 2000 compliant have been replaced or are
scheduled to be replaced in the fourth quarter of calendar year 1998. The cost
of replacing these machines and software is estimated to be $43,500 in
capitalized fixed assets in fiscal year 1999.
The Risks of the Company's Year 2000 Issues. The Company has established
parameters and processes for management to identify material customers, evaluate
their preparedness, assess their credit risk and implement controls to manage
the risk arising from their failure to properly address Year 2000 technology
issues. The Company faces increased credit, liquidity, or counterparty trading
risk when customers encounter Year 2000-related problems. Customers that must be
evaluated and monitored are those that, if adversely impacted by Year 2000
technology issues, represent a significant financial exposure to the Company in
terms of either credit loss or liquidity. The organizations that have been
identified as material customers of the Company will be monitored because of
their reliance on technology for their successful business operations.
Failure of borrowers, counterparties or servicers to address Year 2000 problems
may increase credit risk to the Company through the inability of these parties
to meet the terms of their contracts and make timely payments of principal and
interest to the Company. Liquidity risk may result if depositors, lenders or
counterparties experience Year 2000-related business disruption or operational
failures and are unable to provide funds or fulfill funding commitments to the
Company. Capital market counterparties, such as trading counterparties or
interest rate swap or interest rate cap/floor counterparties, provide contracts
that allow the Company to enter into forward commitments to purchase or sell
securities or to use hedges to reduce interest rate risk. Liquidity and credit
risk may result if capital market counterparties are unable to fulfill
contractual commitments due to operational problems caused by the Year 2000 date
change.
In those cases where the Company is not fully satisfied that its counterparties
will be Year 2000 ready, mitigating controls will be established such as early
termination agreements, additional collateral, netting arrangements, and
third-party payment arrangements or guarantees. In cases where the Company has a
high degree of uncertainty regarding a counterparty's ability to address its
Year 2000 problems, the Company will avoid all transactions with that
counterparty that mature on or after January 1, 2000 with liquidity, credit, or
settlement risk. The Company will not resume normal transaction activities until
the counterparty has demonstrated that it is prepared for the Year 2000.
The Company's Contingency Plan-Data Service Bureau. In the event, the data
service bureau used by the Bank fails to operate satisfactorily after the turn
of the century, the Bank would be forced to operate on a manual system until a
conversion could be made to a different service bureau or the existing service
bureau corrects its problems. The Bank would establish ledger cards for each
customer account and would manually post transactions to the cards each day.
Transactions would also be batched and manually posted to the general ledger.
The ledger cards would be balanced to the general ledger. The ledger cards would
be balanced to the general ledger frequently to provide some assurance that the
manual system is functioning accurately.
The Bank would have to make some temporary changes in its product menu during
the time operating on a manual system. For instance, the Bank would probably
discontinue originating mortgage loans because of the complexities involved with
them. The Bank would also stop opening new checking accounts. The Bank might
have to convert its existing checking accounts to savings accounts (with
appropriate advance
27
notice and disclosures to the customers) so that the Bank could more efficiently
process these accounts. The Bank would also have to put a temporary moratorium
on ATM transactions because the Bank would be effectively running in an off-line
mode.
Undoubtedly, the Bank would experience significant deposit run-off were the Bank
to function in such a limited capacity for any length of time. However, the Bank
has a substantial mortgage-backed security portfolio which provides the Bank
with ready liquidity should the need arise to liquidate deposits.
Investment Securities. The Company has received assurances that most major
brokers with which it trades are Year 2000 compliant. Many smaller regional
brokers have yet to provide these assurances. Beginning in November 1999, the
Company will no longer enter into any transactions with regional brokers that
are not Year 2000 compliant. In this way, the Company will control its exposure
to Year 2000 risks with these brokers. After the turn of the millennium, the
Company will carefully evaluate regional brokers individually before resuming
business with them.
Most of the Company's securities are in safekeeping at the FHLB of Indianapolis,
which is progressing towards being Year 2000 compliant. If the FHLB is not Year
2000 compliant by 1999, the Company will engage a new safekeeping agent that is
compliant. Similarly, if any assets are pledged with brokers, the Company will
verify well before the end of 1999 that those brokers are already Year 2000
compliant and if not, these assets will be pledged only with Year 2000 compliant
brokers.
Personal Computers. By the end of calendar year 1998, the Company will have
replaced or upgraded all of its personal computers which failed Year 2000
compliance tests. Thus, it is expected that the Company's PCs will be in
compliance when the century turns. The Company has previously tested the
software used on its PCs, and those software packages that did not properly
handle the Year 2000 have been replaced.
Other Vendors and Service Providers. The Company is closely monitoring all of
its other vendors and service providers to determine if they will be Year 2000
compliant on a timely basis. If any vendors or service providers have not yet
become Year 2000 compliant by the end of the first quarter of calendar year
1999, the Bank will immediately find a replacement vendor or service provider
who is compliant. It is possible, although unlikely, that increased cost to the
institution could result from engaging replacement vendors.
General. The costs of the project and the date on which the Company plans to
complete the Year 2000 compliance program are based on management's best
estimates which were derived utilizing numerous assumptions of future events
including the continued availability of certain resources, third party
modification plans and other factors. However, there can be no guarantee that
these estimates will be achieved, and actual results could differ materially
from these estimates.
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. 130, 131, and
133 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.
28
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands except share data)
June 30, 1998 1997
- ----------------------------------------------------------------------------------------------------------
ASSETS
Cash ...................................................................... $ 1,567 $ 1,207
Interest-bearing deposits (Note 13) ....................................... 10,212 8,309
--------- ---------
Total cash and cash equivalents ......................................... 11,779 9,516
Securities held for trading - at fair value (amortized cost of
$289,137 and $314,953) (Notes 2, 8, 13) ................................. 290,609 317,355
Securities available for sale - at fair value (amortized cost of
$924 and $1,183) (Note 2) ............................................... 922 1,125
Due from brokers .......................................................... 11,308
Loans receivable (net of allowance for loan losses of
$360 and $213) (Note 3) ................................................. 163,546 93,958
Interest receivable, net (Note 4) ......................................... 2,318 2,080
Premises and equipment, net (Note 5) ...................................... 5,614 4,424
Federal Home Loan Bank of Indianapolis stock - at cost .................... 4,878 4,852
Deferred income taxes, net (Note 10) ...................................... 240
Income taxes receivable (Note 10) ......................................... 435 1,118
Other ..................................................................... 4,056 1,061
========= =========
TOTAL ASSETS ................................................................. $ 484,397 $ 446,797
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits (Note 6) ......................................................... $ 178,311 $ 136,175
Securities sold under agreements to repurchase (Note 7) ................... 240,396 245,571
Federal Home Loan Bank advances (Note 8) .................................. 26,000 26,000
Note payable (Note 9) ..................................................... 13,495 9,995
Interest payable on securities sold under agreements to repurchase (Note 7) 282 300
Other interest payable .................................................... 1,596 787
Advance payments by borrowers for taxes and insurance ..................... 785 585
Deferred income taxes, net (Note 10) ...................................... 1,249
Accrued expenses payable and other liabilities ............................ 868 1,141
--------- ---------
Total liabilities ....................................................... 461,733 421,803
--------- ---------
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 3,399,938 and 3,256,738 shares,
outstanding 3,275,886, and 3,256,738 shares ............................. 425 407
Additional paid-in capital ................................................ 16,962 15,623
Treasury stock, 124,052 shares at cost .................................... (1,467)
Unrealized loss on securities available for sale, net of deferred
taxes of $1 and $23 ..................................................... (1) (35)
Retained earnings ......................................................... 6,745 8,999
--------- ---------
Total stockholders' equity .............................................. 22,664 24,994
========= =========
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ................................... $ 484,397 $ 446,797
========= =========
See notes to consolidated financial statements.
29
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands except share data)
Years Ended June 30, 1998 1997 1996
- ------------------------------------------------------------------------------------------------------------
INTEREST INCOME:
Securities held for trading ....................................... $ 25,426 $ 27,538 $ 18,286
Net interest expense on interest rate contracts maintained in
the trading portfolio (Note 13) ................................ (1,479) (730) (252)
Securities available for sale ..................................... 91 133 194
Loans receivable (Note 3) ......................................... 8,734 6,087 4,276
Dividends on Federal Home Loan Bank of Indianapolis stock ......... 392 249 200
Deposits .......................................................... 792 1,197 780
-------- -------- --------
33,956 34,474 23,484
-------- -------- --------
INTEREST EXPENSE:
Deposits (Notes 6, 13) ............................................ 8,303 7,466 7,151
Federal Home Loan Bank advances (Note 8) .......................... 1,843 1,644 1,596
Short-term borrowings (Note 7) .................................... 17,905 16,391 8,352
Long-term borrowings (Note 9) ..................................... 981 907 905
-------- -------- --------
29,032 26,408 18,004
-------- -------- --------
NET INTEREST INCOME .................................................. 4,924 8,066 5,480
PROVISION (CREDIT) FOR LOAN LOSSES (Note 3) .......................... 147 92 (1)
-------- -------- --------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES .................. 4,777 7,974 5,481
-------- -------- --------
OTHER INCOME (LOSS):
Gain (loss) on sale of securities held for trading (Notes 2, 13) .. (775) (1,623) 1,834
Unrealized gain (loss) on securities held for trading (Notes 2, 13) (930) 2,117 (1,960)
Other ............................................................. 295 239 256
-------- -------- --------
(1,410) 733 130
-------- -------- --------
OTHER EXPENSE:
Salaries and employee benefits (Note 12) .......................... 3,295 2,174 1,776
Premises and equipment expense (Note 5) ........................... 805 532 466
SAIF assessment (Note 16) ......................................... 830
FDIC insurance premiums ........................................... 86 180 276
Marketing ......................................................... 183 136 200
Computer services ................................................. 243 165 143
Consulting fees (Note 15) ......................................... 287 281 232
Other ............................................................. 1,561 1,146 647
-------- -------- --------
6,460 5,444 3,740
-------- -------- --------
INCOME (LOSS) BEFORE INCOME TAX PROVISION (BENEFIT) .................. (3,093) 3,263 1,871
INCOME TAX PROVISION (BENEFIT) (Note 10) ............................. (1,234) 1,261 648
======== ======== ========
NET INCOME (LOSS) .................................................... $ (1,859) $ 2,002 $ 1,223
======== ======== ========
BASIC EARNINGS (LOSS) PER SHARE (Note 1) ............................. $ (0.57) $ 0.61 $ 0.57
======== ======== ========
DILUTED EARNINGS (LOSS) PER SHARE (Note 1) ........................... $ (0.57) $ 0.61 $ 0.56
======== ======== ========
See notes to consolidated financial statements.
30
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(Dollars in thousands except share data)
Additional
Shares Common Paid-in Treasury
Outstanding Stock Capital Stock
--------- ---------- ---------- ----------
BALANCES, JULY 1, 1995 ....................................... 980,813 $ 245 $ 4,183
Stock split 2 for 1 ....................................... 980,813
Stock options exercised (Note 12) ......................... 30,112 4 161
Issuance of common stock under initial public offering .... 1,265,000 158 11,279
(Note 1)
Net income ................................................
Net change in unrealized gain (loss) on securities
available for sale, net of deferred tax of $(4)...........
---------- ---------- ---------- ----------
BALANCES, JUNE 30, 1996 ...................................... 3,256,738 407 15,623
Net income ................................................
Cash dividends declared on common stock ($0.03 per share) .
Net change in unrealized gain (loss) on securities
available for sale, net of deferred tax of $(23).........
---------- ---------- ---------- ----------
BALANCES, JUNE 30, 1997 ...................................... 3,256,738 407 15,623
Stock options exercised (Note 12) ....................... 143,200 18 1,056
Tax benefit from exercise of non-qualified stock options 283
Net loss ................................................
Cash dividends declared on common stock ($0.12 per share)
Purchase of treasury stock .............................. (124,052) $ (1,467)
Net change in unrealized gain (loss) on securities
available for sale, net of deferred tax of $22.........
---------- ---------- ---------- ----------
BALANCES, JUNE 30, 1998 ...................................... 3,275,886 $ 425 $ 16,962 $ (1,467)
========== ========== ========== ==========
Unrealized Total
Gain Retained Stockholders'
(Loss) Earnings Equity
---------- ---------- ----------
BALANCES, JULY 1, 1995 ....................................... $ 61 $ 5,872 $ 10,361
Stock split 2 for 1 .......................................
Stock options exercised (Note 12) ......................... 165
Issuance of common stock under initial public offering .... 11,437
(Note 1)
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 ...................................... (8) 7,095 23,117
Net income ................................................ 2,002 2,002
Cash dividends declared on common stock ($0.03 per share) . (98) (98)
Net change in unrealized gain (loss) on securities
available for sale, net of deferred tax of $(23)......... (27) (27)
---------- ---------- -------
BALANCES, JUNE 30, 1997 ...................................... (35) 8,999 24,994
Stock options exercised (Note 12) ....................... 1,074
Tax benefit from exercise of non-qualified stock options 283
Net loss ................................................ (1,859) (1,859)
Cash dividends declared on common stock ($0.12 per share) (395) (395)
Purchase of treasury stock .............................. (1,467)
Net change in unrealized gain (loss) on securities
available for sale, net of deferred tax of $22......... 34 34
---------- ---------- ----------
BALANCES, JUNE 30, 1998 ...................................... $ (1) $ 6,745 $ 22,664
========== ========== ==========
See notes to consolidated financial statements.
31
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- ---------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) .......................................... $ (1,859) $ 2,002 $ 1,223
Adjustments to reconcile net income (loss) to net
cash provided by (used) in operating activities:
Provision (credit) for loan losses ....................... 147 92 (1)
Depreciation ............................................. 348 235 210
Premium and discount amortization on securities, net ..... 1,434 1,925 1,887
Amortization of premiums and discounts on loans receivable 150 9 (37)
(Gain) loss on sale of securities held for trading ....... 775 1,623 (1,834)
Unrealized (gain) loss on securities held for trading .... 930 (2,117) 1,960
Loss on disposal of premises and equipment ............... 115
Deferred income tax provision ............................ (1,245) 605 (913)
Increase in interest receivable .......................... (238) (273) (454)
Increase (decrease) in interest payable .................. 791 (883) 278
Decrease in accrued income taxes ......................... (115) (80)
Purchases of securities held for trading ................. (657,211) (913,766) (390,743)
(Increase) decrease in amounts due from brokers .......... 11,308 (6,934) (4,374)
Proceeds from maturities of securities held for trading .. 28,438 26,398 25,407
Proceeds from sales of securities held for trading ....... 652,380 888,429 290,209
(Increase) decrease in other assets ...................... (2,995) 239 640
(Increase) decrease in income taxes receivable ........... 700 (1,118)
Increase (decrease) in accrued expenses .................. (273) (1,590) 2,374
Increase in other liabilities ............................ 200 193 128
--------- --------- ---------
Net cash provided by (used in) operating activities . 33,895 (5,046) (74,120)
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of Federal Home Loan Bank of Indianapolis stock ... (26) (2,207) (145)
Proceeds from maturities of securities available for sale .. 259 879 422
Loan originations, net of principal repayments ............. (69,885) (28,134) (28,877)
Purchases of premises and equipment ........................ (1,653) (1,554) (923)
--------- --------- ---------
Net cash used in investing activities .................. (71,305) (31,016) (29,523)
--------- --------- ---------
(Continued)
32
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- -----------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits ............................................ 42,136 1,032 19,831
Increase (decrease) in securities sold under agreements to repurchase (5,175) 26,504 88,850
Proceeds from issuance of common stock under initial public offering 11,437
Proceeds from stock options exercised ............................... 1,074 165
Proceeds from Federal Home Loan Bank advances ....................... 99,000 3,300 10,000
Proceeds from note payable .......................................... 3,500 2,300 800
Principal repayments on Federal Home Loan Bank advances ............. (99,000) (3,300) (15,000)
Principal repayments on note payable ................................ (1,303) (1,002)
Dividends paid on common stock ...................................... (395) (98)
Purchase of treasury stock .......................................... (1,467)
--------- --------- ---------
Net cash provided by financing activities ....................... 39,673 28,435 115,081
--------- --------- ---------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ................... 2,263 (7,627) 11,438
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR ......................... 9,516 17,143 5,705
--------- --------- ---------
CASH AND CASH EQUIVALENTS AT END OF YEAR ............................... $ 11,779 $ 9,516 $ 17,143
========= ========= =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for interest ............................................. $ 29,624 $ 25,434 $ 18,354
Cash paid for income taxes ......................................... 321 1,889 1,600
Noncash activities occurred consisting of a decrease in current and deferred
income tax payable and a corresponding increase in additional paid in capital
from the tax benefit from exercise of non-qualified stock options of $283 during
fiscal year 1998.
See notes to consolidated financial statements.
33
NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS
1. 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 and
Marion 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 operations.
Premiums and discounts are amortized over the contractual lives of the
related securities using the level yield method. Purchases and sales of
securities are recorded in the balance sheet on the trade date. Gains and
losses from security sales or disposals are recognized as of the trade
date in the statement of operations for the period in which securities are
sold or otherwise disposed of. The Company also enters into forward
contracts to purchase or sell securities held for trading. Changes in the
fair value of the forward contract are recognized in earnings as they
occur. Securities purchased or sold under a forward contract are recorded
at their fair values at the settlement date.
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 operations as a component of net interest
income.
The Company's available for sale portfolio consists of municipal bonds and
a non-agency participation certificate.
Fair values of securities are based on quoted market prices or dealer
quotes. Where such quotes are not available, 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 -
SFAS No. 119, Disclosure About Derivative Instruments and Fair Value of
Financial Instruments, 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
34
about amounts and the nature and terms of derivative financial instruments
regardless of whether they result in off-balance-sheet risk or 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 the interest rate exposure of its trading portfolio. These
financial instruments are included in the trading portfolio and are
reported at market 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 interest rate cap agreements to
effectively fix the interest rate on a portion of the Bank's floating-rate
securities sold under agreements to repurchase and on the Bank's Federal
Home Loan Bank advance. The premiums paid to enter into such interest rate
cap agreements are included in other assets and are amortized using the
straight-line method over the related term of the agreements. 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 market value of interest rate swaps and of the
interest rate caps 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 caps are designated to a portion of the Bank's
securities sold under agreements to repurchase and the Bank's Federal Home
Loan Bank advance which alter the designated instruments' interest rate
characteristics.
Due from Brokers consists of amounts receivable from sales of securities
in which the transactions have not settled as of the balance sheet date.
Loans Receivable are carried at the principal amount outstanding, adjusted
for premiums or discounts which are amortized or accreted using a
level-yield method. SFAS No. 114 and No. 118, Accounting by Creditors for
Impairment of a Loan and Income Recognition and Disclosures, 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. An impaired loan is charged off by
management as a loss when deemed uncollectible although collection efforts
continue and future recoveries may occur.
Discounts and premiums on purchased residential real estate loans are
amortized to income using the interest method over the remaining period to
contractual maturity.
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 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 projected cash flows using
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.
35
Federal Income Taxes - The Company and its wholly-owned subsidiary file a
consolidated tax return. 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.
Earnings Per Share - Earnings per share of common stock is based on the
weighted average number of common shares outstanding during the year. All
per share information has been restated to reflect the Company's
two-for-one stock split in October 1995.
The Company adopted SFAS No. 128, Earnings per Share, for fiscal year 1998
with all prior period earnings per share data restated. This statement
established new accounting standards for the calculation of basic earnings
per share as well as diluted earnings per share. The adoption of this
statement did not have a material effect on the Company's calculation of
earnings per share. The following is a reconciliation of the weighted
average common shares for the basic and diluted earnings per share
computations:
Years Ended June 30, 1998 1997 1996
- --------------------------------------------------------------------------------
Basic earnings per share:
Weighted average common shares ....... 3,285,166 3,256,738 2,160,233
--------- --------- ---------
Diluted earnings per share:
Weighted average common shares ....... 3,285,166 3,256,738 2,160,233
Dilutive effect of stock options .... 24,876 42,214 40,914
--------- --------- ---------
Weighted average common and
incremental shares (1) .......... 3,310,042 3,298,952 2,201,147
--------- --------- ---------
(1) The calculation for diluted earnings per share for the fiscal year
ended June 30, 1998 was based upon the weighted average common shares
as the effect of the stock options were anti-dilutive due to the net
loss for the year.
New Accounting Pronouncements - In June 1997, SFAS No. 130, Comprehensive
Income, was issued and becomes effective for fiscal years beginning after
December 15, 1997 and requires reclassification of earlier financial
statements for comparative purposes. SFAS No. 130 requires that changes in
the amounts of certain items, including gains and losses on certain
securities, be shown in the financial statements. SFAS No. 130 does not
require a specific format for the financial statement in which
comprehensive income is reported, but does require that an amount
representing total comprehensive income be reported in that statement.
This statement will result in additional financial statement disclosures
upon adoption.
Also in June 1997, SFAS No. 131, Disclosures about Segments of an
Enterprise and Related Information, was issued. This Statement will change
the way public companies report information about segments of their
business in their annual financial statements and requires them to report
selected segment information in their quarterly reports issued to
shareholders. It also requires entity-wide disclosures about the products
and services an entity provides, the material countries in which it holds
assets and reports revenues, and its major customers. SFAS No. 131 is
effective for fiscal years beginning after December 15, 1997. Management
has not yet determined the effect, if any, of SFAS No. 131 on the
consolidated financial statements.
SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities, was issued in June 1998 and is effective for all fiscal
quarters of all fiscal years beginning after June 15, 1999. This statement
establishes accounting and reporting standards for derivative instruments
and for hedging activities. It requires that an entity recognize all
derivatives as either assets or liabilities in the statement of financial
condition and measure those instruments at fair value. If certain
conditions are met, a derivative may be specifically designated as a fair
value hedge, a cash flow hedge, or a hedge of foreign currency exposure.
The accounting for changes in the fair value of a derivative (that is,
gains and losses) depends on the intended use of the derivative and the
resulting designation. Management has not yet quantified the effect of the
new standard on the financial statements.
Reclassifications of certain amounts in the 1997 and 1996 consolidated
financial statements have been made to conform to the 1998 presentation.
36
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)
Gross Gross
Amortized Unrealized Unrealized Fair
Year Ended June 30, 1998 Cost Gains Losses Value
- ------------------------------------------------------------------------------------------
Securities held for trading:
GNMA certificates ................... $142,951 $ 1,282 $ 14 $144,219
FHLMC certificates .................. 50,555 808 134 51,229
FNMA certificates ................... 57,252 1,000 8 58,244
Commercial mortgage backed securities 17,540 248 17,788
Non-agency participation certificates 1,884 33 42 1,875
Collateralized mortgage obligations . 10,930 484 11,414
Residuals ........................... 309 55 364
Interest-only strips ................ 1,118 5 605 518
Principal-only strips ............... 599 119 718
Interest rate swaps ................. 397 (397)
Interest rate collar ................ 38 60 (22)
Interest rate caps .................. 2,384 2,157 227
Interest rate floors ................ 3,410 1,423 393 4,440
Options ............................. 68 19 37 50
Futures ............................. 257 (257)
Equity securities ................... 99 100 199
-------- -------- -------- --------
Totals ................................. $289,137 $ 5,576 $ 4,104 $290,609
======== ======== ======== ========
Securities available for sale:
Municipal bonds ..................... $ 319 $ 16 $ 335
Non-agency participation certificate 605 $ 18 587
-------- -------- -------- --------
Totals ................................. $ 924 $ 16 $ 18 $ 922
======== ======== ======== ========
The Bank's collateralized mortgage obligation (CMO) portfolio at June 30, 1998
consisted of three agency investments with an estimated remaining weighted
average life of 7.5 years.
37
Gross Gross
Amortized Unrealized Unrealized Fair
(Dollars in thousands) Cost Gains Losses Value
- -----------------------------------------------------------------------------------------
Securities held for trading:
GNMA certificates ................... $165,894 $ 2,291 $ 83 $168,102
FHLMC certificates .................. 41,194 401 79 41,516
FNMA certificates ................... 68,800 628 73 69,355
Non-agency participation certificates 2,545 42 85 2,502
Collateralized mortgage obligations . 25,789 295 52 26,032
Residuals ........................... 508 566 38 1,036
Interest-only strips ................ 2,028 41 620 1,449
Principal-only strips ............... 821 42 3 860
Interest rate swaps ................. 626 45 581
Interest rate collar ................ 50 58 (8)
Interest rate caps .................. 3,025 1,480 1,545
Interest rate floors ................ 3,916 572 947 3,541
Options ............................. 78 54 24
Futures ............................. 356 356
Equity securities ................... 305 159 464
-------- -------- -------- --------
Totals ................................. $314,953 $ 6,019 $ 3,617 $317,355
======== ======== ======== ========
Securities available for sale:
Municipal bonds ..................... $ 317 $ 18 $ 335
Non-agency participation certificate 866 $ 76 790
-------- -------- -------- --------
Totals ................................. $ 1,183 $ 18 $ 76 $ 1,125
======== ======== ======== ========
The Bank's CMO portfolio at June 30, 1997 consisted of four agency investments
with an estimated remaining weighted average life of 16.1 years.
For a complete discussion of the Bank's Risk Management Activities, see Note 13.
38
The amortized cost and estimated fair values of securities by contractual
maturity are as follows:
(Dollars in thousands)
Held for Trading Available for Sale
-------------------- -------------------
Amortized Fair Amortized Fair
Year Ended June 30, 1998 Cost Value Cost Value
- -----------------------------------------------------------------------------------------
Debt securities (due after 1 year through
5 years) ............................. $ 319 $ 335
Mortgage-backed securities .............. $268,298 $271,480
Non-agency participation certificates ... 1,884 1,875 605 587
Collateralized mortgage obligations ..... 10,930 11,414
Mortgage-backed derivatives ............. 2,026 1,600
Interest rate contracts ................. 5,900 4,041
Equity securities ....................... 99 199
-------- -------- -------- --------
$289,137 $290,609 $ 924 $ 922
======== ======== ======== ========
Securities with a total amortized cost of $245,510,000 and $255,387,000
and a total fair value of $248,537,000 and $257,826,000 were pledged at
June 30, 1998 and 1997, respectively, to secure interest rate swaps and
securities sold under agreements to repurchase. As of June 30, 1998 and
1997, the Bank had a blanket collateral agreement for the Federal Home
Loan Bank advances instead of utilizing specific securities as collateral.
Activities related to the sale of securities are summarized as follows:
(Dollars in thousands)
Year Ended June 30, 1998 1997 1996
- ----------------------------------------------------------------------------------------
Proceeds from sales of securities held for trading . $652,380 $888,429 $290,209
Gross gains on sales of securities held for trading 46,537 44,324 30,492
Gross losses on sales of securities held for trading 47,312 45,947 28,658
39
3. LOANS RECEIVABLE
----------------
Approximately 78% of the Bank's loans are to customers in Wayne, Hamilton
and Marion 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, 1998 1997
- --------------------------------------------------------------------------------
Loans secured by one to four family residences:
Real estate mortgage ............................. $ 154,148 $ 90,914
Participation loans purchased .................... 188 226
Commercial ......................................... 4,723 258
Property improvement ............................... 1,248 690
Loans on savings accounts .......................... 221 252
Consumer and home equity lines of credit ........... 2,288 1,446
Other consumer loans ............................... 253
--------- ---------
Subtotal ........................................... 163,069 93,786
Unamortized push-down accounting adjustment ........ (113) (136)
Undisbursed loan proceeds .......................... (6) (9)
Net deferred loan fees, premiums and discounts ..... 956 530
Allowance for loan losses .......................... (360) (213)
--------- ---------
Loans receivable, net .............................. $ 163,546 $ 93,958
========= =========
The principal balance of loans on nonaccrual status totaled approximately
$285,000 and $336,000 at June 30, 1998 and 1997, respectively. For the
years ended June 30, 1998, 1997 and 1996, gross interest income which
would have been recorded had the Bank's nonaccruing loans been current
with their original terms amounted to $15,000, $6,000, and $6,000,
respectively. At June 30, 1998 and June 30, 1997, the Company had no
impaired loans required to be disclosed under SFAS No. 114 and No. 118.
The Bank had commitments to originate or purchase loans consisting
primarily of real estate mortgages secured by one to four family
residences approximating $11,863,000 and $3,182,000 excluding undisbursed
portions of loans in-process at June 30, 1998 and 1997, respectively.
The Bank has transactions in the ordinary course of business with
directors, officers, employees and an affiliate (Smith Breeden Associates
Inc., see Note 15). Loans to such individuals totaled $1,927,000 and
$228,000 at June 30, 1998 and 1997, respectively.
The amount of loans serviced for others totaled $3,411,000, $4,657,000,
and $5,587,000 at June 30, 1998, 1997 and 1996, 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 borrowers' escrow balances of $27,000 and $31,000 at June 30,
1998 and 1997, respectively.
Loan servicing fee income included in other income for the years ended
June 30, 1998, 1997 and 1996 was $15,000, $19,000 and $23,000,
respectively.
An analysis of the allowance for loan losses is as follows:
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- --------------------------------------------------------------------------------
Beginning balance ...................... $ 213 $ 120 $ 121
Provision for loan losses .............. 147 92 (1)
Recoveries ............................. 1
----- ----- -----
Ending balance ......................... $ 360 $ 213 $ 120
===== ===== =====
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 $133 and
$124 million at June 30, 1998 and 1997, respectively. Also under FIRREA,
the loans-to-one borrower limitation is generally 15% of unimpaired
capital and surplus which, for the Bank, was approximately $5 million at
June 30, 1998 and 1997. The Bank was in compliance with all of these
requirements at June 30, 1998 and 1997.
40
4. INTEREST RECEIVABLE
-------------------
Interest receivable is summarized as follows:
(Dollars in thousands)
June 30, 1998 1977
- --------------------------------------------------------------------------------
Loans (less allowance for uncollectibles - $15 and $6) ... $ 744 $ 413
Interest-bearing deposits ................................ 2 34
Securities held for trading .............................. 1,543 1,599
Securities available for sale ............................ 29 34
------ ------
Interest receivable, net ................................. $2,318 $2,080
====== ======
5. PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows:
(Dollars in thousands)
June 30, 1998 1977
- --------------------------------------------------------------------------------
Land ........................................... $ 1,003 $ 1,003
Buildings and leasehold improvements ........... 4,422 3,510
Furniture, fixtures and equipment .............. 1,673 1,059
------- -------
Total .......................................... 7,098 5,572
Less accumulated depreciation .................. (1,484) (1,148)
------- -------
Premises and equipment, net .................... $ 5,614 $ 4,424
======= =======
Depreciation expense included in operations during the years ended June
30, 1998, 1997 and 1996 totaled $348,000, $235,000, and $210,000 respectively.
6. DEPOSITS
--------
(Dollars in thousands)
June 30, 1998 1997
- --------------------------------------------------------------------------------
Weighted Weighted
Average Average
Amount Rate Amount Rate
------ ---- ------ ----
NOW accounts ................ $ 8,202 2.39% $ 4,778 2.42%
Savings accounts ............ 31,076 4.37 20,523 4.18
Money market deposit accounts 2,705 4.43 1,930 4.00
-------- --------- ----
41,983 27,231
-------- --------- ----
Certificates of deposit:
1 year and less ............. 113,237 74,586
1 to 2 years ................ 13,169 19,437
2 to 3 years ................ 3,570 7,486
3 to 4 years ................ 3,198 1,845
Over 4 years ................ 3,154 5,590
-------- ---------
136,328 5.96 108,944 5.88
-------- ---- --------- ----
Total deposits .............. $178,311 $136,175
======== =========
Certificates of deposit in the amount of $100,000 or more totaled
approximately $25 million and $18 million at June 30, 1998 and 1997,
respectively.
A summary of certificate accounts by scheduled fiscal year maturities at
June 30, 1998, is as follows:
(Dollars in thousands) 1999 2000 2001 2002 2003 Thereafter Total
-------- -------- -------- -------- -------- -------- --------
3.00% or less .. $ 1 $ 8 $ 9
3.01%-5.00% .... $ 9,877 $ 953 $ 55 $ 72 100 11,057
5.01%-7.00% .... 100,665 11,050 2,725 1,152 1,863 742 118,197
7.01%-9.00% .... 2,384 1,158 117 1,974 169 271 6,073
9.01% or greater 311 8 673 992
-------- -------- -------- -------- -------- -------- --------
Totals ...... $113,237 $ 13,169 $ 3,570 $ 3,198 $ 2,133 $ 1,021 $136,328
======== ======== ======== ======== ======== ======== ========
41
Interest expense on deposits is as follows:
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- --------------------------------------------------------------------------------
NOW accounts ............................ $ 166 $ 124 $ 110
Savings accounts ........................ 1,117 844 613
Money market deposit accounts ........... 101 82 77
Certificates of deposit ................. 6,919 6,416 6,351
------ ------ ------
$8,303 $7,466 $7,151
====== ====== ======
Interest expense on certificates of deposit is net of interest income on
interest rate contracts of $70,000, $130,000, and $129,000 for the years
ended June 30, 1998, 1997 and 1996, 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)
Years Ended June 30, 1998 1997
- --------------------------------------------------------------------------------
Securities sold under agreements to repurchase:
Same securities ...................................... $240,396 $191,664
Substantially identical securities ................... 53,907
-------- --------
$240,396 $245,571
-------- --------
Accrued interest on securities sold under agreements
to repurchase ........................................ $ 282 $ 300
======== ========
At June 30, 1998, securities sold under agreements to repurchase mature
within one month.
An analysis of securities sold under agreements to repurchase, excluding
related accrued interest, is as follows:
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- --------------------------------------------------------------------------------
Maximum amount outstanding at any month-end . $342,094 $343,427 $219,067
Daily average amount outstanding ............ 319,579 306,034 148,524
Weighted average interest rate at end of year 5.65% 5.47% 5.21%
Assets pledged to secure securities sold under agreements to repurchase
are concentrated among six and seven dealers as of June 30, 1998 and 1997,
respectively. The Bank exercises control over the securities pledged when
the same security is repurchased. Assets pledged are as follows:
(Dollars in thousands)
Years Ended June 30, 1998 1997
- --------------------------------------------------------------------------------
Mortgage-backed securities:
At amortized cost ........................ $245,510 $249,018
At fair value ............................ $248,537 $251,317
An analysis of the amount at risk under repurchase agreements with
counterparties exceeding 10% of stockholders' equity at June 30, 1998 is
as follows:
Weighted
Amount Accrued Average
Outstanding Interest Maturity
(Dollars in thousands) (in days)
- ---------------------------------------------------------------------------------------
Federal Home Loan Mortgage Corporation $ 34,214 $ 30 11
Federal National Mortgage Association 118,648 136 10
Merrill Lynch ........................ 8,100 8 19
Morgan Stanley Market Products, Inc. . 2,527 3 27
Nomura Securities International, Inc. 42,232 60 16
First Union .......................... 34,675 45 15
-------- --------
$240,396 $ 282
======== ========
8. FEDERAL HOME LOAN BANK ADVANCES
-------------------------------
Advances from the Federal Home Loan Bank of Indianapolis are as follows:
(Dollars in thousands)
June 30, 1998 1997
- --------------------------------------------------------------------------------
Variable Variable
Weighted Weighted
Fiscal Year Average Average
Maturity Amount Rate Amount Rate
-------- ------ ---- ------ ----
1999 $ 26,000 5.64%
1998 $ 26,000 5.78%
As of June 30, 1998 and 1997, the Bank had a blanket collateral agreement
for the Federal Home Loan Bank advances instead of utilizing specific
securities as collateral.
42
9. NOTE PAYABLE
------------
At June 30, 1998, the Company maintained a $15,000,000 loan facility from
Mercantile Bancorporation, Inc. (formerly Mark Twain Bank) consisting of a
revolving line of credit of $5,000,000, of which $3,500,000 was
outstanding as of June 30, 1998, and a $10,000,000 term loan of which
$5,000 had been repaid under the term loan at June 30, 1998. Quarterly
interest-only payments, based on the prime rate published in the Wall
Street Journal (8.50% at June 30, 1998), are payable through maturity of
June 2000. The unpaid principal balance outstanding is payable in full in
June 2000.
As of June 30, 1998, the loan was secured by the Harrington Bank, FSB
stock held by HFG, a blanket security interest in all of the Company's
assets and the assignment of certain life insurance policies owned by HFG.
Under the terms of the agreement, the Company is bound by certain
restrictive debt covenants. As of June 30, 1998, HFG was in compliance
with all such debt covenants.
10. INCOME TAXES
------------
An analysis of the income tax provision (benefit) is as follows:
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- --------------------------------------------------------------------------------
Current:
Federal ................................ $ 7 $ 451 $ 1,203
State .................................. 4 205 358
Deferred:
Federal ................................ (989) 484 (776)
State .................................. (256) 121 (137)
------- ------- -------
Total income tax provision (benefit) ..... $(1,234) $ 1,261 $ 648
======= ======= =======
The difference between the financial statement provision (benefit) and
amount computed by using the statutory rate of 34% is reconciled as follows:
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- ------------------------------------------------------------------------------------------
Federal statutory income tax at 34% .......... $(1,052) $ 1,109 $ 636
Tax exempt interest and dividends ............ (12) (14) (29)
State income taxes, net of federal tax benefit (166) 185 129
Amortization of fair value adjustments ....... (1) (12) (53)
Other, net ................................... (3) (7) (35)
------- ------- -------
Total income tax provision (benefit) ......... $(1,234) $ 1,261 $ 648
======= ======= =======
The Company's deferred income tax assets and liabilities are as follows:
(Dollars in thousands)
Years Ended June 30, 1998 1997
- --------------------------------------------------------------------------------
Deferred tax assets:
Net operating loss carryforward ....................... $ 1,016
Tax benefit from exercise of non-qualified options .... 266
Bad debt reserves, net ................................ 15
Deferred compensation ................................. 24 $ 35
Deferred loan fees/costs, net ......................... 1 9
Differences in depreciation methods ................... 3 2
Unrealized loss on securities available for sale ...... 1 23
Other ................................................. 57 27
------- -------
1,383 96
------- -------
Deferred tax liabilities:
Bad debt reserves, net ................................ 43
Unrealized gain on securities held for trading ........ 793 951
Differences in income recognition on investments ...... 350 351
------- -------
1,143 1,345
------- -------
Deferred income taxes, net .............................. $ 240 $(1,249)
======= =======
The Company's net operating loss carryforward expires in fiscal year 2013.
Retained earnings at June 30, 1998 and 1997 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. The Bank has delayed the timing of this recapture for
taxable years 1998 and 1997 as certain residential loan test requirements
were met. The six year recovery period for the excess reserves will begin
in taxable year 1999. The adoption of the act did not have a material
adverse effect on the Company's consolidated financial position.
43
11. REGULATORY CAPITAL REQUIREMENTS
-------------------------------
The Bank is subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum
capital requirements can initiate certain mandatory and possibly
additional discretionary actions by regulators that, if undertaken, could
have a direct material effect on the Bank's financial statements. Under
capital adequacy guidelines and the regulatory framework for prompt
corrective action, the Bank must meet specific capital guidelines that
involve quantitative measures of the Bank's assets, liabilities, and
certain off-balance-sheet items as calculated under regulatory accounting
practices. The Bank's capital amounts and classification are also subject
to qualitative judgments by the regulators about components, risk
weightings, and other factors.
Quantitative measures that have been established by regulation to ensure
capital adequacy require the Bank to maintain minimum capital amounts and
ratios (set forth in the table below). The Bank's primary regulatory
agency, the OTS, currently requires that the Bank maintain minimum ratios
of tangible capital (as defined in the regulations) of 1.5%, core capital
(as defined) of 4%, and total risk-based capital (as defined) of 8%. The
Bank is also subject to prompt corrective action capital requirement
regulations set forth by the Federal Deposit Insurance Corporation
("FDIC"). The FDIC requires the Bank to maintain minimum capital amounts
and ratios of total and Tier I capital (as defined in the regulations) to
risk-weighted assets (as defined), and of Tier I capital (as defined) to
average assets (as defined). Management believes, as of June 30, 1998,
that the Bank meets all capital adequacy requirements to which it is
subject.
As of June 30, 1998 and 1997, the most recent notification from the OTS
categorized the Bank as "well capitalized" under the regulatory framework
for prompt corrective action. To be categorized as "well capitalized" the
Bank must maintain minimum total risk-based, Tier I risk-based and Tier I
leverage ratios as set forth in the table. There are no conditions or
events since that notification that management believes have changed the
institution's category.
To Be Categorized as
"Well Capitalized"
Under Prompt
For Capital Corrective Action
(Dollars in thousands) Actual Adequacy Purposes Provisions
- -----------------------------------------------------------------------------------------------------------------------
Amount Ratio Amount Ratio Amount Ratio
As of June 30, 1998:
Tangible capital (to total assets) ........ $33,240 6.88% $ 7,247 1.50% N/A N/A
Core capital (to total assets) ............ 33,240 6.88% 19,326 4.00% N/A N/A
Total risk-based capital (to risk weighted
assets) ................................. 33,596 21.92% 12,262 8.00% $15,328 10.00%
Tier I risk-based capital (to risk weighted
assets) ................................. 33,240 21.69% N/A N/A 9,197 6.00%
Tier I leverage capital (to average assets) 33,240 6.88% N/A N/A 24,158 5.00%
------- ----- ------- ---- ------- -----
As of June 30, 1997:
Tangible capital (to total assets) ........ $31,031 6.96% $ 6,687 1.50% N/A N/A
Core capital (to total assets) ............ 31,031 6.96% 13,375 3.00% N/A N/A
Total risk-based capital (to risk weighted
assets) ................................. 31,239 31.14% 8,025 8.00% $10,032 10.00%
Tier I risk-based capital (to risk weighted 31,031 30.93% N/A N/A 6,020 6.00%
assets)
Tier I leverage capital (to average assets) 31,031 6.96% N/A N/A 22,292 5.00%
------- ----- ------- ---- ------- -----
44
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, 1998, 1997 and 1996 were $87,000, $85,000, and $39,000,
respectively.
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 prices at least equal to the
fair market value of the stock on the date of the grant. The options are
nontransferable and are forfeited upon termination of employment, as
applicable. At June 30, 1998, all outstanding stock options were
exercisable through May 2008. The following is an analysis of stock option
activity for each of the three years in the period ended June 30, 1998 and
the stock options outstanding at the end of the respective years:
1998 1997 1996
Weighted Weighted Weighted
Average Average Average
Years Ended June 30, Shares Price Shares Price Shares Price
- -----------------------------------------------------------------------------------------------------------------------
Outstanding, beginning of fiscal year .. 176,450 $ 8.08 $ 155,700 $ 7.70 163,200 $ 7.32
Granted ................................ 31,950 12.11 21,000 10.89 26,612 7.51
Exercised .............................. (143,200) 7.50 (30,112) 5.48
Forfeited or expired ................... (5,200) 11.25 (250) 10.00 (4,000) 7.50
-------- --------- --------- --------- --------- -------
Outstanding, end of fiscal year ........ 60,000 $ 11.33 $ 176,450 $ 8.08 $ 155,700 $ 7.70
======== ========= ========= ========= ========= =======
Options exercisable at end of
fiscal year ........................... 8,310 $ 10.42 2,500 $ 10.00 -- --
======== ========= ========= ========= ========= =======
As of June 30, 1998, options outstanding have exercise prices between
$10.00 and $12.50 and a weighted average remaining contractual life of 9
years.
The Company applies APB Opinion No. 25, Accounting for Stock Issued to
Employees, and related interpretations in accounting for the plans;
accordingly, since the grant price of the stock options is at least 100%
of the fair value at the date of the grant no compensation expense has
been recognized by the Company in connection with the option grants. Had
compensation cost for the plans been determined based on the fair value at
the grant dates for awards under the plan consistent with the fair value
method of SFAS No. 123, Accounting for Stock-Based Compensation, the
Company's net per share would have decreased to the pro forma amounts
indicated below:
(Dollars in thousands, except per share data)
Years Ended June 30, 1998 1997 1996
- ----------------------------------------------------------------------------
Net income (loss):
As reported .......................... $ (1,859) $ 2,002 $ 1,223
Pro forma ........................... $ (1,875) $ 1,995 $ 1,221
Basic earnings (loss) per share:
As reported .......................... $ (0.57) $ 0.61 $ 0.57
Pro forma ............................ $ (0.57) $ 0.61 $ 0.57
Diluted earnings (loss) per share:
As reported .......................... $ (0.57) $ 0.61 $ 0.56
Pro forma ............................ $ (0.57) $ 0.60 $ 0.55
45
The weighted average fair value of options granted was $3.72, $3.42 and
$1.51 in fiscal years 1998, 1997 and 1996, respectively. The fair value of
the option grants is estimated on the date of grant using the
Black-Scholes option pricing model with the following assumptions:
dividend yields ranging from 0% - 1.04%, risk-free interest rates ranging
from 5.29% - 6.62%, expected volatilities ranging from 0% - 26.83% and
expected lives ranging from 23 days to five years. The pro forma amounts
are not representative of the effects on reported net income for future
years.
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
are eligible to participate in the ESOP. During the 1997 fiscal year, the
ESOP purchased 5,000 shares at $10.25 per share which have been allocated
to eligible employees. During the 1996 fiscal year, the ESOP purchased
7,000 shares in the initial public offering which have been allocated to
eligible employees. Contributions are 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 or
committed to be contributed to the ESOP by the Company) for fiscal years
1998, 1997 and 1996 was $73,000, $51,000 and $70,000, respectively.
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 market value of its
trading portfolio. The interest rate caps and floors generally have
indexes equal to one or 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
repricings.
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 $2,100,000 and $1,300,000 at June
30, 1998 and 1997, 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 hedging activities. The Bank maintains trading positions with a
variety of counterparties or obligors (counterparties). To limit credit
exposure arising from such transactions, the Bank evaluates the credit
standing of counterparties, 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
counterparties and records gains and losses on derivative financial
instruments net in the trading portfolio.
46
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 counterparties
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. Counterparties 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.
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, 1998
- ------------------------------------------------------------------------------------------------------------------------
Contract or Estimated
Notional Fair Value Weighted Average Interest Rate
Amount Asset Liability Payable Receivable Cap Floor
------ ----- --------- ------- ---------- --- -----
Interest rate swaps:
Pay fixed rate ... $ 121,000 $ 397 6.16% 5.67% N/A N/A
Interest rate caps . 133,000 $ 227 N/A N/A 7.92% N/A
Interest rate floors 250,000 4,440 N/A N/A N/A 6.25%
Interest rate collar 3,076 22 N/A N/A 10.25% 5.25%
Futures ............ 2,780,300 257 N/A N/A N/A N/A
Options ............ 66,000 50 N/A N/A N/A N/A
----------------------------------------------------------------------------------------------
$3,353,376 $ 4,717 $ 676
========== ========== =========
(Dollars in thousands)
June 30, 1997
- -----------------------------------------------------------------------------------------------------------------------
Contract or Estimated
Notional Fair Value Weighted Average Interest Rate
Amount Asset Liability Payable Receivable Cap Floor
------ ----- --------- ------- ---------- --- -----
Interest rate swaps:
Pay fixed rate ... $ 267,500 $ 581 5.92% 5.80% N/A N/A
Interest rate caps . 133,000 1,545 N/A N/A 7.92% N/A
Interest rate floors 275,000 3,541 N/A N/A N/A 6.38%
Interest rate collar 4,268 $ 8 N/A N/A 10.25% 5.25%
Futures ............ 1,546,400 356 N/A N/A N/A N/A
Options ............ 77,900 24 N/A N/A N/A N/A
---------- ---------- ------ --------------------------------------------------
$2,304,068 $ 6,047 $ 8
========== ========== ======
(Dollars in thousands)
Years Ended June 30, 1998 1997
- -----------------------------------------------------------------------------------
Monthly Monthly
Average Average
Fair Value Fair Value
--------------------------------------------
Asset Liability Asset Liability
Interest rate swaps:
Pay fixed rate .................. $ 376 $ 952 $ 45
Interest rate caps ............... $ 720 2,389
Interest rate floors ............. 4,946 4,945
Interest rate collar ............. 19 13
Futures .......................... 256 95
Options .......................... 125 154
--------------------------------------------
$5,791 $ 651 $8,440 $ 153
--------------------------------------------
47
The following table shows the various components of the Company's recorded
net gain on its trading portfolio. All realized and unrealized gains and
losses are reported as other income in the statement of operations. 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 statements of operations as interest income.
(Dollars in thousands)
Realized Unrealized Net Trading
Gains/ Gains/ Gains/
Year Ended June 30, 1998 (Losses) (Losses) (Losses)
- --------------------------------------------------------------------------------
Interest rate contracts:
Swaps ............................. $ 13 $ (978) $ (965)
Caps .............................. (677) (677)
Floors ............................ 1,405 1,405
Collar ............................ (2) (2)
Futures ........................... (7,961) (613) (8,574)
Options ........................... 332 36 368
------- ------- -------
Total ............................. (7,616) (829) (8,445)
MBS and other trading assets ...... 6,841 (101) 6,740
======= ======= =======
Total trading portfolio ........... $ (775) $ (930) $(1,705)
======= ======= =======
(Dollars in thousands)
Realized Unrealized Net Trading
Gains/ Gains/ Gains/
Year Ended June 30, 1997 (Losses) (Losses) (Losses)
- --------------------------------------------------------------------------------
Interest rate contracts:
Swaps ............................. $ (39) $ (39)
Caps .............................. (862) (862)
Floors ............................ (810) (810)
Collar ............................ 32 32
Futures ........................... $(5,045) 1,140 (3,905)
Options ........................... 114 (65) 49
------- ------- -------
Total ............................. (4,931) (604) (5,535)
MBS and other trading assets ...... 3,308 2,721 6,029
------- ------- -------
Total trading portfolio ........... $(1,623) $ 2,117 $ 494
======= ======= =======
(Dollars in thousands)
Realized Unrealized Net Trading
Gains/ Gains/ Gains/
Year Ended June 30, 1996 (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)
======= ======= =======
48
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,
1998.
(Dollars in thousands)
Maturities During Fiscal
Years Ending June 30, 1999 2000 2001 2002 2003 Thereafter
- ------------------------------------------------------------------------------------------------------------------------------------
Interest rate swaps-Pay fixed rate
Notional amount ................. $100,000 $ 16,000 $ 5,000
Weighted average payable rate ... 6.12% 6.27% 6.58%
Weighted average receivable rate 5.66% 5.69% 5.66%
Interest rate caps
Notional amount ................ 37,000 10,000 $ 66,000 $ 20,000
Weighted average cap rate ...... 8.09% 6.50% 7.71% 9.00%
Interest rate floors
Notional amount ................ 60,000 30,000 70,000 $ 20,000 60,000 15,000
Weighted average floor rate .... 6.42% 6.50% 6.50% 6.00% 5.75% 6.50%
Interest rate collar
Notional amount ................ 3,076
Weighted average cap rate ...... 10.25%
Weighted average floor rate .... 5.25%
Futures
Notional amount ................ 766,300 479,000 505,000 475,000 348,000 207,000
Options
Notional amount ................. 66,000
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, 1998 and 1997, the Bank held approximately $5.2 million and
$6.2 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. The
interest rate swaps protect the Bank against the exposure to falling
interest rates inherent in these CDs.
The Bank also has interest caps which are used to effectively cap the
interest rates on specific floating-rate borrowings. As of June 30, 1998,
the Bank held three 6% and one 7% interest rate caps which are used to
effectively cap the interest rates on a portion of the Company's
securities sold under agreements to repurchase and the $26 million Federal
Home Loan Bank advance. As of June 30, 1998, the caps had a total notional
amount of $90 million and reprice based on the three month LIBOR. The
repricing characteristics of the Company's floating-rate borrowings are
similar in nature to those of the related interest rate cap agreements.
The securities sold under agreements to repurchase and the Federal Home
Loan Bank advance reach their maturities before the maturities of the
matched interest rate caps; however, it is the Bank's intent to replace
the floating-rate borrowings when they mature with additional
floating-rate liabilities, which will be designated against the interest
rate caps.
The Bank had a 7% interest rate cap as of June 30, 1997, which was used to
effectively cap the interest rate on the Company's floating-rate Federal
Home Loan Bank advances. As of June 30, 1997, the cap had a notional
amount of $30 million and repriced based on the three month LIBOR.
49
The market values of the following interest rate swaps and interest rate
caps are not reflected in the Company's financial statements. The periodic
exchanges of interest payments and the net expense of the interest rate
caps are included in interest expense in the statements of operations.
(Dollars in thousands)
Contract or Estimated Fair Value Weighted Average Interest Rate
Notional --------------------------------------------------------
June 30, 1998 Amount Asset Liability Payable Receivable
- ---------------------------------------------------------------------------------------------------------------
Interest rate swaps:
Pay floating rate ......... $ 7,500 $ 137 5.74% 6.96%
Interest rate caps .......... $90,000 $ 2,495 N/A N/A
(Dollars in thousands)
Contract or Estimated Fair Value Weighted Average Interest Rate
Notional --------------------------------------------------------
June 30, 1997 Amount Asset Liability Payable Receivable
- ---------------------------------------------------------------------------------------------------------------
Interest rate swaps:
Pay floating rate ........ $ 7,500 $ 91 6.00% 6.96%
Interest rate cap .......... $30,000 $ 351 N/A N/A
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 caps used to cap a portion of the Bank's securities sold under
agreements to repurchase and the Federal Home Loan Bank advance as of June
30, 1998:
(Dollars in thousands)
Maturities During Fiscal
Years Ending June 30, 1999 2000 2001 2002 2003 Thereafter
- ----------------------------------------------------------------------------------------------------------------
Interest rate swaps-Pay
floating rate
Notional amount .......................... $ 7,500
Weighted average payable rate ........... 5.74%
Weighted average receivable rate ......... 6.96%
Interest rate caps
Notional amount .......................... $ 30,000 $ 60,000
Weighted average cap rate ................ 7.00% 6.00%
50
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.
The following table sets forth the Bank's real estate loan commitments
whose contract amounts represent credit risk and the applicable range of
interest rates for such loan commitments.
(Dollars in thousands)
June 30, 1998 1997
- --------------------------------------------------------------------------------
Interest Interest
Amount Rates Amount Rates
------ ----- ------ -----
Fixed rate ............ $11,863 6.75-10.00% $ 573 7.625-8.375%
Adjustable Rate ....... 2,609 6.50-7.50%
------- -------
$11,863 $ 3,182
======= =======
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 and directors of HFG are also principals of SBA. The
amount of consulting expense relating to SBA for fiscal years ending June
30, 1998, 1997 and 1996 was $287,000, $281,000 and $232,000 respectively.
SBA has a commercial loan outstanding with the Bank at June 30, 1998, see
Note 4.
16. STOCKHOLDERS' EQUITY AND REGULATORY MATTERS
-------------------------------------------
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, $7,362,000 was available for
dividends at June 30, 1998.
Reserve Requirements -As of June 30, 1998, the Bank was not required to
maintain reserve balances with the Federal Reserve Bank.
SAIF Assessment -On September 30, 1996, the President signed into law an
omnibus appropriations act for fiscal year 1997 that included, among other
things, the recapitalization of the Savings Association Insurance Fund
(SAIF) in a section entitled "The Deposit Insurance Funds Act of 1996"
(the Act). The Act included a provision where all insured depository
institutions would be charged a one-time special assessment on their SAIF
assessable deposits as of March 31, 1995. The Company recorded a pre-tax
charge of $830,000 during the year ended June 30, 1997.
51
17. FAIR VALUES OF FINANCIAL INSTRUMENTS
------------------------------------
The following disclosures of the estimated fair value of financial
instruments are made in accordance with the requirements of SFAS No. 107,
Disclosures about Fair Value of Financial Instruments:
(Dollars in thousands)
June 30, 1998 1997
- ------------------------------------------------------------------------------------
Carrying Fair Carrying Fair
Value Value Value Value
--------------------------------------------
ASSETS:
Cash .............................. $ 1,567 $ 1,567 $ 1,207 $ 1,207
Interest-bearing deposits ........ 10,212 10,212 8,309 8,309
Securities held for trading ....... 290,609 290,609 317,355 317,355
Securities available for sale ..... 922 922 1,125 1,125
Loans receivable, net ............. 163,546 166,400 93,958 94,800
Interest receivable ............... 2,318 2,318 2,080 2,080
Federal Home Loan Bank stock ...... 4,878 4,878 4,852 4,852
Due from brokers .................. 11,308 11,308
LIABILITIES:
Deposits .......................... 178,311 178,400 136,175 136,200
Securities sold under agreements
to repurchase ................... 240,396 240,400 245,571 245,600
Federal Home Loan Bank advances ... 26,000 26,000 26,000 26,000
Interest payable on securities sold
under agreements to repurchase .. 282 282 300 300
Other interest payable ............ 1,596 1,596 787 787
Note payable ...................... 13,495 13,495 9,995 9,995
Advance payments by borrowers for
taxes and insurance ............. 785 785 585 585
OFF BALANCE SHEET HEDGING
INSTRUMENTS:
Interest rate swaps ............... 137 91
Interest rate caps ................ 3,595 2,495 685 351
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,
principal-only strips, interest rate swaps, an interest rate collar,
interest rate caps, interest rate floors, options, futures and equity
securities. 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.
52
Due from brokers consists of amounts receivable from sales of securities
in which the transactions have not settled as of the balance sheet date.
The fair value is determined by the carrying amounts of the securities
sold.
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 NOW, savings and money market deposit
accounts is the amount payable on demand at the reporting date. The fair
value of fixed maturity certificates is estimated using rates currently
offered for deposits of similar remaining maturities.
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
interest rate caps used to modify the interest rate sensitivity of certain
certificates of deposits, a portion of the Bank's securities sold under
agreements to repurchase and the Federal Home Loan Bank advance. 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, 1998 and 1997. 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 such dates,
and therefore, current estimates of fair value may differ significantly
from the amounts presented herein.
53
18. HARRINGTON FINANCIAL GROUP, INC. FINANCIAL INFORMATION
(PARENT COMPANY ONLY)
------------------------------------------------------
The following condensed balance sheets as of June 30, 1998 and 1997, and
condensed statements of operations and cash flows for the three years in
the period ended June 30, 1998 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, 1998 1997
- --------------------------------------------------------------------------------
ASSETS
Cash and cash equivalents .......................... $ 1,944 $ 3,500
Securities held for trading ....................... 199 464
Deferred income taxes, net ......................... 791
Income taxes receivable ............................ 23 124
Other assets ....................................... 146 55
Intercompany receivable (payable) .................. 5 (1)
Investment in subsidiary ........................... 33,240 30,997
-------- --------
TOTAL ASSETS ....................................... $ 36,348 $ 35,139
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Note payable ....................................... $ 13,495 $ 9,995
Deferred income taxes, net ......................... 63
Accrued expenses payable and other liabilities ..... 189 87
-------- --------
Total liabilities .............................. 13,684 10,145
-------- --------
Common stock ....................................... 425 407
Additional paid-in capital ......................... 16,962 15,623
Treasury stock ..................................... (1,467)
Unrealized loss on securities available for sale ... (1) (35)
Retained earnings .................................. 6,745 8,999
-------- --------
Total stockholders' equity ..................... 22,664 24,994
-------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ......... $ 36,348 $ 35,139
======== ========
CONDENSED STATEMENTS OF OPERATIONS
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- ----------------------------------------------------------------------------------------
Dividends from subsidiary ........................... $ 4,000 $ 855
Interest income from securities held for trading .... $ 6 76 8
Interest on deposits ................................ 18 8 12
Gain on sale of securities held for trading ......... 94 12 42
Unrealized gain (loss) on securities held for trading (59) 105 28
------- ------- -------
Total income .................................... 59 4,201 945
------- ------- -------
Interest expense on long-term borrowings ............ 981 907 905
Salaries and employee benefits ...................... 263 231 105
Other expenses ...................................... 249 315 12
------- ------- -------
Total expenses .................................. 1,493 1,453 1,022
------- ------- -------
Income (loss) before equity in undistributed earnings (1,434) 2,748 (77)
Income tax provision (benefit) ...................... (566) (509) (359)
Equity in undistributed earnings of subsidiary ...... (991) (1,255) 941
------- ------- -------
Net income (loss) ................................... $(1,859) $ 2,002 $ 1,223
======= ======= =======
54
CONDENSED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- ---------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) ........................................... $ (1,859) $ 2,002 $ 1,223
Adjustments to reconcile net income (loss) to net
cash provided by (used
in) operating activities:
Decrease (increase) in other assets ....................... (91) 27 8
Decrease (increase) in income taxes receivable ............ 118 (124)
Decrease (increase) in intercompany receivable ............ (6) 71 (70)
Increase (decrease) in accrued expenses and other
liabilities ............................................. 102 (10) 83
Gain on sale of securities held for trading ............... (94) (12) (42)
Unrealized gain (loss) on securities held for trading ..... 59 (105) (28)
Purchases of securities held for trading .................. (2,000) (545)
Proceeds from sales of securities held for trading ........ 2,300 203 314
Deferred income tax provision ............................. (588) 53 16
Increase in accrued income taxes .......................... 210 211
Decrease (increase) in undistributed earnings of subsidiary 991 1,255 (941)
-------- -------- --------
Net cash provided by (used in)
operating activities ................................. (1,068) 3,570 229
-------- -------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital contributions to subsidiary ........................ (3,200) (6,240) (6,792)
-------- -------- --------
Net cash used in investing activities .................. (3,200) (6,240) (6,792)
-------- -------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock
under initial public offering ............................ 11,437
Proceeds from stock options exercised ...................... 1,074 165
Proceeds from note payable ................................. 3,500 2,300 800
Principal repayments on note payable ....................... (1,303) (1,002)
Dividends paid on common stock ............................. (395) (98)
Purchase of treasury stock ................................. (1,467)
-------- -------- --------
Net cash provided by financing activities .............. 2,712 899 11,400
-------- -------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ........ (1,556) (1,771) 4,837
CASH AND CASH EQUIVALENTS,
Beginning of year .......................................... 3,500 5,271 434
-------- -------- --------
CASH AND CASH EQUIVALENTS,
End of year ................................................ $ 1,944 $ 3,500 $ 5,271
======== ======== ========
55
INDEPENDENT AUDITORS' REPORT
Board of Directors and Stockholders
Harrington Financial Group, Inc.
Richmond, Indiana
- -----------------------------------
We have audited the accompanying consolidated balance sheets of Harrington
Financial Group, Inc. and its subsidiary (the "Company") as of June 30, 1998 and
1997, and the related consolidated statements of operations, changes in
stockholders' equity and cash flows for each of the three years in the period
ended June 30, 1998. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with 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 consolidated financial statements present fairly, in all
material respects, the financial position of Harrington Financial Group, Inc.
and its subsidiary as of June 30, 1998 and 1997, and the results of their
operations and their cash flows for each of the three years in the period ended
June 30, 1998 in conformity with generally accepted accounting principles.
/s/DELOITTE & TOUCHE LLP
- ------------------------
DELOITTE & TOUCHE LLP
Indianapolis, Indiana
July 27, 1998
56