UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from _____________ to ____________
Commission File Number 0-27940
HARRINGTON FINANCIAL GROUP, INC.
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(Exact name of registrant as specified in its charter)
Indiana 48-1050267
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
722 East Main
Richmond, Indiana 47374
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(Address of principal executive office) (Zip Code)
(765) 962-8531
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(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [ X ] No [ ]
Indicate the number of shares outstanding of each of the issuer's
classes of common stock, as of the latest practicable date: As of November 5,
1998, there were issued and outstanding 3,205,339 shares of the Registrant's
Common Stock, par value $.125 per share.
HARRINGTON FINANCIAL GROUP, INC. AND SUBSIDIARY
TABLE OF CONTENTS
Page
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Part I. Financial Information
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Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 1998
(unaudited) and June 30, 1998 1
Consolidated Statements of Operations (unaudited) for the three
months ended September 30, 1998 and 1997. 2
Consolidated Statements of Cash Flows (unaudited) for the three
months ended September 30, 1998 and 1997. 3
Notes to Unaudited Consolidated Financial Statements 4
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 6
Item 3. Quantitative and Qualitative Disclosures About Market Risk 13
Part II. Other Information
Item 1. Legal Proceedings 15
Item 2. Changes in Securities 15
Item 3. Defaults Upon Senior Securities 15
Item 4. Submission of Matters to a Vote of Security-Holders 15
Item 5. Other Information 15
Item 6. Exhibits and Reports on Form 8-K 15
Signatures
HARRINGTON FINANCIAL GROUP, INC. AND SUBSIDIARY
Consolidated Balance Sheets
(Dollars in Thousands)
(Unaudited)
September 30, June 30,
1998 1998
--------- ---------
ASSETS
Cash ...................................................... $ 1,470 $ 1,567
Interest-bearing deposits ................................. 6,217 10,212
--------- ---------
Total cash and cash equivalents ......................... 7,687 11,779
Securities held for trading - at fair value
(amortized cost of $340,702 and $289,137) ............... 347,945 290,609
Securities available for sale - at fair value
(amortized cost of $903 and $924) ....................... 923 922
Loans receivable, net ..................................... 188,747 163,546
Interest receivable, net .................................. 2,552 2,318
Premises and equipment, net ............................... 5,960 5,614
Federal Home Loan Bank of Indianapolis stock .............. 4,878 4,878
Other ..................................................... 7,226 4,731
========= =========
Total assets ............................................ $ 565,918 $ 484,397
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits .................................................. $ 210,412 $ 178,311
Securities sold under agreements to repurchase ............ 292,470 240,396
Federal Home Loan Bank advances ........................... 26,000 26,000
Interest payable on securities sold under agreements to
repurchase .............................................. 326 282
Other interest payable .................................... 2,123 1,596
Note payable .............................................. 13,495 13,495
Advance payments by borrowers for taxes & insurance ....... 1,217 785
Accrued expenses payable and other liabilities ............ 716 868
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Total liabilities ....................................... 546,759 461,733
--------- ---------
Common stock .............................................. 425 425
Additional paid-in-capital ................................ 16,946 16,962
Treasury stock, 194,599 and 124,052 shares at cost ........ (2,162) (1,467)
Retained earnings ......................................... 3,938 6,745
Accumulated other comprehensive income (loss), net of taxes 12 (1)
--------- ---------
Total stockholders' equity .............................. 19,159 22,664
--------- ---------
Total liabilities and stockholders' equity ............ $ 565,918 $ 484,397
========= =========
See notes to unaudited consolidated financial statements.
-1-
HARRINGTON FINANCIAL GROUP, INC. AND SUBSIDIARY
Consolidated Statements of Operations
(Dollars in Thousands Except Share Data)
(Unaudited)
Three Months Ended
September 30,
---------------------
1998 1997
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INTEREST INCOME
Securities held for trading ....................... $ 5,768 $ 6,077
Securities available for sale ..................... 20 25
Loans receivable .................................. 3,196 1,824
Dividends on Federal Home Loan Bank stock ......... 99 101
Deposits .......................................... 117 309
Net interest expense on interest rate contracts
maintained in the trading portfolio ............. (282) (199)
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Interest income ................................... 8,918 8,137
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INTEREST EXPENSE
Deposits .......................................... 2,726 1,908
Federal Home Loan Bank advances ................... 501 422
Short-term borrowings ............................. 4,454 4,004
Long-term borrowings .............................. 294 218
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Interest expense .................................. 7,975 6,552
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NET INTEREST INCOME .................................. 943 1,585
PROVISION FOR LOAN LOSSES ............................ 150 --
------- -------
NET INTEREST INCOME AFTER
PROVISION FOR LOAN LOSSES ......................... 793 1,585
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OTHER INCOME (LOSS)
Loss on sale of securities held for trading ....... (9,240) (198)
Unrealized gain on securities held for trading .... 5,771 323
Other ............................................. 100 68
------- -------
Total other income (loss) ......................... (3,369) 193
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HARRINGTON FINANCIAL GROUP, INC. AND SUBSIDIARY
Consolidated Statements of Operations
(Dollars in Thousands Except Share Data)
(Unaudited)
(continued)
Three Months Ended
September 30,
---------------------
1998 1997
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OTHER EXPENSE
Salaries and employee benefits .................... 947 649
Premises and equipment expense .................... 288 152
FDIC insurance premiums ........................... 26 21
Marketing ......................................... 100 24
Computer services ................................. 82 47
Consulting fees ................................... 74 70
Other ............................................. 397 294
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Total other expenses .............................. 1,914 1,257
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INCOME (LOSS) BEFORE INCOME TAX
PROVISION ......................................... (4,490) 521
INCOME TAX PROVISION (BENEFIT) ....................... (1,780) 204
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NET INCOME (LOSS) .................................... $(2,710) $ 317
======= =======
BASIC EARNINGS (LOSS) PER SHARE ...................... $ (0.83) $ 0.10
======= =======
DILUTED EARNINGS (LOSS) PER SHARE .................... $ (0.83) $ 0.10
======= =======
See notes to unaudited consolidated financial statements.
-2-
HARRINGTON FINANCIAL GROUP, INC. AND SUBSIDIARY
Consolidated Statements of Cash Flows
(Dollars in Thousands)
(Unaudited)
Three Months Ended
September 30,
------------------------
1998 1997
--------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) .............................................. $ (2,710) $ 317
Adjustments to reconcile net income (loss) to net cash used
in operating activities:
Provision for loan losses ................................... 150 --
Depreciation ................................................ 123 69
Premium and discount amortization of securities, net ........ 400 333
Amortization of premiums and discounts on loans ............. 44 15
Loss on sale of securities held for trading ................. 9,240 198
Unrealized gain on securities held for trading .............. (5,771) (323)
Deferred income tax provision ............................... (141) (31)
Increase in interest receivable ............................. (234) (165)
Increase in interest payable ................................ 571 742
Increase in accrued income taxes ............................ -- 236
Increase in income tax receivable ........................... (1,555) --
Purchases of securities held for trading ................... (189,265) (277,950)
Decrease in amounts due from brokers ........................ -- 11,308
Proceeds from maturities of securities held for trading ..... 10,076 6,306
Proceeds from sales of securities held for trading .......... 117,984 193,973
Decrease (increase) in other assets ......................... (799) 106
Increase (decrease) in accrued expenses and other liabilities 280 (349)
--------- ---------
Net cash used in operating activities .................... (61,607) (65,215)
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturities of securities available for sale ... 13 97
Change in loans receivable, net ............................. (25,395) (5,654)
Purchases of premises and equipment ......................... (469) (171)
--------- ---------
Net cash used in investing activities ..................... (25,851) (5,728)
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HARRINGTON FINANCIAL GROUP, INC. AND SUBSIDIARY
Consolidated Statements of Cash Flows
(Dollars in Thousands)
(Unaudited)
(continued)
Three Months Ended
September 30,
------------------------
1998 1997
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CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits .................................... 32,101 2,746
Increase in securities sold under agreements to repurchase .. 52,074 70,674
Proceeds from Federal Home Loan Bank advances ............... 13,000 --
Principal repayments on Federal Home Loan Bank advances ..... (13,000) --
Purchase of treasury stock .................................. (784) --
Proceeds from issuance of treasury stock .................... 73 --
Dividends paid on common stock .............................. (98) (98)
--------- ---------
Net cash provided by financing activities ................. 83,366 73,322
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NET INCREASE (DECREASE) IN CASH AND EQUIVALENTS ................ (4,092) 2,379
CASH AND CASH EQUIVALENTS
Beginning of period ......................................... 11,779 9,516
--------- ---------
CASH AND CASH EQUIVALENTS
End of period ............................................... $ 7,687 $ 11,895
========= =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW
INFORMATION:
Cash paid for interest ...................................... $ 8,440 $ 7,263
Cash paid for income taxes .................................. 43 --
See notes to unaudited consolidated financial statements.
-3-
HARRINGTON FINANCIAL GROUP, INC. AND SUBSIDIARY
Notes to Unaudited Consolidated Financial Statements
Note 1 - Business of the Company
Harrington Financial Group, Inc. (the "Company") is a savings and loan
holding company incorporated in 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 seven full-service branch offices located in Carmel,
Fishers, Noblesville and Indianapolis, Indiana, and Mission, Kansas. The
Company is a growing community bank with a focus on the origination and
management of mortgage loans and securities. The Company also operates a
commercial loan division for business customers and a trust and
investment management division for individuals.
Earnings per Share
The following is a reconciliation of the weighted average common shares
for the basic and diluted earnings per share computations in accordance
with Statement of Accounting Standards (SFAS) No. 128:
Three Months Ended
September 30,
-----------------------
1998 1997
--------- ---------
Basic earnings per share:
Weighted average common shares ..... 3,250,049 3,256,738
========= =========
Diluted earnings per share:
Weighted average common shares ..... 3,250,049 3,256,738
Dilutive effect of stock options (1) -- 60,623
--------- ---------
Weighted average common and
incremental shares ............... 3,250,049 3,317,361
========= =========
(1) No dilutive effect of stock options for the three months ended
September 30, 1998 was used in the calculation as the effects of the
stock options were anti-dilutive.
Note 2 - Basis of Presentation
The accompanying unaudited consolidated financial statements of the
Company have been prepared in accordance with instructions to Form 10-Q.
Accordingly, they do not include all of the information and footnotes
required by generally accepted accounting principles for complete
financial statements. However, such information reflects all adjustments
(consisting solely of normal recurring adjustments) which are, in the
opinion of management, necessary for a fair presentation of results for
the interim periods.
The results of operations for the three months ended September 30, 1998
are not necessarily indicative of the results to be expected for the
year ending June 30, 1999. The unaudited consolidated financial
statements and notes thereto should be read in conjunction with the
audited financial statements and notes thereto for the year ended June
30, 1998.
-4-
Note 3 - Recent Accounting Pronouncements
The Company adopted SFAS No. 130, Comprehensive Income, effective July
1, 1998. It 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. All prior year financial statements have
been reclassified for comparative purposes.
The following is a summary of the Corporation's total comprehensive
income (loss) for the interim three month periods ended September 30,
1998 and 1997 under SFAS No. 130:
Three Months Ended
September 30,
--------------------
1998 1997
------- -------
Net income (loss) ..................................... $(2,710) $ 317
------- -------
Other comprehensive income, net of tax:
Unrealized gains on securities:
Unrealized holding gains arising during period
13 8
------- -------
Other comprehensive income
13 8
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COMPREHENSIVE INCOME (LOSS) ........................... $(2,697) $ 325
======= =======
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. The Company will include the appropriate segment information
beginning in the annual financial statements for the year ending June
30, 1999, and all quarterly reports thereafter. Management has not yet
determined the effect, if any, of SFAS No. 131 on the consolidated
financial statements.
SFAS No. 133, Accounting for Derivative and Similar Financial
Instruments and for 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 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 consolidated financial
statements.
-5-
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Financial Condition
At September 30, 1998, the Company's total assets amounted to $565.9
million, as compared to $484.4 million at June 30, 1998. The $81.5 million or
16.8% increase in total assets during the three months ended September 30, 1998
was primarily the result of a $57.3 million increase in securities held for
trading and a $25.2 million increase in net loans receivable. The increase in
securities held for trading was a result of utilization of the Company's
capital. The increase in net loans receivable reflected the Company's continuing
efforts to increase its retail banking operations, particularly the origination
(both directly and through correspondent mortgage banking companies) of
single-family residential loans. The increase in the Company's assets from June
30, 1998 to September 30, 1998 was funded primarily by a $52.1 million or 21.7%
increase in securities sold under agreements to repurchase and a $32.1 million
or 18.0% increase in deposits.
At September 30, 1998, the Company's stockholders' equity amounted to
$19.2 million, as compared to $22.7 million at June 30, 1998. The 15.5% decrease
in stockholders' equity was primarily due to the $2.7 million of net loss
recognized during the three month period, the quarterly $0.03 per share payments
of cash dividends totaling $98,000, and the repurchase of stock for $784,000
which was partially offset by $73,000 from the treasury stock purchased by the
Company's employee stock ownership plan. At September 30, 1998, the Bank's Tier
1 core capital amounted to $30.8 million or 5.5% of adjusted total assets, which
exceeded the minimum 4.0% requirement by $8.2 million. Additionally, as of such
date, the Bank's risk-based capital totaled $31.3 million or 16.3% of total
risk-adjusted assets, which exceeded the minimum 8.0% requirement by $16.0
million.
Results of Operations
General. The Company reported losses of $2.7 million or $0.83 per share
during the three months ended September 30, 1998, as compared to earnings of
$317,000 or $0.10 per share during the prior comparable period. The $3.0 million
decrease in earnings during the three months ended September 30, 1998, as
compared to the same period in the prior year, was primarily due to a $642,000
decrease in net interest income, a $3.6 million increase in realized and
unrealized net losses on securities held for trading and a $657,000 increase in
operating expenses which were partially offset by a $2.0 million decrease in the
Company's income tax provision.
-6-
Selected Financial Ratios. The following schedule shows selected
financial ratios for the three months ended September 30, 1998 and 1997.
At or for the Three
Months Ended
September 30,
-------------------
1998 1997
------- ---------
Return on average assets ................. -1.90% 0.26%
Return on average equity ................. -50.70 5.07
Interest rate spread (1) ................. 0.60 1.13
Net interest margin (2) .................. 0.68 1.32
Operating expenses to average assets ..... 1.34 1.02
Efficiency ratio (3) ..................... 214.33 76.04
Non-performing assets to total assets .... 0.16 0.20
Loan loss reserves to non-performing loans 188.19 60.57
- ---------
(1) Interest rate spread is the difference between interest income as a
percentage of interest-earning assets and interest expense as a percentage of
interest-bearing liabilities.
(2) Net interest margin is net interest income divided by average
interest-earning assets.
(3) The efficiency ratio is total other expense as a percentage of the net
interest income after provision for loan losses plus other income, excluding
gains and losses on securities held for trading.
Interest Income. Interest income increased by $781,000 or 9.6% during
the three months ended September 30, 1998, as compared to the same period in the
prior year. This increase was primarily due to a $1.4 million increase in
interest income from the loan portfolio which was partially offset by a $314,000
decrease in interest income from the Company's investment portfolio, an $83,000
increase in net interest expense on interest rate contracts maintained in the
trading portfolio and a $192,000 decrease in interest income from deposits. The
increase in interest income on the loan portfolio was a direct result of the
$78.9 million increase in the level of the average loan portfolio which was
partially offset by a 31 basis point decline in the interest yield earned. The
decrease in interest income from the Company's investment portfolio was a result
of the 50 basis point decline in the interest yield earned which was partially
offset by the $8.1 million increase in the level of the average investment
portfolio. The decline in the return or yield in 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. Maturities and new interest rate contract
agreements were primarily the cause of the increase in net interest expense on
interest rate contracts maintained in the trading portfolio. The decrease in
interest income from deposits was a result of the change in regulatory liquidity
requirements which allowed an average of $13.2 million in funds to be invested
in higher yielding investment opportunities.
Interest Expense. Interest expense increased by $1.4 million during the
three months ended September 30, 1998, as compared to the same period in the
prior year. This increase was primarily due to a $82.7 million increase in the
level of average interest-bearing liabilities and a 19 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.
-7-
Net Interest Income. Net interest income decreased by $642,000 or 40.5%
during the three months ended September 30, 1998, as compared to the same period
in the prior year.
Provision for Loan Losses. During the three months ended September 30,
1998, the Company increased the general allowance for loan losses by $150,000 in
response to the substantial loan growth. Delinquencies and loan write-offs
continue to be low and the non-performing assets remain stable. No additional
provision for loan losses was made during the three months ended September 30,
1997.
Other Income (Loss). Total other income (loss) amounted to $(3.4)
million during the three months ended September 30, 1998, as compared to
$193,000 during the respective period in the prior year. This income (loss)
principally represents the net market value gain or loss (realized or
unrealized) on securities held for trading, offset by the net market value gain
or loss (realized or unrealized) on interest rate contracts used for hedging
such securities. 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 a positive hedged excess return (i.e.
total return, which includes interest income plus realized and unrealized net
gains/losses on investments minus the one month LIBOR funding cost for the
period) on the investment portfolio using option-adjusted pricing analysis.
During the three months ended September 30, 1998, the Company recognized
$9.2 million of realized losses on the sale of securities held for trading which
were partially offset by $5.8 million of unrealized gains on securities held for
trading (which include interest rate contracts used for hedging purposes).
Losses on hedge contracts during the quarter ended September 30, 1998
substantially exceeded gains on mortgage investments as U.S. Treasury and
mortgage rates declined to the lowest level in many years. The primary reasons
for the underperformance of mortgages were (1) fears of an unprecedented wave of
mortgage refinancings and (2) dramatically increased volatility in many
financial markets (stocks, corporate bonds, and emerging markets). This
volatility caused a flight to quality that increased risk premiums and widened
spreads to comparable Treasury securities in all of these markets, including
mortgage securities.
During the three months ended September 30, 1997, the Company recognized
$323,000 of unrealized gains on the sale of securities and hedge contracts held
for trading which were partially offset by $198,000 of realized losses on
securities held for trading.
Other Expense. Total other expense amounted to $1.9 million during the
three months ended September 30, 1998, as compared to $1.3 million during the
respective period in the prior year. The increase in total other expense was due
to increases in salaries, premises and equipment expense, and other operating
expenses, which were primarily the result of the Company's retail growth
(including the opening of four new branch offices in the Indianapolis, Indiana
area). Furthermore, the Company added a new commercial loan division and an
additional branch in Mission, Kansas, which opened in August of 1998.
Income Tax Provision. The Company received an income tax benefit of $1.8
million during the three months ended September 30, 1998, as compared to income
tax expense of
-8-
$204,000 during the respective period in the prior year. During the three months
ended September 30, 1998, the Company's effective benefit rate amounted to 39.6%
as compared to an effective tax rate of 39.2% during the same period in 1997.
Changes in the effective tax/benefit rate were a result of different levels of
permanent differences.
Liquidity and Capital Resources
The Bank is required under applicable federal regulations to maintain
specified levels of "liquid" investments as defined by the Office of Thrift
Supervision ("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 16.6% at
September 30, 1998, as compared to 15.6% and 5.3% at June 30, 1998 and 1997,
respectively. At September 30, 1998, the Bank's average "liquid" assets totaled
approximately $88.0 million, which was $66.9 million in excess of the current
OTS minimum requirement.
At September 30, 1998, the Company's total approved originated loan
commitments outstanding amounted to $16.3 million, and the unused lines of
credit outstanding totaled $7.7 million. At the same date, commitments
outstanding to purchase investment securities and loans were $65.0 million and
$12.3 million, respectively. Certificates of deposit scheduled to mature in one
year or less at September 30, 1998 totaled $121.2 million. The Company believes
that it has adequate resources to fund ongoing commitments such as investment
security and loan purchases as well as deposit account withdrawals and loan
commitments.
"Safe Harbor" Statement under the Private Securities Litigation Reform Act of
1995
In addition to historical information, forward-looking statements are
contained herein that 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 the Company
operates), the impact of competition for the Company's customers from other
providers of financial services, the impact of government legislation and
regulation (which changes from time to time and over which the Company has no
control), and other risks detailed in this Form 10-Q and in the Company'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. The Company 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 the Company files
from time to time with the SEC.
-9-
Year 2000 Disclosure
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.
I. 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.
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 signed a contract with 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 has revised
its code and is in the process of client testing for Year 2000 compliance.
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.
-10-
II. 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.
III. 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.
IV. 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
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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 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 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
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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.
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
The OTS requires each thrift institution to calculate the estimated
change in the institution's market value of portfolio equity (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. MVPE is defined as the
net present value of an institution's existing assets, liabilities and
off-balance sheet instruments. The OTS permits institutions to perform this MVPE
analysis using their own internal model based upon reasonable assumptions. The
Company has contracted with Smith Breeden Associates, Inc. for the provision of
consulting services regarding, among other things, the management of its
investments and borrowings, the pricing of loans and deposits, the use of
various financial instruments to reduce interest rate risk and assistance 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.
The following table sets forth at September 30, 1998, the estimated
sensitivity of the Bank's MVPE to parallel yield curve shifts using the
Company'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.
In addition to this internal market value calculation based on projected
cashflows, the Company also evaluates the market value changes using time
varying empirical elasticity (TVEE) analysis. This analysis measures the market
value changes of the mortgage investment based on historical price relationships
to changes in Treasury rates and other variables. This empirical analysis is
conducted for smaller shifts in rates of plus or minus 100 basis points in 25
basis point increments. Management believes this regression based analysis is a
valuable tool in estimating the level of net market value changes of the
investment and total portfolios.
The table set forth below does not purport to show the impact of
interest rate changes on the Company'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
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instruments are marked to market and (2) over the life of the instruments as an
impact on recorded yields.
Change in Interest Rates
(In Basis Points)(1)
(Dollars in Thousands) -400 -300 -200 -100 - +100 +200 +300 +400
- -----------------------------------------------------------------------------------------------------------------------------------
Market value gain (loss) of assets $36,706 $25,241 $15,224 $ 7,319 --- $(14,721) $(36,787) $(62,065) $(88,009)
Market value gain (loss) of liabilities (5,149) (3,910) (2,672) (1,389) --- 1,550 3,307 5,299 7,466
Market value gain (loss) of net
assets before interest rate contracts 31,557 21,331 12,552 5,930 --- (13,171) (33,480) (56,766) (80,543)
Market value gain (loss) of interest
rate contracts (8,700) (8,023) (6,652) (4,294) --- 8,097 20,627 35,897 52,473
------- ------- ------- ------- -------- -------- -------- --------
Total change in MVPE (2) (Model) $22,857 $13,308 $ 5,900 $ 1,636 --- $ (5,074) $(12,853) $(20,869) $(28,070)
======= ======= ======= ======= ======== ======== ======== ========
Total change in MVPE (2) (TVEE) $(1,370) --- $ (2,904)
======= ========
Change in MVPE as a percent of:
MVPE (2) (Model) 65.0% 37.8% 16.8% 4.6% --- (14.4)% (36.5)% (59.3)% (79.8)%
Total assets of the Bank 4.0% 2.4% 1.0% 0.3% --- (0.9)% (2.3)% (3.7)% 5.0)%
(1) Assumes an instantaneous parallel change in interest rates at all
maturities.
(2) Based on the Bank's pre-tax MVPE of $35.2 million at September 30, 1998.
Since a large portion of the Company'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, the Company'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%.
Change in Interest Rates
(In Basis Points)
(Dollars in Thousands) -400 -300 -200 -100 - +100 +200 +300 +400
- -----------------------------------------------------------------------------------------------------------------------------------
After tax market value gain (loss)
of assets $ 17,627 $ 12,120 $ 7,292 $ 3,327 -- $ (5,412) $(13,522) $(23,092) $(33,165)
After tax market value gain (loss)
of interest rate contracts (4,605) (4,149) (3,334) (2,101) -- 3,963 10,022 17,350 25,362
-------- -------- -------- -------- -------- -------- -------- --------
After tax gain (loss) in equity (Model)$ 13,022 $ 7,971 $ 3,958 1,226 -- $ (1,449) $ (3,500) $ (5,742) $ (7,803)
======== ======= ======== ===== ======== ======== ======== ========
After tax gain (loss) in equity (TVEE) $ 144 -- $ (707)
======== ===== ========
After tax gain (loss) in equity as
a percent of the Company's equity
at September 30, 1998 (Model) 68.0% 41.6% 20.7% 6.4% -- (7.6)% (18.3)% (30.0)% (40.7)%
-14-
HARRINGTON FINANCIAL GROUP, INC. AND SUBSIDIARY
Part II
Item 1. Legal Proceedings
Neither the Company nor the Bank is involved in any pending legal
proceedings other than non-material legal proceedings occurring
in the ordinary course of business.
Item 2. Changes in Securities
Not applicable.
Item 3. Defaults Upon Senior Securities
Not applicable.
Item 4. Submission of Matters to a Vote of Security-Holders
Not applicable.
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
a) Exhibit 3.1: Amended and Restated Articles of
Incorporation of Harrington Financial Group, Inc. This
exhibit is incorporated herein by reference from the
Registration Statement on Form S-1 (Registration No.
333-1556) filed by the Company with the SEC on February
20, 1996, as amended.
b) Exhibit 3.2: Amended and Restated Bylaws of Harrington
Financial Group, Inc. This exhibit is incorporated herein
by reference from the Registration Statement on Form S-1
(Registration No. 333-1556) filed by the Company with the
SEC on February 20, 1996, as amended.
c) Exhibit 27: Financial Data Schedule
d) No Form 8-K reports were filed during the quarter.
-15-
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HARRINGTON FINANCIAL GROUP, INC.
Date: November 5, 1998 By: /s/ Craig J. Cerny
------------------
Craig J. Cerny
President
Date: November 5, 1998 By: /s/ Twana L. Cheek
------------------
Twana L. Cheek
Principal Financial & Accounting Officer