UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended: June 30, 1999
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File No.: 0-27940
HARRINGTON FINANCIAL GROUP, INC.
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(Exact name of registrant as specified in its charter)
Indiana 48-1050267
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(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
722 East Main Street, P. O. Box 968
Richmond, Indiana 47375
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(Address of Principal (Zip Code)
Executive Offices)
Registrant's telephone number, including area code: (765) 962-8531
Securities registered pursuant to Section 12(b) of the Act:
Not Applicable
Securities registered pursuant to Section 12(g) of the Act:
Common Stock (par value $0.125 per share)
-----------------------------------------
(Title of Class)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
As of September 16, 1999, the aggregate value of the 904,530 shares of Common
Stock of the Registrant issued and outstanding on such date, which excludes
2,300,852 shares held by all directors and executive officers of the Registrant
as a group, was approximately $6.8 million. This figure is based on the last
known trade price of $7.50 per share of the Registrant's Common Stock on
September 16, 1999.
Number of shares of Common Stock outstanding as of September 16, 1999:
3,205,382.
DOCUMENTS INCORPORATED BY REFERENCE
List hereunder the following documents incorporated by reference and the
Part of the Form 10-K into which the document is incorporated:
(1) Portions of the Annual Report to Stockholders for the fiscal year ended June
30, 1999 are incorporated into Parts II and IV.
(2) Portions of the definitive proxy statement for the Annual Meeting of
Stockholders are incorporated into Part III.
PART I.
Item 1. Business
General
Harrington Financial Group, Inc. (the "Company") is an
Indiana-chartered, registered thrift holding company for Harrington Bank, FSB
(the "Bank"). The Bank is a federally chartered savings bank which conducts
business through eight full-service offices located in Carmel, Fishers,
Noblesville, Indianapolis, and Richmond, Indiana, and Mission, Kansas. In
addition, the Bank opened its first full service banking facility in Chapel
Hill, North Carolina in July of 1999.
The Company was organized in March 1988 in connection with its
acquisition of the Bank. The Bank was originally organized in 1889 as an
Indiana-chartered savings association under the name "The Peoples Home and
Savings Association of Richmond, Indiana." In 1936, the Bank obtained federal
insurance and in 1984 adopted a federal charter and changed its name to "Peoples
Federal Savings Association." In 1985, the Bank converted from mutual to stock
form and, in March 1994, changed its name to "Harrington Bank, FSB." On May 6,
1996, the Company sold 1,265,000 shares of common stock at $10.00 per share to
investors in an initial public offering resulting in gross proceeds of
$12,650,000 to the Company. Net proceeds to the Company after offering expenses
were $11,437,000. At June 30, 1999, the Company had total consolidated assets of
$471.3 million, total consolidated borrowings of $114.2 million, total
consolidated deposits of $333.2 million, and total consolidated stockholders'
equity of $19.1 million.
The Company was organized in March 1988 by certain principals of Smith
Breeden Associates, Inc. ("Smith Breeden") for the sole purpose of acquiring the
Bank. This investor group purchased the Bank with the intention of expanding the
Bank's mortgage originations, investment and retail operations and improving the
Bank's return on equity. The Company has contracted with Smith Breeden to
provide investment advisory services and interest rate risk analysis. Certain
stockholders and directors of the Company are also principals of Smith Breeden.
Smith Breeden has a commercial loan outstanding with the Bank at June 30, 1999.
The Company's business strategy focuses on achieving attractive returns
consistent with prudent risk management. The Company has sought to implement
this strategy by (1) expanding its banking locations and product offerings in
order to build a strong community banking franchise primarily through de novo
branching; (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.
Highlights of the principal elements of the Company's business strategy are as
follows:
o Expand Banking Locations and Product Offerings. An integral part of the
Company's strategy is to increase the Bank's emphasis on
opportunistically expanding products, services and banking locations
for business and retail customers in markets where the Company's
management and directors have market knowledge and customer
relationship potential. A total of seven new banking locations were
opened since May 1994, with one being opened in fiscal year 1999. The
Company's primary lending emphasis is on the origination (both directly
and through correspondents) of loans secured by first liens on
single-family (one-to-four units) residences. Originations of such
loans have increased from $37.2 million during fiscal 1997 to $106.2
million during fiscal 1999. See "- Lending Activities." In addition,
the Company's retail deposits (including transaction accounts and
retail certificates of deposit) have increased from $123.5 million or
90.7% of total deposits at June 30, 1997 to $320.8 million or 96.3% of
total deposits at June 30, 1999. See "- Sources of Funds - Deposits."
The Company believes that single-family residential loan originations
generally offer attractive risk adjusted returns and, with respect to
direct originations, allow the Company to establish a relationship with
the underlying borrower which the Company can utilize to cross-sell
additional products and services. In addition, the Company believes
that retail deposits are a cost-effective source of funds, provide an
additional source of fee income, and also permit the further cross
selling of additional products and services. Consequently, the Company
expects to continue to focus on increasing its retail deposit base and
its portfolio of single-family residential loans. Furthermore, the
Company has developed a commercial lending division to provide funding
to commercial borrowers and to increase business deposits. The Company
also formed Harrington Wealth Management Company ("HWM") in February
1999. HWM is a strategic alliance between the Bank (51% owner) and Los
Padres Bank (49% owner), a federally chartered savings bank located in
California. HWM provides trust, investment management, and custody
services for individuals and institutions.
o Control Interest Rate Risk. The Company attempts to manage its assets
and liabilities in order to maintain a portfolio which produces
positive returns in either an increasing or decreasing interest rate
environment. The Company has sought to control interest rate risk both
internally through the management of the composition of its assets and
liabilities and externally through the utilization of interest rate
contracts. Interest rate contracts, along with mortgage backed
derivative securities, are purchased with the intention of protecting
the market value of the Bank's portfolio and net interest income.
The Company 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 the Company'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 community banking
growth opportunities. The Company recognizes that marking substantially
all of its assets to market subjects the Company to potential earnings
volatility. Market value volatility is not unique to the Company as
most unhedged financial institutions
2
have even greater volatility in market values. The difference is that
the Company reflects the changes in market values directly in earnings,
while most other institutions do not.
o Control Credit Risk. In order to limit the Company's credit exposure
and as part of its strategy to earn a positive interest rate spread,
the Company maintains a substantial portion of its assets in
mortgage-backed and related securities, which are primarily issued or
guaranteed by U.S. Government agencies or government sponsored
enterprises, and single-family residential loans. At June 30, 1999, the
Company's investment in mortgage-backed and related securities amounted
to $180.1 million or 98.0% of the Company's securities portfolio (both
held for trading and available for sale) and 38.2% of the Company's
total assets. In addition, as of such date, the Company's investment in
single-family residential loans amounted to $216.5 million or 45.9% of
total assets. See "- Lending" and "- Investment Activities."
o Utilize Excess Capital Balances. The Company utilizes excess capital
balances through the management of a hedged investment portfolio
primarily consisting of mortgage backed securities. Although
mortgage-backed securities often carry lower yields than traditional
mortgage loans, such securities generally increase the quality of the
Company's assets, as they have 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 community bank expansion opportunities as they arise.
The Company's primary goal in fiscal years 1999 and 1998 was to improve
the value of the banking franchise through profitable deposit, loan, market and
business line expansion. The market expansion into Kansas and North Carolina and
the establishment of the necessary infrastructure were substantially completed
during fiscal years 1999 and 1998. The recent losses are due primarily to the
underperformance of the investment portfolio combined with the necessary
investment spending to complete the market expansion and develop the
infrastructure to support continued growth into the future. With the foundation
now in place for its community banks in Indiana, Kansas and North Carolina, the
Company is making marked improvement in its core banking income (net interest
income after provision for loan losses plus fees minus operating expenses). Net
interest income has increased by $1.2 million over fiscal year 1998, which
reflects the tremendous growth in the Company's loan portfolio and deposits.
Furthermore, the core income deficit has been reduced from $1.1 million in the
June 1998 quarter to $219,000 in the June 1999 quarter. Contributing to this
margin improvement is a lower cost of deposits compared to initial promotional
levels, falling from 5.50% at June 30, 1998 to 4.80% at June 30, 1999. The net
interest margin also increased from 0.69% in the June 1998 quarter to 1.77% in
the June 1999 quarter.
The Company, as a registered savings and loan holding company, is
subject to examination and regulation by the Office of Thrift Supervision
("OTS") and is subject to various reporting and other requirements of the
Securities and Exchange Commission ("SEC"). The Bank, as a federally chartered
savings bank, is subject to comprehensive regulation and examination by the OTS,
as its chartering authority and primary regulator, and by the Federal Deposit
Insurance Corporation
3
("FDIC"), which administers the Savings Association Insurance Fund ("SAIF"),
which insures the Bank's deposits to the maximum extent permitted by law. The
Bank is a member of the Federal Home Loan Bank ("FHLB") of Indianapolis, which
is one of the 12 regional banks which comprise the FHLB System. The Bank is
further subject to regulations of the Board of Governors of the Federal Reserve
System ("Federal Reserve Board") governing reserves required to be maintained
against deposits and certain other matters. See "- Supervision and Regulation."
Investment Advisor
Smith Breeden is a money management and consulting firm providing
investment management services to taxable and tax-exempt clients such as
corporate, state and municipal pension funds, university endowments and mutual
fund investors and consulting and investment advisory services to taxable
financial institutions. Smith Breeden specializes in mortgage-backed and related
securities, interest rate risk management, and the application of option pricing
to loans and investments. Smith Breeden currently advises, or manages on a
discretionary basis, assets totaling over $24 billion. Over the past 17 years,
the firm has acted as a consultant to banks, thrifts and governmental agencies
charged with the regulation of financial institutions and the resolution of
troubled thrifts.
Smith Breeden was co-founded in 1982 by Douglas T. Breeden and Gregory
Smith, who retired in 1988. Dr. Breeden is Chairman of the Board of the Company.
He previously served on the faculty at Massachusetts Institute of Technology,
the University of Chicago, Stanford University, where he obtained his Ph.D. in
Finance, and Duke University's Fuqua School of Business. He is editor of the
Journal of Fixed Income.
- -----------------------
Since 1988, Smith Breeden and certain of its principals have made
equity investments in financial institutions that apply the firm's approach to
banking and investment management. Certain of the principals of Smith Breeden
are investors in a number of banks and thrift institutions.
Smith Breeden is based in Chapel Hill, North Carolina, and employs
approximately 85 people in its main office and its offices in Overland Park,
Kansas; Dallas, Texas; Boulder, Colorado and Los Angeles, California.
4
Lending Activities
General. At June 30, 1999, the Bank's net loan portfolio totaled $259.7
million, representing approximately 55.1% of the Company's $471.3 million of
total assets at that date. In addition to utilizing option-adjusted pricing
analysis in order to manage the Company's investment portfolio, the Company also
uses such analysis to price its loan originations and ascertain the net spread
expected to be earned with respect to the Bank's loan portfolio. The Bank's
primary focus with respect to its lending operations continues to be in the
direct origination and servicing of single-family residential mortgage loans.
Since fiscal 1995, the Bank has also been active in originating whole
residential mortgage loans through correspondents which meet its pricing and
credit quality objectives. In the latter part of fiscal year 1998, the Company
initiated the development of a commercial loan division. The Company's
origination of commercial mortgage and commercial and industrial loans provides
further diversification of business lines and fulfills a critical component of
the Company's community banking strategy. Currently, approximately 83.5% of the
Bank's loan portfolio consists of conventional loans, which are loans that are
neither insured by the Federal Housing Administration nor partially guaranteed
by the Department of Veterans Affairs.
The risks associated with residential mortgage lending are well defined
and controllable. Credit risk is controlled through the adherence, with few
exceptions, to secondary market underwriting guidelines. In addition, the
commercial real estate loans and collateralized commercial loans are
underwritten to comply with stringent internal guidelines. A strong internal
loan review program monitors compliance with the Bank's underwriting standards,
which is reflected by the low level of non-performing assets. See - "Asset
Quality - Non-Performing Assets." Market risk is controlled by a disciplined
approach to pricing and by regular monitoring and hedging of the institution's
overall sensitivity to interest rate changes.
As a federally chartered savings institution, the Bank has general
authority to originate and purchase loans secured by real estate located
throughout the United States. Notwithstanding this nationwide lending authority,
the Company estimates that at June 30, 1999, approximately 86% of the loans in
the Bank's portfolio are to customers located in the immediate market areas of
its offices in Richmond and Indianapolis, Indiana as well as Mission, Kansas and
Chapel Hill, North Carolina.
Although the Bank has historically originated loans with lesser dollar
balances than the maximum permitted by federal regulations, current loans-to-one
borrower limitations may restrict its ability to do business with certain
customers. A savings institution generally may not make loans to any one
borrower and related entities in an amount which exceeds 15% of its unimpaired
capital and surplus, although loans in an amount equal to an additional 10% of
unimpaired capital and surplus may be made to a borrower if the loans are fully
secured by readily marketable securities. At June 30, 1999, the Bank's
regulatory limit on loans-to-one borrower was $5.0 million and its five largest
loans or groups of loans-to-one borrower, including related entities, aggregated
$2.8 million, $2.8 million, $2.6 million, $2.3 million and $2.0 million. All
five of the Bank's largest loans or groups of loans are secured primarily by
commercial real estate or commercial business assets and were performing in
accordance with their terms at June 30, 1999.
5
Loan Portfolio Composition. The following table sets forth the
composition of the Bank's loan portfolio by type of loan at the dates indicated.
June 30,
---------------------------------------------------------------------------------------
1999 1998 1997
-------------------------- ---------------------------- -----------------------------
Amount Percent Amount Percent Amount Percent
------------ ----------- -------------- ------------ ---------------- -----------
(Dollars in Thousands)
Single-family residential (1) $216,511 83.5% $154,336 94.6% $91,140 97.2%
Commercial real estate (2) 16,707 6.4 3,522 2.2 258 0.3
-------- ----- -------- ----- ------- -----
Total real estate loans 233,218 89.9 157,858 96.8 91,398 97.5
Collateralized commercial loans 17,071 6.6 1,201 0.7 -- --
Consumer loans:
Deposit secured 426 0.2 221 0.1 252 0.2
Home improvement/equity 5,443 2.1 3,536 2.2 2,136 2.3
Automobile 2,811 1.1 13 -- -- --
Other 369 0.1 240 0.2 -- --
-------- ----- -------- ----- ------- -----
Total consumer loans 9,049 3.5 4,010 2.5 2,388 2.5
-------- ----- -------- ----- ------- -----
Total loans 259,338 100.0% 163,069 100.0% 93,786 100.0%
===== ===== =====
Less:
Unamortized push-down
accounting adjustment (3) (54) (113) (136)
Unamortized discount on loans -- -- --
Undisbursed funds (4) (2) (6) (9)
Deferred loan origination
(fees) costs 1,260 956 530
Allowance for loan losses (868) (360) (213)
-------- -------- -------
Net loans $259,674 $163,546 $93,958
======== ======== =======
June 30,
-------------------------------------------------------
1996 1995
-------------------------- ---------------------------
Amount Percent Amount Percent
-------------- ---------- ------------- ------------
(Dollars in Thousands)
Single-family residential (1) $64,899 97.8% $35,998 96.1%
Commercial real estate (2) 441 0.7 711 1.9
------- ----- ------- -----
Total real estate loans 65,340 98.5 36,709 98.0
Collateralized commercial loans
-- -- -- --
Consumer loans:
Deposit secured 267 0.4 255 0.7
Home improvement/equity 732 1.1 498 1.3
Automobile -- -- -- --
Other -- -- -- --
------- ----- ------- -----
Total consumer loans 999 1.5 753 2.0
------- ----- ------- -----
Total loans 66,339 100.0% 37,462 100.0%
===== =====
Less:
Unamortized push-down
accounting adjustment (3) (182) (350)
Unamortized discount on loans (7) (13)
Undisbursed funds (4) (420) (43)
Deferred loan origination
(fees) costs 315 75
Allowance for loan losses (120) (121)
------- -------
Net loans $65,925 $37,010
======= =======
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(1) Includes single-family residential construction loans. At June 30,
1999, the Bank had $545,000 in single-family residential and $1.2
million in commercial real estate construction loans in process.
(2) Includes $63,000, $224,000, $258,000, $291,000, and $321,000 of
mortgage revenue bonds secured by commercial real estate at each of the
respective dates.
(3) Reflects the balance of the fair value adjustments made on the loan
portfolio as a result of the completion in September 1988 of the
Company's acquisition of the Bank, which acquisition was accounted for
under the purchase method of accounting.
(4) Includes undisbursed funds relating to construction loans.
6
Contractual Principal Repayments and Interest Rates. The following table sets
forth certain information at June 30, 1999 regarding the dollar amount of loans
maturing in the Bank's total loan portfolio, based on the contractual terms to
maturity, before giving effect to net items.
Due After Due After
Due in One One to Five Five or More
Year or Less Years Years Total
-------------------- ----------------- ------------------ ---------------
(In Thousands)
Single-family residential $ 11 $ 425 $ 216,075 $ 216,511
Commercial 10,134 6,003 17,641 33,778
Consumer 340 3,462 5,247 9,049
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Total $10,485 $ 9,890 $ 238,963 $ 259,338
======= ======= ========= =========
The following table sets forth the dollar amount of all loans, before
net items, due after one year from June 30, 1999, which have fixed interest
rates or which have floating or adjustable interest rates.
Floating or
Fixed Rates Adjustable-Rates Total
------------------ ----------------------- -------------------
(In Thousands)
Single-family residential $ 184,370 $ 32,130 $ 216,500
Commercial 17,927 5,717 23,644
Consumer 5,438 3,271 8,709
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Total $ 207,735 $ 41,118 $ 248,853
========= ========= =========
Origination, Purchase and Sale of Loans. The lending activities of the
Bank are subject to the written, non-discriminatory underwriting standards and
loan origination procedures established by the Bank's Board of Directors and
management. Loan originations are obtained by a variety of sources, including
referrals from real estate brokers, builders, existing customers, walk-in
customers, loan officers and advertising. In its marketing, the Bank emphasizes
its community ties, customized personal service, competitive rates, and an
efficient underwriting and approval process. Property valuations are performed
by independent outside appraisers approved by the Bank's Board of Directors. The
Bank requires title, hazard and, to the extent applicable, flood insurance on
all security property.
Mortgage loan applications are reviewed by Bank employees who have
approval authority up to designated limits. All loans in excess of an
individual's designated limits are referred to the Bank's Loan Committee, which
has approval authority for all loans up to $1.0 million. Any loans exceeding
$1.0 million (of which, at June 30, 1999, there were nine) must be approved by
the Board of Directors of the Bank. In addition, the Board of Directors of the
Bank ratifies all loans originated and purchased by the Bank.
7
The single-family residential loans originated by the Bank are
generally made on terms, conditions and documentation which permit the sale to
the Federal Home Loan Mortgage Corporation ("FHLMC"), the Federal National
Mortgage Association ("FNMA") and other institutional investors in the secondary
market. From fiscal 1991 to fiscal 1993, the Bank sold substantially all of its
fixed-rate single-family residential loans to FNMA in the secondary market as a
means of generating fee income as well as providing additional funds for
lending, investing and other purposes. Sales of loans were generally under terms
which did not provide any recourse to the Company by the purchaser in the event
of default on the loan by the borrower. With respect to such loan sales, the
Company generally retained responsibility for collecting and remitting loan
payments, inspecting the properties, making certain insurance and tax payments
on behalf of borrowers and otherwise servicing the loans it sold, and received a
fee for performing these services. At June 30, 1999, the Company was servicing
$2.0 million of loans for others.
During fiscal year 1994, the Bank initiated programs to increase its
portfolio of single-family residential loans in accordance with its community
banking expansion. In addition, during fiscal 1995, the Bank began originating
single-family residential loans through correspondent mortgage banking
companies. Currently, the Bank is utilizing mortgage banking companies located
in Indianapolis, Indiana and Overland Park, Kansas. The Bank requires that all
loans originated through correspondents be underwritten in accordance with its
underwriting guidelines and standards. The Bank reviews the loans for adherence
to its underwriting standards prior to acceptance from the correspondent. Such
loans are obtained with servicing released.
The following table sets forth the loan origination activity of the
Company during the periods indicated.
Year Ended June 30,
-------------------------------------------------------------------
1999 1998 1997
-------------------- ------------------- --------------------
(Dollars in Thousands)
Direct loan originations:
Single-family residential $ 66,644 $39,772 $12,615
Commercial 51,585 4,506 --
Consumer 9,967 4,355 2,931
-------- ------- -------
Total loans originated
directly 128,196 48,633 15,546
Originations by
correspondents (1) 39,523 47,921 24,545
-------- ------- -------
Total loans originated 167,719 96,554 40,091
Loan principal reductions (71,450) (27,271) (12,644)
-------- ------- -------
Net increase in loan portfolio $ 96,269 $69,283 $27,447
======== ======= =======
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(1) Consisted solely of single-family residential loans.
Single-Family Residential Real Estate Loans. Historically, savings
institutions such as the Bank have concentrated their lending activities on the
origination of loans secured primarily by first mortgage liens on existing
single-family residences. At June 30, 1999,
8
$216.5 million or 83.5% of the Bank's total loan portfolio consisted of
single-family residential real estate loans, substantially all of which are
conventional loans.
The Bank offers fixed-rate single family residential loans with terms
of 10 to 30 years. Such loans are amortized on a monthly basis with principal
and interest due each month. Generally, the value of fixed-rate loans fluctuates
inversely with changes in interest rates. Consequently, if left unhedged,
long-term fixed-rate single-family residential loans would increase the Bank's
interest rate risk. However, the Bank believes that its sophisticated asset and
liability management techniques provide the Bank with a competitive advantage
and allow for the Bank to continue to offer fixed-rate residential mortgage
loans over a variety of interest rate scenarios.
Since the early 1980s, the Bank has also been offering adjustable-rate
single-family residential mortgage loans. Such loans generally have up to
30-year terms and an interest rate which adjusts after one, three or five years
in accordance with a designated index (the weekly average yield on U.S. Treasury
securities adjusted to a constant comparable maturity of one year, as made
available by the Federal Reserve Board). Such loans currently have a 2% cap on
the amount of any increase or decrease in the interest rate per year, and a 6%
limit on the amount by which the interest rate can increase or decrease over the
life of the loan. In addition, the Bank's adjustable-rate loans are currently
not convertible into fixed-rate loans and do not contain prepayment penalties.
Approximately 12.4% of the single-family residential loans in the Bank's loan
portfolio at June 30, 1999 had adjustable interest rates.
Adjustable-rate mortgage loans decrease but do not eliminate the risks
associated with changes in interest rates. Because periodic and lifetime caps
limit the interest rate adjustments, the value of adjustable-rate mortgage loans
also fluctuates inversely with changes in interest rates. In addition as
interest rates increase, the required payments by the borrower increase, thus
increasing the potential for default.
The demand for adjustable-rate loans in the Bank's primary market area
has been a function of several factors, including the level of interest rates,
the expectations of changes in the level of interest rates and the difference
between the interest rates and loan fees offered for fixed-rate loans and
adjustable-rate loans. The relative amount of fixed-rate and adjustable-rate
residential loans that can be originated at any time is largely determined by
the demand for each in a competitive environment.
Pursuant to underwriting guidelines adopted by the Board of Directors,
the Bank will generally lend up to 95% of the appraised value of the property
securing a single-family residential loan. However, the Bank generally obtains
private mortgage insurance on the principal amount that exceeds 80% of appraised
value of the security property.
Although the Bank does not emphasize the origination of residential
construction loans, in recent years the Bank has occasionally originated loans
in its primary market area to construct single-family residences. At June 30,
1999, the Bank had $545,000 in single-family residential and $1.2 million in
commercial real estate construction loans in process.
9
Commercial Real Estate Loans. At June 30, 1999, $16.7 million or 6.4%
of the Bank's total loan portfolio consisted of loans secured by commercial real
estate. At June 30, 1999, the Bank's commercial real estate loan portfolio
included term loans secured by commercial buildings located within the Company's
primary market areas.
Commercial real estate lending entails different and significant risks
when compared to single-family residential lending because such loans typically
involve large loan balances to single borrowers and because the payment
experience on such loans is typically dependent on the successful operation of
the project or the borrower's business. During the latter part of the 1998
fiscal year, the Bank developed a commercial lending division by implementing
the necessary policies, operating procedures, loan systems and hiring support
personnel. These loans are made in conformance with strict underwriting
guidelines and adherence to the Bank's policies.
Collateralized Commercial Loans. At June 30, 1999, $17.1 million or
6.6% of the Bank's total loan portfolio consisted of collateralized commercial
loans. These collateralized loans consist of both term loans as well as lines of
credit which are secured by business assets or stock.
As previously mentioned, the Bank's recent development of the
commercial lending division allows for the origination of non-real estate
business loans in strict compliance with the Bank's underwriting standards.
Collateralized commercial lending also entails different and significant risks
in relation to single-family residential lending.
Consumer Loans. The Bank is authorized to make loans for a wide variety
of personal or consumer purposes. The Bank has been originating consumer loans
in recent years in order to provide a wider range of financial services to its
customers and because such loans generally have higher interest spreads than
mortgage loans. The consumer loans offered by the Bank include home equity loans
and lines of credit, home improvement loans and deposit account secured loans.
At June 30, 1999, $9.0 million or 3.5% of the Bank's total loan portfolio
consisted of consumer loans.
Home equity loans and lines of credit are originated by the Bank for up
to 90% of the appraised value, less the amount of any existing prior liens on
the property. The Bank also offers home improvement loans in amounts up to 95%
of the appraised value, less the amount of any existing prior liens on the
property, provided the loan is guaranteed by an approved insurer. Home equity
loans and home improvement loans have a maximum term of twenty years and carry
fixed interest rates. Home equity lines of credit have a maximum repayment term
of 10 years, a five-year term with respect to draws, and carry interest rates
which adjust monthly in accordance with a designated prime rate. The Bank will
secure each of these types of loans with a mortgage on the property (generally a
second mortgage) and will originate the loan even if another institution holds
the first mortgage. At June 30, 1998, home equity loans and lines of credit and
home improvement loans totaled $5.4 million or 60.2% of the Bank's total
consumer loan portfolio.
The Bank currently offers loans secured by deposit accounts, which
amounted to $426,000 or 4.7% of the Bank's total consumer loan portfolio at June
30, 1999. Such loans
10
are originated for up to 95% of the deposit account balance, with a hold placed
on the account restricting the withdrawal of the account balance.
During fiscal year 1998, the Bank expanded its consumer loan products
to include automobile and personal loans. As of June 30, 1999, these other loans
amounted to $3.2 million or 35.1% of the Bank's total consumer loan portfolio.
Consumer loans generally have shorter terms and higher interest rates
than mortgage loans but generally involve more credit risk than mortgage loans
because of the type and nature of the collateral. In addition, consumer lending
collections are dependent on the borrower's continuing financial stability, and
thus are more likely to be adversely affected by job loss, divorce, illness and
personal bankruptcy. The Bank believes that the generally higher yields earned
on consumer loans compensate for the increased credit risk associated with such
loans, and the Company intends to continue to offer consumer loans in order to
provide a full range of services to its customers.
Asset Quality
Loan Delinquencies. When a borrower fails to make a required payment on
a loan, the Bank attempts to cure the deficiency by contacting the borrower and
seeking payment. Contacts are generally made following the fifteenth day after a
payment is due, at which time a late payment is assessed. In most cases,
deficiencies are cured promptly. If a delinquency extends beyond 15 days, the
loan and payment history is reviewed and efforts are made to collect the loan.
While the Bank generally prefers to work with borrowers to resolve such
problems, when the account becomes 90 days delinquent, the Bank does institute
foreclosure or other proceedings, as necessary, to minimize any potential loss.
Non-Performing Assets. All loans are reviewed on a regular basis and
are placed on non-accrual status when, in the opinion of management, the
probability of collection of additional interest is deemed insufficient to
warrant further accrual. As a matter of policy, the Bank does not accrue
interest on loans past due 90 days or more except when the estimated value of
the collateral and collection efforts are deemed sufficient to ensure full
recovery. The Bank provides an allowance for the loss of uncollected interest on
all non-accrual loans. Impaired loans covered under Statement of Financial
Accounting Standards ("SFAS") No. 114 and No. 118 are defined by the Company to
consist of non-accrual commercial loans which have not been collectively
evaluated for impairment. The allowance is established by a charge to interest
income equal to all interest previously accrued, and income is subsequently
recognized only to the extent that cash payments are received until, in
management's judgment, the borrower's ability to make periodic interest and
principal payments returns to normal, in which case the loan is returned to
accrual status.
Real estate acquired through foreclosure is carried at the lower of the
loan's unpaid principal balance (cost) or fair value less estimated selling
expenses at the date of transfer. A loan charge-off is recorded for any
write-down in the loan's carrying value to fair value at the date of transfer.
Real estate loss provisions are recorded if the properties' fair value
subsequently declines below the value determined at the recording date. In
determining the
11
lower of cost or fair value at acquisition, costs relating to development and
improvement of property are considered. Costs relating to holding real estate
acquired through foreclosure, net of rental income, are charged against earnings
as incurred.
Automobiles acquired through repossession are carried at the lower of
the loan's unpaid principal balance (cost) or fair value based on current
National Automobile Dealers Association valuation, adjusted for any damage or
vandalism. A loan charge-off is recorded for any write-down in the loan's
carrying value to fair value at the date of transfer. Loss provisions are
recorded if the fair value of the automobile subsequently declines below the
value determined at the recording date. After repossession, costs relating to
holding the automobile are charged against earnings as incurred.
The following table sets forth the amounts and categories of the Bank's
non-performing assets at the dates indicated. The Bank did not have any troubled
debt restructuring at any of the periods presented.
June 30,
--------------------------------------------------------------------------------
1999 1998 1997 1996 1995
------------- ------------- ------------- -------------- -------------
(Dollars in Thousands)
Non-accruing loans:
Single-family residential $ 70 $ 285 $ 336 $ 261 $ 350
Consumer 6 -- -- -- --
Commercial -- -- -- -- --
----- ----- ------ ------ ------
Total non-accruing loans 76 285 336 261 350
Accruing loans greater than
90 days delinquent -- -- -- -- --
----- ----- ------ ------ ------
Total non-performing loans 76 285 336 261 350
Real estate owned -- 18 -- -- --
Repossessed automobiles 22 -- -- -- --
Other non-performing assets (1) 502 587 789 1,088 1,415
----- ----- ------ ------ ------
Total non-performing assets $ 600 $ 890 $1,125 $1,349 $1,765
===== ===== ====== ====== ======
Total non-performing loans
as a percentage of total
loans 0.03% 0.17% 0.36% 0.40% 0.95%
==== ==== ==== ==== ====
Total non-performing assets
as a percentage of total
assets 0.13% 0.18% 0.25% 0.32% 0.59%
==== ==== ==== ==== ====
- -----------------------------------
(1) Consists of a non-agency participation certificate. See "- Classified
Assets."
The interest income that would have been recorded during the years
ended June 30, 1999, 1998, 1997, 1996 and 1995 if the Bank's non-accrual loans
at the end of such periods had been current in accordance with their terms
during such periods was $1,000, $15,000, $6,000, $6,000 and $13,000,
respectively.
Classified Assets. Federal regulations require that each insured
savings institution classify its assets on a regular basis. In addition, in
connection with examinations of insured institutions, federal examiners have
authority to identify problem assets and, if appropriate, classify them. There
are three classifications for problem assets: "substandard," "doubtful" and
"loss." Substandard assets have one or more defined weaknesses and are
characterized by the distinct possibility that the insured institution will
sustain some loss if the deficiencies are not corrected. Doubtful assets have
the weaknesses of substandard assets with the additional characteristic that the
weaknesses make collection or liquidation in full on the
12
basis of currently existing facts, conditions and values questionable, and there
is a high possibility of loss. An asset classified loss is considered
uncollectible and of such little value that continuance as an asset of the
institution is not warranted. Another category designated "special mention" also
must be established and maintained for assets which do not currently expose an
insured institution to a sufficient degree of risk to warrant classification as
substandard, doubtful or loss. Assets classified as substandard or doubtful
require the institution to establish general allowances for loan losses. If an
asset or portion thereof is classified loss, the insured institution must either
establish specific allowances for loan losses in the amount of 100% of the
portion of the asset classified loss, or charge-off such amount. General loss
allowances established to cover possible losses related to assets classified
substandard or doubtful may be included in determining an institution's
regulatory capital, while specific valuation allowances for loan losses do not
qualify as regulatory capital.
The Bank's classified assets at June 30, 1999 consisted of $1.1 million
of assets classified as substandard (including $612,000 of loans and $502,000 of
securities) and one loan in the amount of $2,000 was classified as doubtful. In
addition, at June 30, 1999, $4.3 million of the Bank's loans were designated
special mention.
The $502,000 of securities classified as substandard at June 30, 1999
relates to a single non-agency participation certificate which was purchased by
the Bank during fiscal 1991. The security was issued by a savings institution
located in Huntington Beach, California and the underlying mortgages consist of
six-month adjustable-rate notes (priced off of LIBOR) which are secured by
single-family properties located in southern California. As of June 30, 1999,
approximately 9.0% of the underlying mortgages were at least 30 days past due
and/or in foreclosure or already foreclosed upon by the servicer. The security
was structured into both senior and subordinate classes and the Bank owns only
senior classes. As of June 30, 1999, the pool had cumulative realized losses of
$23.5 million which were initially absorbed by certain credit supports and
subsequently absorbed by subordinate certificate holders. Currently, senior
certificate holders (such as the Bank) are having to absorb the losses. The
credit supports, which totaled $11.0 million at the date of issuance, had been
depleted as of June 30, 1999. The security is currently held in the Bank's
available for sale portfolio and its $502,000 carrying value at June 30, 1999
reflects $41,000 of net unrealized gains as of such date as well as $414,000 and
$253,000 of write-downs with respect to such security which were recognized by
the Bank during fiscal 1995 and 1994, respectively.
Allowance for Loan Losses. It is management's policy to maintain an
allowance for estimated losses on loans based upon the estimated net realizable
value of the underlying collateral, general economic conditions, particularly as
they relate to the Bank's market area, historical loss experience, and other
factors related to the collectibility of the loan portfolio. Although management
believes that it uses the best information available to make such
determinations, future adjustments to the allowance may be necessary, and net
income could be significantly affected, if circumstances differ substantially
from the assumptions used in making the initial determinations.
Effective December 21, 1993, the OTS, in conjunction with the Office of
the Comptroller of the Currency, the FDIC and the Federal Reserve Board, issued
an Interagency
13
Policy Statement on the Allowance for Loan and Lease Losses ("Policy
Statement"). The Policy Statement includes guidance (1) on the responsibilities
of management for the assessment and establishment of an adequate allowance and
(2) for the agencies' examiners to use in evaluating the adequacy of such
allowance and the policies utilized to determine such allowance. The Policy
Statement also sets forth quantitative measures for the allowance with respect
to assets classified substandard and doubtful and with respect to the remaining
portion of an institution's loan portfolio. Specifically, the Policy Statement
sets forth the following quantitative measures which examiners may use to
determine the reasonableness of an allowance: (1) 50% of the portfolio that is
classified doubtful; (2) 15% of the portfolio that is classified substandard and
(3) for the portions of the portfolio that have not been classified (including
loans designated special mention), estimating credit losses over the upcoming
twelve months based on facts and circumstances available on the evaluation date.
While the Policy Statement sets forth this quantitative measure, such guidance
is not intended as a "floor" or "ceiling."
The following table sets forth an analysis of the Bank's allowance for
loan losses during the periods indicated.
Year Ended June 30,
----------------------------------------------------------------------------------
1999 1998 1997 1996 1995
------------- ------------- ------------ --------------- --------------
(Dollars in Thousands)
Total loans outstanding, net $259,674 $163,546 $93,958 $65,925 $37,010
======== ======== ======= ======= =======
Average loans outstanding, net $223,174 $116,982 $78,545 $52,399 $25,467
======== ======== ======= ======= =======
Balance at beginning of period $ 360 $ 213 $ 120 $ 121 $ 106
Charge-offs:
Single-family residential -- -- -- -- --
Commercial real estate -- -- -- -- --
Consumer -- -- -- -- --
-------- -------- ------- ------- -------
Total charge-offs -- -- -- -- --
Recoveries:
Single-family residential 1 -- -- -- --
Consumer -- -- -- -- --
-------- -------- ------- ------- -------
Total recoveries 1 -- -- -- --
-------- -------- ------- ------- -------
Net charge-offs (1) -- -- -- --
Provision (recovery) for loan
losses 509 147 93 (1) 15
-------- -------- ------- ------- -------
Balance at end of period $ 868 $ 360 $ 213 $ 120 $ 121
======== ======== ======= ======= =======
Allowance for loan losses as a
percent of total loans
outstanding 0.3% 0.2% 0.2% 0.2% 0.3%
=== === === === ===
Ratio of net charge-offs to
average loans outstanding --% --% --% --% --%
=== === === === ===
The Bank established provisions (recoveries) for loan losses of
$509,000, $147,000, $93,000, $(1,000) and $15,000 during the years ended June
30, 1999, 1998, 1997, 1996 and 1995, respectively. During such periods, loan
charge-offs (net of recoveries) amounted to $(1,000), $0, $0, $0 and $0,
respectively. The increases in the provision for loan losses during the periods
presented were due to substantial growth in the Company's mortgage, consumer and
commercial loan portfolios.
14
The following table sets forth information concerning the allocation of
the Bank's allowance for loan losses by loan categories at the dates indicated.
June 30,
-----------------------------------------------------------------------------------------
1999 1998 1997
--------------------------- ----------------------------- -----------------------------
Percent of Percent of Percent of
Loans in Loans in Loans in
Each Each Each
Category to Category to Category to
Amount Total Loans Amount Total Loans Amount Total Loans
------------ ------------- ------------- -------------- ------------- --------------
(Dollars in Thousands)
Single-family residential $ 377 43.4% $ 302 83.9% $ 188 97.2%
loans
Commercial loans 411 47.4 43 11.9 10 0.3
Consumer loans 80 9.2 15 4.2 15 2.5
----- ----- ----- ----- ----- -----
Total $ 868 100.0% $ 360 100.0% $ 213 100.0%
===== ===== ===== ===== ===== =====
June 30,
-------------------------------------------------------------
1996 1995
----------------------------- ------------------------------
Percent of Percent of
Loans in Loans in
Each Each
Category to Category to
Amount Total Loans Amount Total Loans
------------- -------------- ------------- --------------
(Dollars in Thousands)
Single-family residential $ 95 97.8% $ 96 96.1%
loans
Commercial loans 10 0.7 10 1.9
Consumer loans 15 1.5 15 2.0
----- ----- ----- -----
Total $ 120 100.0% $ 121 100.0%
===== ===== ===== =====
15
Investment Activities
General. The Company's securities portfolio is managed by investment
officers in accordance with a comprehensive written investment policy which
addresses strategies, types and levels of allowable investments and which is
reviewed and approved by the Bank's Board of Directors on an annual basis. The
management of the securities portfolio is set in accordance with the direction
of the Bank's Investment Committee. In addition, the Bank has entered into an
agreement with Smith Breeden whereby Smith Breeden has been appointed as
investment advisor with respect to the management of the Bank's securities
portfolio. With the assistance of Smith Breeden, the Bank's Chief Executive
Officer and Chief Investment Officer execute various transactions with respect
to the portfolio and are responsible for informing the Investment Committee of
the types of investments available, the status and performance of the portfolio
and current market conditions. The investment officers are authorized to:
purchase or sell any securities as well as commitments to hedge eligible
investments; purchase or sell eligible investments under repurchase or reverse
repurchase agreements; execute hedging strategies approved by the Investment
Committee; pledge securities owned as collateral for public agency deposits or
repurchase accounts or agreements; and lend securities to approved dealers in
government securities or approved commercial banks. Any one investment officer
has the authority to purchase or sell securities up to $5.0 million in any one
transaction and acting together, two members of the Investment Committee have
authority to purchase or sell securities up to $10.0 million in any one
transaction. For purchases or sales greater than $10.0 million, the prior
approval of a majority of the Investment Committee is required. Investment
officers are also authorized to invest excess liquidity in approved liquid
investment vehicles. In addition, both the Investment Committee and the Board of
Directors of the Bank ratify all securities purchased and sold by the Bank.
The Company invests in a portfolio of mortgage-backed securities,
mortgage-backed derivative securities, interest rate risk management contracts,
equity securities and municipal bonds. In selecting securities for its
portfolio, the Company employs option-adjusted pricing analysis with the
assistance of Smith Breeden in order to ascertain the net risk-adjusted spread
expected to be earned with respect to the various investment alternatives. The
nature of this analysis is to quantify the costs embedded in the yield of an
investment, such as the duration matched funding cost, the costs of the options
embedded in the investment's cash flows (such as a borrower's ability to prepay
a mortgage) and servicing costs. The objective of the Company's investment
management process is to select investments with the greatest net spreads and
actively manage the underlying risks of these investments.
The Company actively manages its securities portfolio in order to
enhance net interest and net market value on a risk-adjusted basis. As a result,
the Company continuously monitors the net risk-adjusted spreads of its
investments and compares them with the spreads available with respect to other
securities in the market. Accordingly, as market conditions fluctuate (e.g., as
risk-adjusted spreads narrow), the Company will sell individual securities prior
to their maturity and reinvest the proceeds into new investments which generally
carry wider risk-adjusted spreads. The Company's securities portfolio also
contains various interest rate risk management contracts (such as interest
16
rate swaps, collars, caps, floors, options and futures) which are primarily
utilized to hedge the Company's interest rate exposure in the trading portfolio
and which require active management in order to respond to changing prepayment
rates on the mortgage securities. The investment portfolio, although hedged for
interest rate risk, is still susceptible to adverse changes in the spreads
between the yields on mortgage securities and the related Treasury and LIBOR
based hedges with the potential for significant earnings volatility from net
mark-to-market changes. That is, the Company designates substantially all of the
investment portfolio as securities held for trading and, therefore, reflects the
market value changes of these investments, net of hedges, in the statement of
operations.
In recognition of the Company's business strategy of actively managing
its securities portfolio, during fiscal 1994, the Company reclassified
substantially all of its securities as held for trading. Pursuant to SFAS No.
115, securities classified as trading securities are reported at fair value with
unrealized gains and losses included in earnings, and securities classified as
available for sale are similarly reported at fair value, but with unrealized
gains and losses excluded from earnings and instead reported as a separate
component of stockholders' equity.
Mortgage-Backed and Related Securities. At June 30, 1999, the Company's
mortgage-backed and related securities portfolio (including $12.2 million of
mortgage-backed derivative securities) amounted to $180.1 million or 98.0% of
the Company's securities portfolio (both held for trading and available for
sale) and 38.2% of the Company's total assets. By investing in mortgage-backed
and related securities, management seeks to achieve a targeted option-adjusted
spread over applicable funding costs.
The Company invests in mortgage-backed and related securities,
including mortgage participation certificates, which are insured or guaranteed
by U.S. Government agencies and government sponsored enterprises, and CMOs and
real estate mortgage investment conduits ("REMICs"). Mortgage-backed securities
(which also are known as mortgage participation certificates or pass-through
certificates) represent a participation interest in a pool of single-family or
multi-family mortgages, the principal and interest payments on which are passed
from the mortgage originators, through intermediaries (generally U.S. Government
agencies and government sponsored enterprises) that pool and repackage the
participation interests in the form of securities, to investors such as the
Company. Such U.S. Government agencies and government sponsored enterprises,
which guarantee the payment of principal and interest to investors, primarily
include the FHLMC, the FNMA and the Government National Mortgage Association
("GNMA").
Mortgage-backed securities typically are issued with stated principal
amounts, and the securities are backed by pools of mortgages that have loans
with interest rates that are within a range and have varying maturities. The
characteristics of the underlying pool of mortgages, (i.e., fixed-rate or
adjustable-rate) as well as prepayment risk, are passed on to the certificate
holder. The term of a mortgage-backed pass-through security thus approximates
the term of the underlying mortgages.
17
The Company's mortgage-backed derivative securities include CMOs, which
include securities issued by entities which have qualified under the Internal
Revenue Code as REMICs. CMOs and REMICs (collectively CMOs) have been developed
in response to investor concerns regarding the uncertainty of cash flows
associated with the prepayment option of the underlying mortgagor and are
typically issued by governmental agencies, government sponsored enterprises and
special purpose entities, such as trusts, corporations or partnerships,
established by financial institutions or other similar institutions. A CMO can
be collateralized by loans or securities which are insured or guaranteed by
FNMA, FHLMC or GNMA. In contrast to pass-through mortgage-backed securities, in
which cash flow is received pro rata by all security holders, the cash flow from
the mortgages underlying a CMO is segmented and paid in accordance with a
predetermined priority to investors holding various CMO classes. By allocating
the principal and interest cash flows from the underlying collateral among the
separate CMO classes, different classes of bonds are created, each with its own
stated maturity, estimated average life, coupon rate and prepayment
characteristics.
The Company's mortgage-backed derivative securities also include
mortgage-backed residuals and interest-only and principal-only strips.
Mortgage-backed residuals consist of certificates of particular tranches of a
CMO whereby the principal repayments and prepayments with respect to the
underlying pool of loans are generally not allocated to the residual until all
other certificates or tranches have been fully paid and retired. Interest-only
strips are a particular class of mortgage-backed derivative security which
receives and pays only interest with respect to the underlying pool of loans,
while principal-only strips receive and pay only principal repayments and
prepayments. As a result of the foregoing, mortgage-backed derivative securities
often exhibit elasticity and convexity characteristics (i.e., respond
differently to changes in interest rates) which the Company can utilize to
internally hedge other components of the Company's portfolio of assets against
interest rate risk.
The OTS has issued a statement of policy which states, among other
things, that mortgage derivative products (including CMOs and CMO residuals and
stripped mortgage-backed securities such as interest-only and principal-only
strips) which possess average life or price volatility materially different from
benchmark fixed-rate 30-year mortgage-backed securities are "high risk mortgage
securities," and must be carried in the institution's trading account or as
assets held for sale, and therefore marked to market on a regular basis. At June
30, 1999, $12.0 million or 6.7% of the securities held in the Company's
portfolio consisted of such "high risk mortgage securities," as defined in such
policy statement. However, the Bank is in compliance with this OTS policy
statement since all of such securities are held in the Company's trading account
and marked to market on a regular basis in accordance with generally accepted
accounting principles.
Like most fixed-income securities, mortgage-backed and related
securities are subject to interest rate risk. However, unlike most fixed-income
securities, the mortgage loans underlying a mortgage-backed or related security
generally may be prepaid at any time without penalty. The ability to prepay a
mortgage loan generally results in significantly increased price and yield
volatility (with respect to mortgage-backed and related securities) than is the
case with non-callable fixed-income securities. Furthermore, mortgage-backed
derivative securities often are more
18
sensitive to changes in interest rates and prepayments than traditional
mortgage-backed securities and are, therefore, even more volatile. Nevertheless,
the Company attempts to hedge against both interest rate and prepayment risk.
Although, as stated, no assurances can be given that these hedges will be
effective.
Although mortgage-backed and related securities often carry lower
yields than traditional mortgage loans, such securities generally increase the
quality of the Company's assets by virtue of the securities' underlying
insurance or guarantees, are more liquid than individual mortgage loans (which
enhances the Company's ability to actively manage its portfolio) and may be used
to collateralize borrowings or other obligations of the Company. At June 30,
1999, $65.6 million or 35.7% of the Company's mortgage-backed and related
securities were pledged to secure various obligations of the Company (such as
reverse repurchase agreements and interest rate swaps). In addition, in relation
to the Company maintaining a substantial portion of its assets in
mortgage-backed and related securities, the Company has been able to maintain a
relatively low level of operating expenses. Furthermore, mortgage-backed
derivative securities are often utilized by the Company to internally hedge its
interest rate exposure and can be attractive alternatives to other hedge
vehicles when their option-adjusted spreads are abnormally wide.
19
The following table sets forth information relating to the amortized
cost and fair value of the Company's securities held for trading and securities
available for sale portfolios.
June 30,
--------------------------------------------------------------------------------------
1999 1998 1997
------------------------- ---------------------------- -----------------------------
Amortized Fair Amortized Fair Amortized Fair
Cost Value Cost Value Cost Value
----------- ------------- ------------- ------------- -------------- --------------
(In Thousands)
Securities held for trading:
FHLMC participation certificates $ 69,114 $ 67,850 $ 50,555 $ 51,229 $ 41,194 $ 41,516
FNMA participation certificates 28,034 27,599 57,252 58,244 68,800 69,355
GNMA participation certificates 37,986 38,116 142,951 144,219 165,894 168,102
Commercial participation certificates 34,896 33,808 17,540 17,788 -- --
Non-agency participation certificates -- -- 1,884 1,875 2,545 2,502
-------- -------- -------- -------- -------- --------
Total mortgage-backed securities 170,030 167,373 270,182 273,355 278,433 281,475
-------- -------- -------- -------- -------- --------
Collateralized mortgage obligations 10,738 11,069 10,930 11,414 25,789 26,032
Residuals 205 226 309 364 508 1,036
Interest-only strips 818 377 1,118 518 2,028 1,449
Principal only strips 403 506 599 718 821 860
-------- -------- -------- -------- -------- --------
Total mortgage-backed
derivative securities 12,164 12,178 12,956 13,014 29,146 29,377
-------- -------- -------- -------- -------- --------
Interest rate swaps -- (175) -- (397) -- 581
Interest rate collar 4 4 38 (22) 50 (8)
Interest rate caps 1,744 587 2,384 227 3,025 1,545
Interest rate floors 3,821 4,382 3,410 4,440 3,916 3,541
Options 298 328 68 50 78 24
Futures -- (1,611) -- (257) -- 356
-------- -------- -------- -------- -------- --------
Total interest rate contracts 5,867 3,515 5,900 4,041 7,069 6,039
-------- -------- -------- -------- -------- --------
Equity securities 69 134 99 199 305 464
-------- -------- -------- -------- -------- --------
Total securities held for trading $188,130 $183,200 $289,137 $290,609 $314,953 $317,355
======== ======== ======== ======== ======== ========
Securities available for sale:
Non-agency participation
certificates $ 461 $ 502 $ 605 $ 587 $ 866 $ 790
-------- -------- -------- -------- -------- --------
Total mortgage-backed securities 461 502 605 587 866 790
Municipal bonds --- --- 319 335 317 335
-------- -------- -------- -------- -------- --------
Total securities available for sale $ 461 $ 502 $ 924 $ 922 $ 1,183 $ 1,125
======== ======== ======== ======== ======== ========
20
The following table sets forth the fair value of the Company's
securities activities (both held for trading and available for sale) for the
periods indicated:
At or For the Years
Ended June 30,
-----------------------------------------
1999 1998 1997
--------- --------- ---------
(In Thousands)
Beginning balance $ 291,531 $ 318,480 $ 321,897
--------- --------- ---------
Mortgage-backed securities purchased-
held for trading 776,200 653,403 890,623
Collateralized mortgage obligations
purchased - held for trading -- -- 19,823
Mortgage-backed derivative securities
purchased - held for trading 1,777 -- --
Interest rate contracts purchased
- held for trading 2,283 1,808 3,320
Equity securities purchased -
held for trading -- 2,000 --
--------- --------- ---------
Total securities purchased 780,260 657,211 913,766
--------- --------- ---------
Less:
Sale of mortgage-backed securities
- held for trading 830,228 634,099 887,468
Sale of collateralized mortgage
obligations - held for trading -- 15,335 --
Sale of mortgage-backed derivative
securities - held for trading 1,720 628 625
Sale of interest rate contracts -
held for trading -- 113 132
Sale of equity securities -
held for trading 30 2,205 204
--------- --------- ---------
Total securities sold 831,978 652,380 888,429
--------- --------- ---------
Less proceeds from maturities of
securities 51,865 28,697 27,277
Realized gain (loss) on sale of
securities held for trading 4,755 (775) (1,623)
Unrealized gain (loss) on securities
held for trading (6,402) (930) 2,117
Change in net unrealized gain (loss)
on securities available for sale 25 56 (46)
Amortization of premium (2,624) (1,434) (1,925)
--------- --------- ---------
Ending balance $ 183,702 $ 291,531 $ 318,480
========= ========= =========
21
At June 30, 1999, the contractual maturity of substantially all of the
Company's mortgage-backed or related securities was in excess of twenty years.
The actual maturity of a mortgage-backed or related security is usually less
than its stated maturity due to prepayments of the underlying mortgages.
Prepayments that are faster than anticipated may shorten the life of the
security and affect its yield to maturity. The yield to maturity is based upon
the interest income and the amortization of any premium or discount related to
the security. In accordance with generally accepted accounting principles,
premiums and discounts are amortized over the estimated lives of the loans,
which decrease and increase interest income, respectively. The prepayment
assumptions used to determine the amortization period for premiums and discounts
can significantly affect the yield of the mortgage-backed or related security,
and these assumptions are reviewed periodically to reflect actual prepayments.
Although prepayments of underlying mortgages depend on many factors, including
the type of mortgages, the coupon rate, the age of mortgages, the geographical
location of the underlying real estate collateralizing the mortgages and general
levels of market interest rates, the difference between the interest rates on
the underlying mortgages and the prevailing mortgage interest rates generally is
the most significant determinant of the rate of prepayments. During periods of
falling mortgage interest rates, if the coupon rate of the underlying mortgages
exceeds the prevailing market interest rates offered for mortgage loans,
refinancing generally increases and accelerates the prepayment of the underlying
mortgages and the related security. At June 30, 1999, of the $180.1 million of
mortgage-backed and related securities held by the Company, an aggregate of
$146.8 million were secured by fixed-rate mortgage loans and an aggregate of
$33.3 million were secured by adjustable-rate mortgage loans.
Other Securities. Other securities owned by the Company at June 30,
1999 include various interest rate risk management contracts, including interest
rate swaps, collars, caps, floors, options and futures and equity securities. At
June 30, 1999, the carrying value of the Company's interest rate contracts and
equity securities amounted to $3.5 million and $134,000, respectively. See Note
2 to the Notes to Consolidated Financial Statements.
Sources of Funds
General. The Company will consider various sources of funds to fund its
investing and lending activities and evaluates the available sources of funds in
order to reduce the Company's overall funding costs. Deposits, securities sold
under agreements to repurchase, advances from the FHLB of Indianapolis, notes
payable, and sales, maturities and principal repayments on loans and securities
have been the major sources of funds for use in the Company's lending and
investing activities, and for other general business purposes. Management of the
Company closely monitors rates and terms of competing sources of funds on a
daily basis and utilizes the source which it believes to be cost effective.
Deposits. The Bank attempts to price its deposits in order to promote
deposit growth and offers a wide array of deposit products in order to satisfy
its customers' needs. The Bank's current deposit products include statement
savings accounts, negotiable order of withdrawal ("NOW") and demand deposit
accounts ("DDA"), money market deposit accounts, fixed-rate, fixed-maturity
retail certificates of deposit ranging in terms from seven days to 10 years,
individual retirement
22
accounts, and non-retail certificates of deposit consisting of jumbo (generally
greater than $95,000) certificates, inverse variable-rate certificates and
brokered certificates of deposit.
The Bank's retail deposits are generally obtained from residents in its
primary market area. The principal methods currently used by the Bank to attract
deposit accounts include offering a wide variety of value-added products and
services and competitive interest rates. The Bank utilizes traditional marketing
methods to attract new customers and savings deposits, including various forms
of advertising. Management estimates that as of June 30, 1999, non-retail
deposit accounts totaled $12.4 million or 3.7% of the Bank's total deposits.
These non-retail deposits consist largely of jumbo certificates of deposit and
inverse variable-rate certificates (which are obtained through brokers). The
Bank's jumbo certificates of deposit and other deposits are also obtained
through the posting of deposit rates on national computerized bulletin boards at
no cost to the Bank. The Bank's inverse variable-rate certificates carry rates
which fluctuate inversely with respect to the three month LIBOR rate. For
example, if LIBOR rates of interest increase, the rates on the inverse
variable-rate certificates would decrease, while if market rates of interest
decrease, the rates on the inverse variable-rate certificates would increase. As
a result, the Bank would generally be paying a higher rate on such certificates
during a declining interest rate environment. The Bank offers inverse
variable-rate certificates when they represent a lower cost source of funds to
comparable duration funding sources. Retail deposits increased $154.0 million,
from $166.8 million at June 30, 1998 to $320.8 million at June 30, 1999,
primarily due to the Company's strategy of rapidly building a community banking
franchise which included the opening of the Kansas branch in August of 1998.
The following table shows the distribution of and certain other
information relating to the Bank's deposits by type as of the dates indicated.
June 30,
---------------------------------------------------------------------------------
1999 1998 1997
-------------------------- ------------------------- --------------------------
Percent of Percent of Percent of
Amount Deposits Amount Deposits Amount Deposits
------------ ------------ ------------ ----------- ------------ -------------
(Dollars in Thousands)
Transaction accounts:
NOW and DDA $ 16,911 5.1% $ 8,202 4.6% $ 4,778 3.5%
Savings accounts 33,163 10.0 26,688 15.0 20,523 15.1
Money market deposit accounts 137,463 41.2 7,093 3.9 1,930 1.4
-------- ----- -------- ----- -------- -----
Total transaction accounts 187,537 56.3 41,983 23.5 27,231 20.0
-------- ----- -------- ----- -------- -----
Certificates of deposit:
Within 1 year 126,592 38.0 113,237 63.5 74,586 54.8
1-2 years 9,543 2.9 13,169 7.4 19,437 14.3
2-3 years 4,730 1.4 3,570 2.0 7,486 5.5
3-4 years 2,867 0.8 3,198 1.8 1,845 1.3
Over 4 years 1,976 0.6 3,154 1.8 5,590 4.1
-------- ----- -------- ----- -------- -----
Total certificate accounts 145,708 43.7 136,328 76.5 108,944 80.0
-------- ----- -------- ----- -------- -----
Total deposits $333,245 100.0% $178,311 100.0% $136,175 100.0%
======== ===== ======== ===== ======== =====
23
The following table shows the distribution of and certain other
information relating to the Bank's certificates of deposit as of the dates
indicated.
June 30,
-----------------------------------------------------------------------------------------------
1999 1998 1997
---------------------------- ------------------------------ ----------------------------
Percent of Percent of Percent of
Amount Deposits Amount Deposits Amount Deposits
------------ ------------ ------------ ----------- ------------ -------------
Total retail certificates $134,027 40.2% $126,096 70.7% $ 96,946 71.2%
-------- ---- -------- ---- -------- ----
Non-retail certificates:
Jumbo certificates 7,440 2.2 2,752 1.5 2,420 1.8
Inverse variable-rate
certificates 2,907 0.9 5,250 3.0 6,218 4.6
Non-brokered out-of-state
deposits 1,334 0.4 2,131 1.2 3,064 2.2
Brokered deposits -- -- 99 0.1 296 0.2
-------- ---- -------- ---- -------- ----
Total non-retail
certificates (1) 11,681 3.5 10,232 5.8 11,998 8.8
-------- ---- -------- ---- -------- ----
Total certificates of
deposit $145,708 43.7% $136,328 76.5% $108,944 80.0%
======== ==== ======== ==== ======== ====
- ------------------------------
(1) Of the Company's $11.7 million of non-retail certificates as of June
30, 1999, $4.9 million was scheduled to mature in six months or less,
$2.8 million was scheduled to mature in 7-12 months, $2.4 million was
scheduled to mature in 13-36 months and $1.6 million was scheduled to
mature in over 36 months.
The following table presents the average balance of each deposit type
and the average rate paid on each deposit type for the periods indicated.
Year Ended June 30,
-----------------------------------------------------------------------------------
1999 1998 1997
-------------------------- --------------------------- ---------------------------
Average Average Average Average Average Average
Balance Rate Paid Balance Rate Paid Balance Rate Paid
------------ ------------ -------------- ----------- ------------- -------------
(Dollars in Thousands)
NOW and DDA accounts $ 13,050 2.3% $ 6,788 2.5% $ 4,697 2.6%
Savings accounts 30,520 4.2 25,188 4.3 20,463 4.1
Money market deposit
accounts 73,256 4.8 2,713 4.7 1,886 4.4
Certificates of deposit 156,262 5.7 117,073 5.9 109,756 5.9
-------- -------- --------
Total deposits $273,088 5.2% $151,762 5.5% $136,802 5.5%
======== === ======== === ======== ===
24
The following table sets forth the deposit account activities of the
Bank during the periods indicated.
Year Ended June 30,
1999 1998 1997
--------- --------- ---------
(In Thousands)
Deposits $ 878,151 $ 264,182 $ 208,032
Withdrawals 742,612 230,421 212,517
--------- --------- ---------
Net increase (decrease) before
interest credited 135,539 33,761 (4,485)
Interest credited 19,395 8,375 5,517
--------- --------- ---------
Net increase in deposits $ 154,934 $ 42,136 $ 1,032
========= ========= =========
The following table shows the interest rate and maturity information
for the Bank's certificates of deposit at June 30, 1999.
Maturity Date
------------------------------------------------------------------------------------------------------
Interest Rate One Year or Less Over 1-2 Years Over 2-3 Years Over 3 Years Total
- -------------------- ------------------ ------------------ ----------------- ----------------- -------------------
(Dollars in Thousands)
3.00% or less $ 4 $ -- $ -- $ 4 $ 8
3.01 - 5.00% 81,554 3,594 467 996 86,611
5.01 - 7.00% 43,809 5,148 2,177 3,015 54,149
7.01 - 9.00% 1,216 127 1,311 828 3,482
9.01% or greater 9 674 775 -- 1,458
--------- -------- ------- ------- ---------
Total $ 126,592 $ 9,543 $ 4,730 $ 4,843 $ 145,708
========= ======== ======= ======= =========
The following table sets forth the maturities of the Bank's
certificates of deposit having principal amounts of $100,000 or more at June 30,
1999.
Certificates of deposit maturing
in quarter ending: Amount
- ---------------------------------------------- --------------
(In Thousands)
September 30, 1999 $ 11,107
December 31, 1999 11,106
March 31, 2000 4,495
After March 31, 2000 4,481
--------
Total certificates of deposit with
balances of $100,000 or more $ 31,189
========
25
Borrowings. The following table sets forth certain information
regarding the borrowings of the Company at or for the dates indicated.
At or For the Year Ended June 30,
--------------------------------------
1999 1998 1997
-------- -------- --------
(Dollars in Thousands)
FHLB advances:
Average balance outstanding $ 36,172 $ 27,488 $ 26,089
Maximum amount outstanding at
any month-end during the period 40,000 64,000 29,300
Balance outstanding at end of period 40,000 26,000 26,000
Average interest rate during the
period 6.9% 6.7% 6.3%
Average interest rate at end of period 4.9% 5.6% 5.8%
Securities sold under agreements to repurchase:
Average balance outstanding $213,428 $319,579 $306,034
Maximum amount outstanding at
any month-end during the period 334,160 342,094 343,427
Balance outstanding at end of period 60,198 240,396 245,571
Average interest rate during the
period 5.4% 5.6% 5.4%
Average interest rate at end of period 4.9% 5.7% 5.5%
The Company obtains both fixed-rate and variable-rate long-term and
short-term advances from the FHLB of Indianapolis upon the security of certain
of its residential first mortgage loans and other assets, provided certain
standards related to creditworthiness of the Bank have been met. FHLB of
Indianapolis advances are available for general business purposes to expand
lending and investing activities. Borrowings have generally been used to fund
the purchase of mortgage-backed and related securities or lending activities and
have been collateralized with a blanket pledge agreement of the Bank's assets.
Advances from the FHLB of Indianapolis are made pursuant to several
different credit programs, each of which has its own interest rate and range of
maturities. The Company currently has one variable-rate advance from the FHLB of
Indianapolis which matures in fiscal 2000. At June 30, 1999, the Company had a
FHLB of Indianapolis advance in the amount of $40.0 million at a weighted
average interest rate of 4.9%.
The Company also obtains funds from the sales of securities to
investment dealers under agreements to repurchase ("reverse repurchase
agreements"). In a reverse repurchase agreement transaction, the Company will
generally sell a mortgage-backed security agreeing to repurchase
26
either the same or a substantially identical security (i.e., "dollar rolls") on
a specified later date (generally not more than 90 days) at a price that is
generally less than the original sales price. The difference in the sale price
and purchase price is the spread between the mortgage cash flows and the implied
financing rate. The mortgage-backed securities underlying the agreements are
delivered to the dealers who arrange the transactions. For agreements in which
the Company has agreed to repurchase substantially identical securities, the
dealers may sell, loan or otherwise dispose of the Company's securities in the
normal course of their operations; however, such dealers or third party
custodians safe-keep the securities which are to be specifically repurchased by
the Company. Reverse repurchase agreements represent a competitive cost funding
source for the Company. Nevertheless, the Company is subject to the risk that
the lender may default at maturity and not return the collateral. The amount at
risk is the value of the collateral which exceeds the balance of the borrowing.
In order to minimize this potential risk, the Company normally deals with large,
established investment brokerage firms when entering into these transactions.
Reverse repurchase transactions are accounted for as financing arrangements
rather than as sales of such securities, and the obligation to repurchase such
securities is reflected as a liability in the Consolidated Financial Statements.
In April 1993, the Company entered into a $10.0 million loan facility
with an unrelated financial institution. This facility, as amended in 1997,
includes a $10.0 million term loan (the "Refinancing Loan") and a non-revolving
line of credit of $5.0 million. Proceeds from the Refinancing Loan were utilized
to repay the unpaid balance of a $10.0 million loan that the Company obtained in
1988 in connection with its acquisition of the Bank, reduce the average interest
rate paid on such indebtedness and increase the capitalization of the Bank. The
loan facility matures in June 2000 and carries an interest rate equal to the
prime rate published in the Wall Street Journal. The loan facility requires
quarterly interest-only repayments with the unpaid principal balance outstanding
payable in full at maturity. The loan facility is secured by (1) a general
pledge agreement between the parties pursuant to which the Company has pledged
100% of the outstanding stock of the Bank; (2) a security agreement between the
parties pursuant to which the Company has provided a blanket security interest
in all of its assets; and (3) the assignment of life insurance policies on
Messrs. Breeden and Cerny by the Company in the aggregate amount of $1.25
million. At June 30, 1999, the total balance of the loan facility was $14.0
million.
27
Subsidiaries
In February 1999, the Bank formed Harrington Wealth Management Company
("HWM"), which provides trust, investment management, and custody services for
individuals and institutions. HWM is a strategic alliance between the Bank (51%
owner) and Los Padres Bank (49% owner), a federally chartered savings bank
located in California. HWM is an operating subsidiary of the Bank and, as such,
is restricted to engage in activities that the Bank can engage in directly. As
of June 30, 1999, HWM administered 69 trust/fiduciary accounts, with aggregate
assets of approximately $29.8 million at such date, a portion of which were
formerly administered by Harrington Investment Management and Trust Services, a
separate division of the Bank. The Bank's investment in HWM is not material to
its operations or financial condition. The accompanying consolidated balance
sheet includes 100 percent of the assets and liabilities of HWM, and the
ownership of Los Padres Bank is recorded as "Minority interest." The results of
operations include 100 percent of the revenues and expenses of HWM from the date
of formation, and the ownership of Los Padres Bank is recorded as "Minority
interest" net of income taxes. See Note 1 to the Notes to Consolidated Financial
Statements.
The Bank is permitted to invest up to 2% of its assets in the capital
stock of, or secured or unsecured loans to, service corporations, with an
additional investment of 1% of assets when such additional investments is
utilized primarily for community development purposes. The Bank's only service
corporation, Pine Tree Mortgage Corp., is an inactive corporation formed in 1987
to originate mortgage loans in North Carolina and has conducted no business
since 1988. The Bank's investment in the service corporation is not material to
its operations or financial condition.
Supervision and Regulation
Set forth below is a brief description of those laws and regulations
which, together with the descriptions of laws and regulations contained
elsewhere herein, are deemed material to an investor's understanding of the
extent to which the Company and the Bank are regulated. The description of the
laws and regulations hereunder, as well as descriptions of laws and regulations
contained elsewhere herein, does not purport to be complete and is qualified in
its entirety by reference to applicable laws and regulations.
The Company
General. The Company is a registered savings and loan holding company
within the meaning of the Home Owners' Loan Act ("HOLA"), and is subject to OTS
regulations, examinations, supervision and reporting requirements. As a
subsidiary of a savings and loan holding company, the Bank is subject to certain
restrictions in its dealings with the Company and affiliates thereof.
Activities Restrictions. Although there are generally no restrictions
on the activities of a savings and loan holding company which holds only one
subsidiary savings institution under
28
applicable OTS regulations, the Company may be considered to be a multiple
savings and loan holding company because principals and affiliates of Smith
Breeden may be deemed for regulatory purposes to control both the Company and
Harrington West Financial Group, a savings and loan holding company which owns
all of the outstanding common stock of Los Padres Savings Bank, F.S.B., Los
Padres, California.
Multiple savings and loan holding companies are subject to restrictions
which do not apply to unitary savings and loan holding companies. Among other
things, no multiple savings and loan holding company or subsidiary thereof which
is not a savings institution shall commence or continue for a limited period of
time after becoming a multiple savings and loan holding company or subsidiary
thereof any business activity, upon prior notice to, and no objection by the
OTS, other than: (1) furnishing or performing management services for a
subsidiary savings institution; (2) conducting an insurance agency or escrow
business; (3) holding, managing, or liquidating assets owned by or acquired from
a subsidiary savings institution; (4) holding or managing properties used or
occupied by a subsidiary savings institution; (5) acting as trustee under deeds
of trust; (6) engaging in those activities authorized by regulation as of March
5, 1987 to be permissible for multiple savings and loan holding companies; or
(7) unless the Director of the OTS by regulation prohibits or limits such
activities for savings and loan holding companies, those activities authorized
by the Federal Reserve Board as permissible for bank holding companies. Those
activities described in (7) above also must be approved by the Director of the
OTS prior to being engaged in by a multiple savings and loan holding company.
The Company does not believe that if the OTS designates it as a multiple thrift
holding company, such a designation will limit its ability to conduct its normal
business operations.
In addition, if the Director of the OTS determines that there is
reasonable cause to believe that the continuation by a savings and loan holding
company of an activity constitutes a serious risk to the financial safety,
soundness or stability of its subsidiary savings institution, the Director may
impose such restrictions as deemed necessary to address such risk, including
limiting (1) payment of dividends by the savings institution; (2) transactions
between the savings institution and its affiliates; and (3) any activities of
the savings institution that might create a serious risk that the liabilities of
the holding company and its affiliates may be imposed on the savings
institution.
Limitations on Transactions with Affiliates. Transactions between
savings institutions and any affiliate are governed by Sections 23A and 23B of
the Federal Reserve Act. An affiliate of a savings institution is any company or
entity which controls, is controlled by or is under common control with the
savings institution. In a holding company context, the parent holding company of
a savings institution (such as the Company) and any companies which are
controlled by such parent holding company are affiliates of the savings
institution. Generally, Sections 23A and 23B (1) limit the extent to which the
savings institution or its subsidiaries may engage in "covered transactions"
with any one affiliate to an amount equal to 10% of such institution's capital
stock and surplus, and contain an aggregate limit on all such transactions with
all affiliates to an amount equal to 20% of such capital stock and surplus and
(2) require that all such transactions be on terms substantially the same, or at
least as favorable, to the institution or subsidiary as those provided to a
non-affiliate. The term "covered transaction" includes the making of loans,
purchase of assets, issuance of a
29
guarantee and other similar transactions. In addition to the restrictions
imposed by Sections 23A and 23B, no savings institution may (1) loan or
otherwise extend credit to an affiliate, except for any affiliate which engages
only in activities which are permissible for bank holding companies, or (2)
purchase or invest in any stocks, bonds, debentures, notes or similar
obligations of any affiliate, except for affiliates which are subsidiaries of
the savings institution.
In addition, Sections 22(h) and (g) of the Federal Reserve Act places
restrictions on loans to executive officers, directors and principal
stockholders. Under Section 22(h), loans to a director, an executive officer and
to a greater than 10% stockholder of a savings institution, and certain
affiliated interests of either, may not exceed, together with all other
outstanding loans to such person and affiliated interests, the savings
institution's loans to one borrower limit (generally equal to 15% of the
institution's unimpaired capital and surplus). Section 22(h) also requires that
loans to directors, executive officers and principal stockholders be made on
terms substantially the same as offered in comparable transactions to other
persons unless the loans are made pursuant to a benefit or compensation program
that (1) is widely available to employees of the institution and (2) does not
give preference to any director, executive officer or principal stockholder, or
certain affiliated interests of either, over other employees of the savings
institution. Section 22(h) also requires prior board approval for certain loans.
In addition, the aggregate amount of extensions of credit by a savings
institution to all insiders cannot exceed the institution's unimpaired capital
and surplus. Furthermore, Section 22(g) places additional restrictions on loans
to executive officers. At June 30, 1999, the Bank was in compliance with the
above restrictions.
Restrictions on Acquisitions. Except under limited circumstances,
savings and loan holding companies are prohibited from acquiring, without prior
approval of the Director of the OTS, (1) control of any other savings
institution or savings and loan holding company or substantially all the assets
thereof or (2) more than 5% of the voting shares of a savings institution or
holding company thereof which is not a subsidiary. Except with the prior
approval of the Director of the OTS, no director or officer of a savings and
loan holding company or person owning or controlling by proxy or otherwise more
than 25% of such company's stock, may acquire control of any savings
institution, other than a subsidiary savings institution, or of any other
savings and loan holding company.
The Director of the OTS may only approve acquisitions resulting in the
formation of a multiple savings and loan holding company which controls savings
institutions in more than one state if (1) the multiple savings and loan holding
company involved controls a savings institution which operated a home or branch
office located in the state of the institution to be acquired as of March 5,
1987; (2) the acquirer is authorized to acquire control of the savings
institution pursuant to the emergency acquisition provisions of the Federal
Deposit Insurance Act ("FDIA"); or (3) the statutes of the state in which the
institution to be acquired is located specifically permit institutions to be
acquired by the state-chartered institutions or savings and loan holding
companies located in the state where the acquiring entity is located (or by a
holding company that controls such state-chartered savings institutions).
30
Under the Bank Holding Company Act of 1956, the Federal Reserve Board
is authorized to approve an application by a bank holding company to acquire
control of a savings institution. In addition, a bank holding company that
controls a savings institution may merge or consolidate the assets and
liabilities of the savings institution with, or transfer assets and liabilities
to, any subsidiary bank which is a member of the BIF with the approval of the
appropriate federal banking agency and the Federal Reserve Board. As a result of
these provisions, there have been a number of acquisitions of savings
institutions by bank holding companies in recent years.
The Bank
General. The OTS has extensive authority over the operations of
federally chartered savings institutions. As part of this authority, savings
institutions are required to file periodic reports with the OTS and are subject
to periodic examinations by the OTS. The last regulatory examination of the Bank
by the OTS was conducted beginning on November 2, 1998. The Bank was not
required to make any material changes to its operations as a result of such
examination. The investment and lending authority of savings institutions are
prescribed by federal laws and regulations, and such institutions are prohibited
from engaging in any activities not permitted by such laws and regulations.
Those laws and regulations generally are applicable to all federally chartered
savings institutions and may also apply to state-chartered savings institutions.
Such regulation and supervision is primarily intended for the protection of
depositors.
The OTS' enforcement authority over all savings institutions and their
holding companies includes, among other things, the ability to assess civil
money penalties, to issue cease and desist or removal orders and to initiate
injunctive actions. In general, these enforcement actions may be initiated for
violations of laws and regulations and unsafe or unsound practices. Other
actions or inactions may provide the basis for enforcement action, including
misleading or untimely reports filed with the OTS.
Insurance of Accounts. The deposits of the Bank are insured to the
maximum extent permitted by the SAIF, which is administered by the FDIC, and are
backed by the full faith and credit of the U.S. Government. As insurer, the FDIC
is authorized to conduct examinations of, and to require reporting by,
FDIC-insured institutions. It also may prohibit any FDIC-insured institution
from engaging in any activity the FDIC determines by regulation or order to pose
a serious threat to the FDIC. The FDIC also has the authority to initiate
enforcement actions against savings institutions, after giving the OTS an
opportunity to take such action.
Both the SAIF and Bank Insurance Fund ("BIF") are statutorily required
to be capitalized to a ratio of 1.25% of insured reserve deposits. The BIF met
its required capitalization levels in 1995 and, as a result, most BIF insured
banks have been paying significantly lower premiums than SAIF institutions. The
legislation enacted by the U.S. Congress, which was signed by the President on
September 30, 1996, has recapitalized the SAIF by a one-time charge of $0.657
for each $100 of assessable deposits held at March 31, 1995. Although this
resulted in pre-tax expense of $830,000 recognized in the Company's earnings in
fiscal year 1997, future earnings will be enhanced due to lower insurance
premiums. The Bank's insurance premiums, which had amounted to $0.23 for
31
every $100 of assessable deposits, were reduced to $0.065 for every $100 of
assessable deposits beginning on January 1, 1997.
The FDIC may terminate the deposit insurance of any insured depository
institution, including the Bank, if it determines after a hearing that the
institution has engaged or is engaging in unsafe or unsound practices or is in
an unsafe or unsound condition to continue operations, or if the insured
depository institution or any of its directors or trustees have violated any
applicable law, regulation, order or any condition imposed by an agreement with
the FDIC. It also may suspend deposit insurance temporarily during the hearing
process for the permanent termination of insurance, if the institution has no
tangible capital. If insurance of accounts is terminated, the accounts at the
institution at the time of the termination, less subsequent withdrawals, shall
continue to be insured for a period of six months to two years, as determined by
the FDIC. Management is aware of no existing circumstances which would result in
termination of the Bank's deposit insurance.
Regulatory Capital Requirements. OTS capital regulations require
savings instituions to satisfy minimum capital standards: risk-based capital
requirements, a leverage requirement and a tangible capital requirement. Savings
institutions must meet each of these standards in order to be deemed in
compliance with OTS capital requirements. In addition, the OTS may require
savings institutions to maintain capital above the minimum capital levels.
All savings institutions are required to meet a minimum risk-based
capital requirement of total capital (core capital plus supplementary capital)
equal to 8% of risk-weighted assets (which includes the credit risk equivalents
of certain off-balance sheet items). In calculating total capital for purposes
of the risk-based requirement, supplementary capital may not exceed 100% of core
capital. Under the leverage requirement, a savings institution is required to
maintain core capital equal to a minimum of 3% of adjusted total assets. (In
addition, under the prompt corrective action provisions of the OTS regulations,
all but the most highly-rated institutions must maintain a minimum leverage
ratio of 4% in order to be adequately capitalized. See "--Prompt Corrective
Action.") A savings institution is also required to maintain tangible capital in
an amount at least equal to 1.5% of its adjusted total assets.
The foregoing capital requirements are viewed as minimum standards by
the OTS, and most institutions are expected to maintain capital levels well
above the minimum. In addition, the OTS regulations provide that minimum capital
levels higher than those provided in the regulations may be established by the
OTS for individual savings institutions, upon a determination that the savings
institution's capital is or may become inadequate in view of its circumstances.
The OTS regulations provide that higher individual minimum regulatory capital
requirements may be appropriate in circumstances where, among others: (1) a
savings institution has a high degree of exposure to interest rate risk,
prepayment risk, credit risk, concentration of credit risk, certain risks
arising from nontraditional activities, or similar risks or a high proportion of
off-balance sheet risk; (2) a savings institution is growing, either internally
or through acquisitions, at such a rate that supervisory problems are presented
that are not dealt with adequately by OTS regulations; and (3) a savings
institution may be adversely affected by activities or condition of its holding
company,
32
affiliates, subsidiaries or other persons or savings institutions with which it
has significant business relationships. The Bank is not subject to any such
individual minimum regulatory capital requirement.
In March 1999, the federal banking agencies amended their risk-based
and leverage capital standards to make uniform their regulations. In particular,
the agencies made risk-based capital treatments for construction loans on
pre-sold residential properties, real estate loans secured by junior liens on
1-to 4-family residential properties, and investments in mutual funds consistent
among the agencies, and simplified and made uniform the agencies' Tier 1
leverage capital standards. The most highly-rated institutions must maintain a
minimum Tier 1 leverage ratio of 3.0 percent, with all other institutions
required to maintain a minimum leverage ratio of 4.0 percent. The OTS
regulations now state that higher-than-minimum capital levels may be required if
warranted, and that institutions should maintain capital levels consistent with
their risk exposures.
Any savings institution that fails any of the capital requirements is
subject to possible enforcement actions by the OTS or the FDIC. Such actions
could include a capital directive, a cease and desist order, civil money
penalties, the establishment of restrictions on the institution's operations
(including growth), termination of federal deposit insurance and the appointment
of a conservator or receiver. The OTS' capital regulation provides that such
actions, through enforcement proceedings or otherwise, could require one or more
of a variety of corrective actions.
Prompt Corrective Action. Under Section 38 of the Federal Deposit
Insurance Act ("FDIA"), each federal banking agency was required to implement a
system of prompt corrective action for institutions which it regulates. The
federal banking agencies, including the OTS, adopted substantially similar
regulations to implement Section 38 of the FDIA, effective as of December 19,
1992. Under the regulations, an institution is deemed to be (1) "well
capitalized" if it has total risk-based capital of 10.0% or more, has a Tier 1
risk-based capital ratio of 6.0% or more, has a Tier 1 leverage capital ratio of
5.0% or more and is not subject to any order or final capital directive to meet
and maintain a specific capital level for any capital measure, (2) "adequately
capitalized" if it has a total risk-based capital ratio of 8.0% or more, a Tier
1 risk-based capital ratio of 4.0% or more and a Tier 1 leverage capital ratio
of 4.0% or more (3.0% under certain circumstances) and does not meet the
definition of "well capitalized," (3) "undercapitalized" if it has a total
risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital
ratio that is less than 4.0% or a Tier 1 leverage capital ratio that is less
than 4.0% (3.0% under certain circumstances), (4) "significantly
undercapitalized" if it has a total risk-based capital ratio that is less than
6.0%, a Tier 1 risk-based capital ratio that is less than 3.0% or a Tier 1
leverage capital ratio that is less than 3.0% and (5) "critically
undercapitalized" if it has a ratio of tangible equity to total assets that is
equal to or less than 2.0%. Section 38 of the FDIA and the regulations
promulgated thereunder also specify circumstances under which a federal banking
agency may reclassify a well capitalized institution as adequately capitalized
and may require an adequately capitalized institution or an undercapitalized
institution to comply with supervisory actions as if it were in the next lower
category (except that the FDIC may not reclassify a significantly
undercapitalized instituion as critically undercapitalized).
33
An institution generally must file a written capital restoration plan
which meets specified requirements with an appropriate federal banking agency
within 45 days of the date that the institution receives notice or is deemed to
have notice that it is undercapitalized, significantly undercapitalized or
critically undercapitalized. A federal banking agency must provide the
institution with written notice of approval or disapproval within 60 days after
receiving a capital restoration plan, subject to extensions by the agency.
An institution which is required to submit a capital restoration plan
must concurrently submit a performance guaranty by each company that controls
the institution. Such guaranty shall be limited to the lesser of (1) an amount
equal to 5.0% of the institution's total assets at the time the institution was
notified or deemed to have notice that it was undercapitalized or (2) the amount
necessary to restore the relevant capital measures of the institution to the
levels required for the institution to be classified as adequately capitalized.
Such a guarantee shall expire after the federal banking agency notifies the
institution that it has remained adequately capitalized for each of four
consecutive calendar quarters. An institution which fails to submit a written
capital restoration plan within the requisite period, including any required
performance guarantee(s), or fails in any material respect to implement a
capital restoration plan, shall be subject to the restrictions in Section 38 of
the FDIA which are applicable to significantly undercapitalized institutions.
Immediately upon becoming undercapitalized, an institution shall become
subject to the provisions of Section 38 of the FDIA (1) restricting payment of
capital distributions and management fees, (2) requiring that the appropriate
federal banking agency monitor the condition of the institution and its efforts
to restore its capital, (3) requiring submission of a capital restoration plan,
(4) restricting the growth of the institution's assets and (5) requiring prior
approval of certain expansion proposals. The appropriate federal banking agency
for an undercapitalized instituiton also may take any number of discretionary
supervisory actions if the agency determines that any of these actions is
necessary to resolve the problems of the institution at the least possible
long-term cost to the deposit insurance fund, subject in certain cases to
specified procedures. These discretionary supervisory actions include requiring
the institution to raise additional capital; restricting transactions with
affiliates; restricting interest rates paid by the institution on deposits;
requiring replacement of senior executive officers and directors; restricting
the activities of the institution and its affiliates; requiring divestiture of
the institution or the sale of the institution to a willing purchaser; and any
other supervisory action that the agency deems appropriate. These and additional
mandatory and permissive supervisory actions may be taken with respect to
significantly undercapitalized and critically undercapitalized institutions.
At June 30, 1999, the Bank was deemed a "well capitalized" institution
for purposes of the above regulations and as such was not subject to the above
mentioned restrictions.
Liquidity Requirements. 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
34
result of this change, the level of assets eligible for regulatory liquidity
calculations increased considerably. At June 30, 1999, the Bank's liquidity
ratio was 16.7%.
Capital Distributions. OTS regulations govern capital distributions by
savings institutions, which include cash dividends, stock redemptions or
repurchases, cash-out mergers, interest payments on certain convertible debt and
other transactions charged to the capital account of a savings institution to
make capital distributions.
In January 1999, the OTS amended its capital distribution regulation to
bring such regulations into greater conformity with the other bank regulatory
agencies. Under the regulation, certain savings institutions would not be
required to file with the OTS. Specifically, savings institutions that would be
well capitalized following a capital distribution would not be subject to any
requirement for notice or application unless the total amount of all capital
distributions, including any proposed capital distribution, for the applicable
calendar year would exceed an amount equal to the savings institution's net
income for that year to date plus the savings institution's retained net income
for the preceding two years. Because the Bank is a subsidiary of the Company,
the regulation, however, would require the Bank to provide notice to the OTS of
its intent to make a capital distribution, unless an application is otherwise
required. The Bank does not believe that the regulation will adversely affect
its ability to make capital distributions.
Loans to One Borrower. The permissible amount of loans-to-one borrower
now generally follows the national bank standard for all loans made by savings
institutions, as compared to the pre-FIRREA rule that applied that standard only
to commercial loans made by federally chartered savings institutions. The
national bank standard generally does not permit loans-to-one borrower to exceed
15% of unimpaired capital and unimpaired surplus. Loans in an amount equal to an
additional 10% of unimpaired capital and unimpaired surplus also may be made to
a borrower if the loans are fully secured by readily marketable securities. If a
savings institution's aggregate lending limitation is less than $500,000, then,
notwithstanding the aforementioned aggregate limitation, such savings
institution may have total loans and extensions of credit, for any purpose, to
one borrower outstanding at one time not to exceed $500,000. For information
about the largest borrowers from the Bank, see "- Lending Activities."
Branching by Federal Savings Institutions. OTS policy permits
interstate branching to the full extent permitted by statute (which is
essentially unlimited). Generally, federal law prohibits federal savings
institutions from establishing, retaining or operating a branch outside the
state in which the federal institution has its home office unless the
institution meets the IRS' domestic building and loan test (generally, 60% of a
thrift's assets must be housing-related) ("IRS Test"). The IRS Test requirement
does not apply if, among other things, the law of the state where the branch
would be located would permit the branch to be established if the federal
savings institution were chartered by the state in which its home office is
located. Furthermore, the OTS will evaluate a branching applicant's record of
compliance with the Community Reinvestment Act of 1977 ("CRA"). An
unsatisfactory CRA record may be the basis for denial of a branching
application.
35
Qualified Thrift Lender Test. All savings institutions are required to
meet a QTL test to avoid certain restrictions on their operations. Under Section
2303 of the Economic Growth and Regulatory Paperwork Reduction Act of 1996, a
savings association can comply with the QTL test by either meeting the QTL test
set forth in the HOLA and implementing regulations or qualifying as a domestic
building and loan association as defined in Section 7701(a)(19) of the Internal
Revenue Code of 1986, as amended ("Code"). The QTL test set forth in the HOLA
requires a thrift institution to maintain 65% of portfolio assets in Qualified
Thrift Investments ("QTIs"). Portfolio assets are defined as total assets less
intangibles, property used by a savings institution in its business and
liquidity investments in an amount not exceeding 20% of assets. Generally, QTIs
are residential housing related assets. At June 30, 1999, the qualified thrift
investments of the Bank were approximately 84.5% of its portfolio assets.
A savings institution that does not meet the QTL test must either
convert to a bank charter or comply with the following restrictions on its
operations: (1) the institution may not engage in any new activity or make any
new investment, directly or indirectly, unless such activity or investment is
permissible for a national bank; (2) the branching powers of the institution
shall be restricted to those of a national bank; (3) the institution shall not
be eligible to obtain any advances from its FHLB; and (4) payment of dividends
by the institution shall be subject to the rules regarding payment of dividends
by a national bank. Upon the expiration of three years from the date the savings
institution ceases to be a QTL, it must cease any activity and not retain any
investment not permissible for a national bank and immediately repay any
outstanding FHLB advances (subject to safety and soundness considerations).
Accounting Requirements. Applicable OTS accounting regulations and
reporting requirements apply the following standards: (1) regulatory reports
will incorporate generally accepted accounting principles ("GAAP") when GAAP is
used by federal banking agencies; (2) savings institution transactions,
financial condition and regulatory capital must be reported and disclosed in
accordance with OTS regulatory reporting requirements that will be at least as
stringent as for national banks; and (3) the Director of the OTS may prescribe
regulatory reporting requirements more stringent than GAAP whenever the Director
determines that such requirements are necessary to ensure the safe and sound
reporting and operation of savings institutions.
Federal Home Loan Bank System. The Bank is a member of the FHLB of
Indianapolis, which is one of 12 regional FHLBs that administers the home
financing credit function of savings institutions. Each FHLB serves as a reserve
or central bank for its members within its assigned region. It is funded
primarily from proceeds derived from the sale of consolidated obligations of the
FHLB System. It makes loans to members (i.e., advances) in accordance with
policies and procedures established by the Board of Directors of the FHLB. At
June 30, 1999, the Company had a $40.0 million FHLB advance. See "Sources of
Funds - Borrowings."
As a member, the Bank is required to purchase and maintain stock in the
FHLB of Indianapolis in an amount equal to at least 1% of its aggregate unpaid
residential mortgage loans, home purchase contracts or similar obligations at
the beginning of each year. At June 30, 1999, the Bank had $4.9 million in FHLB
stock, which was in compliance with this requirement.
36
The FHLBs are required to provide funds for the resolution of troubled
savings institutions and to contribute to affordable housing programs through
direct loans or interest subsidies on advances targeted for community investment
and low- and moderate-income housing projects. These contributions have
adversely affected the level of FHLB dividends paid in the past and could
continue to do so in the future. These contributions also could have an adverse
effect on the value of FHLB stock in the future.
Federal Reserve System. The Federal Reserve Board requires all
depository institutions to maintain reserves against their transaction accounts
(primarily NOW and Super NOW checking accounts) and non-personal time deposits.
As of June 30, 1999, the Bank was in compliance with this requirement. Because
required reserves must be maintained in the form of vault cash or a non-interest
bearing account at a Federal Reserve Bank, the effect of this reserve
requirement is to reduce an institution's earning assets.
Federal Taxation
General. The Company and Bank are subject to the generally applicable
corporate tax provisions of the Code, and Bank is subject to certain additional
provisions of the Code which apply to thrifts and other types of financial
institutions. The following discussion of federal taxation is intended only to
summarize certain pertinent federal income tax matters material to the taxation
of the Company and the Bank and is not a comprehensive discussion of the tax
rules applicable to the Company and Bank.
Year. The Company files a consolidated federal income tax return on the
basis of a fiscal year ending on June 30. The Company's federal income tax
returns for the tax years ended June 30, 1996 forward are open under the statute
of limitations and are subject to review by the IRS.
Bad Debt Reserves. Prior to the enactment, on August 20, 1996, of the
Small Business Job Protection Act of 1996 (the "Small Business Act"), for
federal income tax purposes, thrift institutions such as the Bank, which met
certain definitional tests primarily relating to their assets and the nature of
their business, were permitted to establish tax reserves for bad debts and to
make annual additions thereto, which additions could, within specified
limitations, be deducted in arriving at their taxable income. The Bank's
deduction with respect to "qualifying loans," which are generally loans secured
by certain interest in real property, could be computed using an amount based on
a six-year moving average of the Bank's actual loss experience (the "Experience
Method"), or a percentage equal to 8.0% of the Bank's taxable income (the "PTI
Method"), computed without regard to this deduction and with additional
modifications and reduced by the amount of any permitted addition to the
non-qualifying reserve.
Under the Small Business Act, the PTI Method was repealed and the Bank
will be required to use the Experience Method of computing additions to its bad
debt reserve for taxable years beginning with the Bank's taxable year beginning
July 1, 1996. In addition, the Bank will be required to recapture (i.e., take
into taxable income) over a six-year period, beginning with the
37
Bank's taxable year beginning July 1, 1996, the excess of the balance of its bad
debt reserves (other than the supplemental reserve) as of June 30, 1996 over (a)
the greater of the balance of such reserves as of June 30, 1988 or (b) an amount
that would have been the balance of such reserves as of June 30, 1996 had the
Bank always computed the additions to its reserves using the Experience Method.
However, under the Small Business Act such recapture requirements will be
suspended for each of the two successive taxable years beginning July 1, 1996 in
which the Bank originates a minimum amount of certain residential loans during
such years that is not less than the average of the principal amounts of such
loans made by the Bank during its six taxable years preceding July 1, 1996. The
Bank 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 began in taxable year 1999.
State Taxation
The State of Indiana imposes a franchise tax on the "adjusted gross
income" of financial institutions at a fixed rate of 8.5% per annum. This
franchise tax is imposed in lieu of the gross income tax, adjusted gross income
tax, and supplemental net income tax otherwise imposed on certain corporate
entities. "Adjusted gross income" is computed by making certain modifications to
an institution's federal taxable income. Tax-exempt interest, for example, is
included in the savings association's adjusted gross income and the bad debt
deduction is limited to actual charge-offs for purposes of the financial
institutions tax.
38
Item 2. Properties
The Company's principal executive office is located at 722 East Main
Street, Richmond, Indiana, 47374. The following table sets forth certain
information with respect to the offices and other properties of the Bank at June
30, 1999.
Net Book Value
Description/Address Leased/Owned of Property(1) Deposits
----------------------------------------- --------------------- ----------------------- ------------------
(In Thousands)
Main Office Owned $ 1,621 $66,127
722 East Main Street
Richmond, Indiana
Carmel Branch (2) Leased (3) 88 69,230
11592 Westfield Boulevard
Carmel, Indiana
Fishers Branch (4) Owned 882 25,833
7150 East 116th Street
Fishers, Indiana
Noblesville Branch (5) Owned 833 22,463
107 West Logan Street
Noblesville, Indiana
Geist Branch (6) Owned 930 15,513
9775 Fall Creek Road
Indianapolis, Indiana
Thompson Road Branch (7) Leased (8) 25 10,574
5249 East Thompson Road
Indianapolis, Indiana
Stop 11 Branch (9) Leased (10) 157 25,250
1121 East Stop 11 Road
Indianapolis, Indiana
Shawnee Mission Branch (11) Leased (12) 135 98,255
6300 Nall Road
Shawnee Mission, Kansas
Chapel Hill Branch (13) Leased (14) 102 --
Suite 271 The Europa Center
Chapel Hill, NC
Executive Offices Leased (15) 26 N/A
10801 Mastin Blvd. Suite 740
Overland Park, KS
39
-----------------------------------------
(1) Includes leasehold improvements.
(2) Branch opened in May 1994.
(3) The lease expires in June 2008 and may be extended for an additional
ten years provided that proper notice is timely given.
(4) Branch opened in December 1995.
(5) Branch opened in June 1997.
(6) Branch opened in December 1997
(7) Branch opened in January 1998.
(8) The lease expires in January 2003 and has three options for additional
terms of five years each.
(9) Branch opened in February 1998.
(10) The lease expires in February 2001 and has three options for additional
terms of five years each.
(11) Branch opened in August 1998.
(12) The lease expires in December 2010 and has four options for additional
terms of five years each.
(13) Branch opened in July 1999.
(14) The lease expires in July 2004.
(15) The lease expires in March 2004.
Item 3. Legal Proceedings.
There are no material legal proceedings to which the Company is a party
or to which any of their property is subject.
Item 4. Submission of Matters to a Vote of Security Holders.
Not applicable.
40
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
Shares of the Company's common stock are traded nationally under the
symbol "HFGI" on the Nasdaq National Market. The following table sets forth the
high, low and closing sales prices for the common stock as reported by the
Nasdaq Stock Market, as well as the dividends paid, for fiscal years 1999 and
1998:
Stock Price per Share
------------------------------------------
High Low Close Dividends
---- --- ----- ---------
1999
First quarter $11.50 $ 8.375 $ 9.00 $0.03
Second quarter 9.00 7.75 8.00 0.03
Third quarter 8.875 7.50 7.875 0.03
Fourth quarter 8.50 7.125 7.25 0.03
1998
First quarter $13.50 $ 11.00 $13.00 $0.03
Second quarter 13.75 12.00 13.00 0.03
Third quarter 13.125 11.125 11.375 0.03
Fourth quarter 11.75 10.75 11.25 0.03
There have been no stock dividends, stock splits or reverse stock
splits. Payment of future dividends is subject to a declaration by the Company's
Board of Directors. Factors considered in determining the size of dividends are
the amount and stability of profits, adequacy of capitalization and expected
asset and liability growth of the Bank.
At September 16, 1999 the Company had approximately 64 stockholders of
record.
Item 6. Selected Financial Data.
The information required herein is incorporated by reference from page
16 of the Registrant's 1999 Annual Report.
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
The information required herein is incorporated by reference from pages
17 to 31 of the Registrant's 1999 Annual Report.
41
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The information required herein is incorporated by reference from pages
18 to 22 of the Registrant's 1999 Annual Report.
Item 8. Financial Statements and Supplementary Data.
The information required herein is incorporated by reference from pages
32 to 59 of the Registrant's 1999 Annual Report.
Item 9. Changes in and Disagreements on Accounting and Financial Disclosure.
Not applicable.
PART III
Item 10. Directors and Executive Officers of the Registrant.
The information required herein is incorporated by reference from pages
2 to 9, and 12 of the Registrant's Proxy Statement dated September 27, 1999
("Proxy Statement").
Item 11. Executive Compensation.
The information required herein is incorporated by reference from pages
12 to 20 of the Registrant's Proxy Statement.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
The information required herein is incorporated by reference from pages
9 to 12 of the Registrant's Proxy Statement.
Item 13. Certain Relationships and Related Transactions.
The information required herein is incorporated by reference from page
17 of the Registrant's Proxy Statement.
42
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.
(a) Document filed as part of this Report.
(1) The following documents are filed as part of this report
and are incorporated herein by reference from the
Registrant's 1999 Annual Report.
Independent Auditors' Report.
Consolidated Balance Sheets as of June 30, 1999 and 1998.
Consolidated Statements of Operations for the Years Ended June 30, 1999,
1998 and 1997.
Consolidated Statements of Changes in Stockholders' Equity for the Years
Ended June 30, 1999, 1998 and 1997.
Consolidated Statements of Cash Flows for the Years Ended June 30, 1999,
1998 and 1997.
Notes to Consolidated Financial Statements.
(2) All schedules for which provision is made in the
applicable accounting regulation of the Securities and
Exchange Commission are omitted because they are not
applicable or the required information is included in the
Consolidated Financial Statements or notes thereto.
43
(3)(a) The following exhibits are filed as part of this Form
10-K, and this list includes the Exhibit Index.
No. Description
- --------------- --------------------------------------------------------------------------------------------------
3.1 Amended and Restated Articles of Incorporation of Harrington Financial Group, Inc.1/
3.2 Amended and Restated Bylaws of Harrington Financial Group, Inc.1/
10.1 Stock Option Plan of Harrington Financial Group, Inc.1/*/
10.2 Loan Agreement between Financial Research Corporation (now Harrington Financial Group,
Inc.) and Mark Twain Kansas Bank (now Mercantile Bancorporation, Inc.), dated April 14,
1994, First Amendment and Loan Agreement between such parties and Smith Breeden
Associates, Inc. and Douglas T. Breeden, dated July 21, 1995.1/
10.2.1 Second Amendment and Loan Modification Agreement between Harrington Financial Group,
Inc. and Mark Twain Kansas City Bank (now Mercantile Bancorporation, Inc.), dated July
26, 1996 (modifies version set forth in Exhibit 10.2) 2/
10.2.2 Third Amendment and Loan Modification Agreement between Harrington Financial Group,
Inc. and Mark Twain Kansas City Bank (now Mercantile Bancorporation, Inc.), dated
January 13, 1997 (modifies version set forth in Exhibits 10.2 and 10.2.1)3/
10.3 Investment Advisory Agreement between Peoples Federal Savings Association (now
Harrington Bank, FSB) and Smith Breeden Associates, Inc. dated April 1, 1992, as
amended on March 1, 1995.1/
10.4 Lease Agreement on Carmel Branch Office Facility, set forth in Assignment of Lease,
between NBD Bank, N.A. and Peoples Federal Savings Association, dated November 8,
1993.1/
10.5 Trust Services Agreement dated September 30, 1994 by and between Harrington Bank, FSB
and the Midwest Trust Company.1/
10.6 Trust Services Agreement dated April 30, 1998 by and between Harrington Bank, FSB and
INFOVISA. 4/
10.7 Terms of Employment between Harrington Bank, FSB and Lawrence T. Loeser dated January
25, 1999.5/*/
13 1999 Annual Report to Stockholders specified portion (pp. 14-59) of the Registrant's
Annual Report to Stockholders for the year ended June 30, 1999.
21 Subsidiaries of the Registrant - Reference is made to Item 1. "Business" for the
Required information
23 Consent of Deloitte & Touche LLP
27 Financial Data Schedule
44
- -----------------
1/ Incorporated by reference from the Registration Statement on Form S-1
(Registration No. 333-1556) filed by the Registrant with the Securities
and Exchange Commission ("SEC") on February 20, 1996, as amended.
2/ Incorporated by reference from the Form 10-K for the fiscal year ended
June 30, 1996 filed by the Registrant with the SEC on September 30,
1996.
3/ Incorporated by reference from the Form 10-K for the fiscal year ended
June 30, 1997 filed by the Registrant with the SEC on September 29,
1997.
4/ Incorporated by reference from the Form 10-K for the fiscal year ended
June 30, 1998 filed by the Registrant with the SEC on September 28,
1998.
5/ Incorporated by reference from the Form 10-Q for the quarterly period
ended March 31, 1999 filed by the Registrant with the SEC on May 17,
1999.
*/ Management contract or compensatory plan or arrangement.
(3)(b) Reports filed on Form 8-K.
None.
45
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
HARRINGTON FINANCIAL GROUP, INC.
By: /s/ Craig J. Cerny
-------------------
Craig J. Cerny
President
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
/s/ Craig J. Cerny September 27, 1999
- ------------------------------------------
Craig J. Cerny
President (Principal Executive Officer)
/s/ John E. Fleener September 27, 1999
- ------------------------------------------
John E. Fleener
Principal Financial & Accounting Officer
/s/ Douglas T. Breeden September 27, 1999
- ------------------------------------------
Douglas T. Breeden
Chairman of the Board
/s/ Russell Breeden III September 27, 1999
- ------------------------------------------
Russell Breeden III
Director
/s/ William F. Quinn September 27, 1999
- ------------------------------------------
William F. Quinn
Director
/s/ Daniel C. Dektar September 27, 1999
- ------------------------------------------
Daniel C. Dektar
Director
/s/ Marianthe Mewkill September 27, 1999
- ------------------------------------------
Marianthe Mewkill
Director
/s/ Michael J. Giarla September 27, 1999
- ------------------------------------------
Michael J. Giarla
Director
/s/ Stephen A. Eason September 27, 1999
- ------------------------------------------
Stephen A. Eason
Director
/s/ Sharon E. Fankhauser September 27, 1999
- ------------------------------------------
Sharon E. Fankhauser
Director
/s/ David F. Harper September 27, 1999
- ------------------------------------------
David F. Harper
Director
/s/ Stanley J. Kon September 27, 1999
- ------------------------------------------
Stanley J. Kon
Director
/s/ John J. McConnell September 27, 1999
- ------------------------------------------
John J. McConnell
Director