1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 1998
Securities and Exchange Commission File Number 0-25722
HF BANCORP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 33-0576146
(State or other jurisdiction (I.R.S. Employer I.D. No.)
Of incorporation or organization)
445 E. Florida Avenue, Hemet, California 92543
(Address of principal executive offices)
Registrant's telephone number, including area code: (909) 658-4411
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 [ ]
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's
classes of common stock, as of the latest practicable date.
There were 6,331,206 shares of the Registrant's common stock
outstanding as of May 12, 1998.
2
HF BANCORP, INC. AND SUBSIDIARY
FORM 10-Q
INDEX
PART I - FINANCIAL INFORMATION PAGE
----
ITEM 1. FINANCIAL STATEMENTS
Consolidated Statements of Financial Condition as of
March 31, 1998 (unaudited), and June 30, 1997 3-4
Consolidated Statements of Operations (unaudited) for the
Three and Nine Months ended March 31, 1998 and 1997 5-6
Consolidated Statements of Changes in Stockholders' Equity (unaudited) 7
Consolidated Statements of Cash Flows (unaudited) for the
Nine Months ended March 31, 1998 and 1997 8-9
Notes to Consolidated Financial Statements (unaudited) 10-14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS 15-38
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK 38
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 39
Item 2. Changes in Securities 39
Item 3. Defaults Upon Senior Securities 39
Item 4. Submission of Matters to a Vote of Security Holders 39
Item 5. Other Information 39
Item 6. Exhibits and Reports on Form 8-K 39
Signature Page 40
2
3
HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
March 31, June 30,
1998 1997
---------- ----------
(Unaudited)
(Dollars In Thousands)
ASSETS
Cash and cash equivalents $ 28,513 $ 18,411
Investment securities held to maturity, at cost (estimated fair value of $10,181
and $26,557 at March 31, 1998 and June 30, 1997, respectively) 10,071 26,794
Investment securities available for sale, at fair value (amortized cost of $112,150
and $147,507 at March 31, 1998 and June 30, 1997, respectively) 112,177 144,997
Loans held for sale 3,644 335
Loans receivable (net of allowance for estimated loan losses of $5,986
and $4,780 at March 31, 1998 and June 30, 1997, respectively) 586,794 484,334
Mortgage-backed securities held to maturity, at cost (estimated fair value of
$131,432 and $148,907 at March 31, 1998 and June 30, 1997, respectively) 131,765 151,369
Mortgage-backed securities available for sale, at fair value (amortized cost of
$151,244 and $108,771 at March 31, 1998 and June 30, 1997, respectively) 151,636 109,493
Accrued interest receivable 6,521 7,332
Investment in capital stock of the Federal Home Loan Bank, at cost 6,509 6,224
Premises and equipment, net 7,551 8,289
Real estate owned, net of valuation allowances
Acquired through foreclosure 1,579 5,287
Acquired for sale or investment -- 418
Repossessed consumer assets 19 11
Gross intangible assets 12,706 14,471
Other assets 6,248 6,984
---------- ----------
Total assets $1,065,733 $ 984,749
========== ==========
3
4
HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Continued)
March 31, June 30,
1998 1997
----------- -----------
(Unaudited)
(Dollars In Thousands Except Per Share Amounts)
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Checking deposits $ 87,502 $ 73,771
Savings deposits 96,946 111,742
Money market deposits 73,150 38,620
Certificates of deposit 610,950 615,522
----------- -----------
Total deposits $ 868,548 $ 839,655
Advances from the Federal Home Loan Bank 100,000 50,000
Accounts payable and other liabilities 5,273 6,888
Income taxes 8,152 7,179
----------- -----------
Total liabilities 981,973 903,722
Stockholders' equity:
Preferred stock, $.01 par value; 2,000,000 shares authorized; none issued -- --
Common stock, $.01 par value; 15,000,000 shares authorized; 6,612,500 issued,
6,311,609 outstanding at March 31, 1998 and 6,281,875 outstanding at 66 66
June 30, 1997
Additional paid-in capital 51,497 51,355
Retained earnings, substantially restricted 39,206 38,441
Net unrealized gain (loss) on securities available for sale, net of taxes 246 (1,050)
Deferred stock compensation (4,208) (4,437)
Treasury stock (3,047) (3,348)
----------- -----------
Total stockholders' equity 83,760 81,027
----------- -----------
Total liabilities and stockholders' equity $ 1,065,733 $ 984,749
=========== ===========
Nominal book value per share $ 13.27 $ 12.90
Tangible book value per share $ 11.74 $ 11.15
Average market price per share on the final trading day of the period $ 17.00 $ 14.38
Shares utilized in above book value calculations 6,311,609 6,281,875
See notes to consolidated financial statements
4
5
HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED MARCH 31, ENDED MARCH 31,
----------------------- -----------------------
1998 1997 1998 1997
-------- -------- -------- --------
(Dollars In Thousands)
INTEREST INCOME:
Interest on loans $ 11,409 $ 9,016 $ 31,885 $ 23,104
Interest on mortgage-backed securities 4,697 3,795 14,179 12,807
Interest and dividends on investment securities 2,531 4,273 9,567 13,466
-------- -------- -------- --------
Total interest income 18,637 17,084 55,631 49,377
INTEREST EXPENSE:
Interest on deposit accounts 10,037 9,894 30,789 28,019
Interest on advances from the Federal Home Loan
Bank and other borrowings 1,681 679 4,757 2,512
Net interest expense of hedging transactions 421 762 1,370 2,318
-------- -------- -------- --------
Total interest expense 12,139 11,335 36,916 32,849
NET INTEREST INCOME BEFORE PROVISION
FOR ESTIMATED LOAN LOSSES 6,498 5,749 18,715 16,528
PROVISION FOR ESTIMATED LOAN LOSSES 2,300 101 2,700 309
-------- -------- -------- --------
NET INTEREST INCOME AFTER PROVISION
FOR ESTIMATED LOAN LOSSES 4,198 5,648 16,015 16,219
OTHER INCOME (EXPENSE):
Loan and other fees 89 105 286 253
Impairment writedown on securities (16) -- (16) --
Loss from real estate operations, net (312) (54) (953) (241)
Gain on sale of mortgage-backed and investment
securities available for sale -- -- 62 1,030
Gain on sale of loans held for sale 56 10 127 20
Deposit related fees 640 378 1,711 929
Gain on sale of merchant bankcard portfolio 200 -- 200 --
Amortization of intangible assets (588) (579) (1,765) (1,391)
Other income 54 62 144 207
-------- -------- -------- --------
Total other income (expense) 123 (78) (204) 807
See notes to consolidated financial statements
5
6
HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS (Continued)
(Unaudited)
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED MARCH 31, ENDED MARCH 31,
----------------------------- ----------------------------
1998 1997 1998 1997
----------- ----------- ----------- -----------
GENERAL AND ADMINISTRATIVE EXPENSES:
Salaries and employee benefits $ 2,604 $ 2,398 $ 7,214 $ 7,111
Occupancy and equipment expense 840 937 2,747 2,470
FDIC insurance and other assessments 185 185 547 1,011
SAIF special assessment -- -- -- 4,757
Legal and professional services 195 161 541 569
Data and item processing service costs 623 611 1,673 1,559
Marketing 155 165 400 472
Deposit servicing expense 34 29 101 46
Supplies and printing expense 118 108 253 299
Other 358 307 1,026 846
----------- ----------- ----------- -----------
Total general and administrative expenses 5,112 4,901 14,502 19,140
EARNINGS (LOSS) BEFORE INCOME TAX
EXPENSE (BENEFIT) (791) 669 1,309 (2,114)
INCOME TAX EXPENSE (BENEFIT) (327) 312 544 (834)
----------- ----------- ----------- -----------
NET EARNINGS (LOSS) APPLICABLE TO BOTH BASIC
AND DILUTED EPS $ (464) $ 357 $ 765 $ (1,280)
=========== =========== ----------- -----------
SHARES APPLICABLE TO BASIC EPS 6,305,292 6,281,875 6,291,108 6,281,875
BASIC EARNINGS (LOSS) PER SHARE $ (0.07) $ 0.06 $ 0.12 $ (0.20)*
=========== =========== =========== ===========
SHARES APPLICABLE TO DILUTED EPS 6,305,292 6,389,113 6,488,333 6,281,875
DILUTED EARNINGS (LOSS) PER SHARE $ (0.07) $ 0.06 $ 0.12 $ (0.20)*
=========== =========== =========== ===========
*$0.24 earnings per share, net of the after-tax effect
of the SAIF special assessment.
See notes to consolidated financial statements
6
7
HF BANCORP, INC.
CONSOLIDATEDSTATEMENT OF CHANGES IN STOCKHOLDERS'EQUITY
Nine Months Ended March 31, 1998
(Unaudited)
Common Additional Retained Unrealized Deferred stock Treasury Total
stock paid-in earnings gain (loss) compensation stock
capital on
securities
available
for sale
------------------------------------------------------------------------------------------
(Dollars In Thousands)
Balance at June 30, 1997 $ 66 $ 51,355 $ 38,441 $ (1,050) $ (4,437) $ (3,348) $ 81,027
Net income for the nine months
ended March 31, 1998 -- -- 765 -- -- -- 765
Change in net unrealized gain
(loss) on securities available for
sale, net of taxes -- -- -- 1,296 -- -- 1,296
Change in deferred stock
compensation -- 144 -- -- 229 -- 373
Utilization of Treasury shares for
exercised stock options -- (2) -- -- -- 301 299
------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------
Balance at March 31, 1998 $ 66 $ 51,497 $ 39,206 $ 246 $ (4,208) $ (3,047) $ 83,760
======== ======== ======== ======== ======== ======== ========
See notes to consolidated financial statements
7
8
HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
FOR THE NINE MONTHS
ENDED MARCH 31,
-------------------------
1998 1997
-------- --------
(Dollars In Thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net earnings (loss) $ 765 $ (1,280)
Adjustments to reconcile net earnings (loss) to net cash provided by (used in)
operating activities:
Write-down of interest only security 16 --
Origination of loans held for sale (14,940) (1,451)
Proceeds from sale of loans held for sale 11,423 1,315
Provisions for estimated loan and real estate losses 3,639 422
Direct write-offs from real estate operations -- 53
Depreciation and amortization 934 900
Amortization of deferred loan fees (586) (539)
Amortization (accretion) of premiums (discounts) on loans
and investment and mortgage-backed securities, net 371 210
Amortization of intangible assets 1,765 1,391
Federal Home Loan Bank stock dividend (285) (294)
Gain on sales of loans held for sale (127) (20)
Loss on sales of real estate, net (151) (112)
Gain on sale of mortgage-backed and investment securities available for sale (62) (1,030)
Loss (gain) on sale of premises and equipment 21 (30)
Decrease (increase) in accrued interest receivable 811 (870)
(Decrease) increase in accounts payable and other liabilities (1,615) 777
Decrease (increase) in other assets 736 662
Other, net 722 1,040
-------- --------
Net cash provided by operating activities 3,437 1,144
CASH FLOWS FROM INVESTING ACTIVITIES:
Net increase in loans receivable (106,565) (83,557)
Purchases of mortgage-backed securities held to maturity -- (15,039)
Purchases of mortgage-backed securities available for sale (80,163) (51,652)
Principal repayments on mortgage-backed securities held to maturity 19,399 14,496
Principal repayments on mortgage-backed securities available for sale 29,006 8,826
Purchases of investment securities held to maturity -- --
Purchases of investment securities available for sale (62,869) (37,968)
Principal repayments on investment securities held to maturity 747 502
Principal repayments on investment securities available for sale 4,127 4,191
Proceeds from sales of mortgage-backed and investment securities available for sale 58,254 71,381
Matured / called investment and mortgage backed securities held to maturity 16,000 9,352
Matured / called investment and mortgage backed securities available for sale 44,033 36,428
Proceeds from sales of real estate acquired by foreclosure 5,593 3,794
Proceeds from sales of real estate held for investment 427 --
Proceeds from sale of premises and equipment 46 6
Acquisitions of premises and equipment (263) (1,749)
Cash payment for acquisition, net of cash received -- (14,707)
-------- --------
Net cash used in investing activities (72,228) (55,696)
8
9
HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(UNAUDITED)
FOR THE NINE MONTHS
ENDED MARCH 31,
---------------------------
1998 1997
--------- ---------
(Dollars In Thousands)
CASH FLOWS FROM FINANCING ACTIVITIES:
Advances received from FHLB $ 60,000 $ --
Proceeds from other borrowings 213,000 --
Decrease in certificate accounts (4,557) (11,061)
Net increase in NOW, passbook, money market investment and
non-interest-bearing accounts 33,450 17,130
Repayment of advances from FHLB (10,000) (20,000)
Repayment of other borrowings (213,000) --
--------- ---------
Net cash provided by (used in) financing activities 78,893 (13,931)
--------- ---------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 10,102 (68,483)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 18,411 100,633
--------- ---------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 28,513 $ 32,150
========= =========
SUPPLEMENTAL CASH FLOW DISCLOSURES:
Cash paid during the period for:
Interest on deposit accounts and other borrowings $ 7,995 $ 5,665
========= =========
Income taxes paid -- --
========= =========
SUPPLEMENTAL DISCLOSURES OF NON CASH
INVESTING AND FINANCING ACTIVITIES:
Real estate acquired through foreclosure $ 2,678 $ 3,764
Loans to facilitate the sale of real estate acquired through foreclosure $ 1,102 $ 896
Purchase of Palm Springs Savings Bank:
Fair value of assets purchased, excluding cash $ -- $ 184,321
Fair value of liabilities assumed -- 169,614
--------- ---------
Cash payment for acquisition, net of cash received $ -- $ 14,707
========= ---------
See notes to consolidated financial statements
9
10
HF BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1998
(UNAUDITED)
Basis of Presentation
The accompanying unaudited consolidated financial statements have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and Article
10 of Regulation S-X. Accordingly, they do not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all necessary adjustments,
consisting only of normal recurring adjustments, necessary for a fair
presentation have been included. The results of operations for the nine month
period ended March 31, 1998, are not necessarily indicative of the results that
may be expected for the entire fiscal year.
HF Bancorp Inc. ("HFB") is the holding company for Hemet Federal
Savings and Loan ("Bank") and its subsidiaries. The Company's headquarters are
in Hemet, California. The Company offers a broad range of financial services to
both consumers and small businesses. All significant intercompany transactions
and balances have been eliminated. Certain reclassifications have been made to
prior years' consolidated financial statements to conform to the current
presentation.
These consolidated financial statements and the information under the
heading "Management's Discussion and Analysis of Financial Condition and Results
of Operations" should be read in conjunction with the audited consolidated
financial statements and notes thereto of HF Bancorp, Inc. for the fiscal year
ended June 30, 1997 included in the Company's Annual Report on Form 10-K for the
fiscal year ended June 30, 1997.
Use of Estimates in the Preparation of Financial Statements
The preparation of the consolidated financial statements of HF
Bancorp, Inc. and subsidiary requires management to make estimates and
assumptions that affect reported amounts. These estimates are based on
information available as of the date of the financial statements. Therefore,
actual results could differ from those estimates.
Computation Of Earnings Per Share
Basic and diluted earnings per share were calculated based upon the
following information:
BASIC EPS SHARES PLUS
Treasury Treasury
EQUALS: Stock Stock EQUALS: Shares Shares *
LESS: Shares Method: Method: Shares * For For
Average Average For Shares Shares For Quarterly Fiscal Fiscal
Total Shares Quarterly For For Quarterly Average YTD YTD
Quarter Shares Treasury BASIC Stock Stock DILUTED Share BASIC DILUTED
Ending Issued Stock EPS Options Awards EPS Price EPS EPS
------ ------ ----- --- ------- ------ --- ----- --- ---
09/30/96 6,612,500 330,625 6,281,875 25 10 6,281,910 $9.54 6,281,875 6,281,910
12/31/96 6,612,500 330,625 6,281,875 41,097 8,462 6,331,434 $10.86 6,281,875 6,306,672
03/31/97 6,612,500 330,625 6,281,875 91,746 15,492 6,389,113 $12.47 6,281,875 6,334,152
06/30/97 6,612,500 330,625 6,281,875 113,369 18,232 6,413,476 $13.47 6,281,875 6,353,983
09/30/97 6,612,500 330,625 6,281,875 148,044 23,922 6,453,841 $14.94 6,281,875 6,453,841
12/31/97 6,612,500 326,343 6,286,157 184,928 30,785 6,501,870 $16.60 6,284,016 6,477,856
03/31/98 6,612,500 307,208 6,305,292 179,413 24,583 6,509,288 $17.13 6,291,108 6,488,333
*Share counts for diluted EPS are applicable only in the event of positive
earnings.
10
11
HF BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1998
(UNAUDITED)
Termination of Swap Agreements
On July 10, 1995, the Company terminated four interest rate swap
agreements with an aggregate outstanding notional amount of $60.0 million. At
June 30, 1995, the weighted average fixed payment rate and variable payment
received rate were 9.53% and 6.11%, respectively. The Company paid a termination
fee of $4,856,000 which has been deferred and is being amortized over the
remaining original terms of the respective swap agreements. The expected future
amortization is as follows: $173,000 for the last three months of fiscal 1998
and $272,000 for the fiscal year 1999. As of March 31, 1998 the remaining
deferred amount was $445,000.
Defined Benefit Plan and Retirement Restoration Plan Terminations
In the quarter ended June 30, 1997, the Company's management and
Board Of Directors determined to terminate two retirement plans. The defined
benefit pension plan was a traditional pension program which provided employees
with monthly retirement income based upon years of service and the employee's
earnings during the sixty months prior to retirement. The retirement restoration
plan was a non qualified supplemental plan designed to compensate certain highly
salaried employees for the impact of wage caps under the Employee Retirement
Income Security Act ("ERISA"), which are applicable to qualified plans such as
the defined benefit pension plan.
A non-recurring $3.0 million charge to accrue expenses related to the
termination of the two retirement plans was recorded in the fourth quarter of
fiscal 1997. As of December 31, 1997, all of the defined benefit pension plan
assets had been distributed, with vested participants receiving, at their
election, either a lump sum or an annuity contract. As of April 30, 1998, the
Company has received a favorable IRS determination letter associated with the
termination of the defined benefit pension plan and is in the process of
preparing a final plan annual return.
Stock Plans
The Company established for eligible employees an Employee Stock
Ownership Plan and Trust ("ESOP"), which became effective upon the conversion of
the Bank from a mutual savings & loan association to a public stock company (the
"Conversion"). On June 30, 1995, the ESOP:
- - subscribed for 7.0% (462,875) of the total shares (6,612,500) of
common stock issued in the Conversion pursuant to the subscription
rights granted under the ESOP plan document
- - borrowed $3,703,000 from HFB under a 9.5 year loan agreement bearing
a 9.0% interest rate in order to fund the purchase of common stock,
pledging the common stock as collateral for the loan
Under the terms of the ESOP plan, shares are allocated to individual
eligible employee accounts at the conclusion of each calendar year. Under the
terms of the original loan agreement, annual principal and interest payments
were to be made to HFB at the end of each calendar year.
In December 1997, the ESOP and HFB amended their loan agreement,
implementing the following revisions:
- - The loan payment for calendar year 1997 would be interest only. No
loan principal would be retired on December 31, 1997.
- - The final maturity of the loan was extended from December 31, 2004 to
December 31, 2012, with an associated reduction in periodic loan
principal amortization.
11
12
HF BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1998
(UNAUDITED)
As of March 31, 1998, prior to the 1997 allocation of shares to
eligible employee accounts, a cumulative total of 104,069 shares of common stock
had been allocated to individual employee accounts, leaving a remainder of
358,806 shares to be allocated over the remaining 15 year life of the ESOP,
including 17,841 shares to be assigned in conjunction with the calendar year
1997 allocation.
At the Company's Annual Meeting of Shareholders on January 11, 1996,
shareholders approved the Hemet Federal Savings & Loan Association 1995 Master
Stock Compensation Plan (the "Stock Compensation Plan") and the HF Bancorp, Inc.
1995 Master Stock Option Plan (the "Stock Option Plan"), both of which became
effective as of the date of approval. These two plans were established to
provide Directors and employees in key management positions with a proprietary
interest in the Company, to attract and retain highly qualified staff, and to
more directly align the objectives of the individuals with the success of the
Company.
The Stock Compensation Plan was authorized to acquire 198,375 shares
of common stock in the open market. The Bank contributed funds to the Stock
Compensation Plan to enable the Plan trustees to acquire the authorized shares
of common stock. On February 28, 1996, the Bank acquired 198,375 shares in the
open market at a price of $10.00 per share. Stock shares are held in trust, and
stock awards typically vest over a five year period.
The Stock Option Plan was authorized to issue up to 661,250 options
for the purchase of common shares, including both Incentive Stock Options and
Non Qualified Stock Options.
On May 22, 1997, the Board Of Directors of HF Bancorp, Inc. adopted
the Amended and Restated HF Bancorp, Inc. Stock Based Incentive Plan (the
"Incentive Plan"). The Incentive Plan merged the Stock Compensation Plan and the
Stock Option Plan, and amended the provisions of these plans to, among other
things:
- - Provide benefits that were not available when the two 1995 Plans were
adopted, including the accelerated vesting of stock awards and stock
options following a change in control of the Company or the Bank
- - Eliminate a number of outdated regulatory requirements no longer
necessary due to amendments to Section 16(b) of the Securities
Exchange Act of 1934 (the "Exchange Act").
At the Company's Annual Meeting of Shareholders on October 28, 1997,
shareholders approved an amendment to the Incentive Plan, which increased the
number of option shares authorized for issuance by 150,000 shares, from 661,250
shares to 811,250 shares. The Incentive Plan retains the prior Stock
Compensation Plan's limitation of 198,375 shares authorized for stock awards.
12
13
HF BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1998
(UNAUDITED)
Additional information concerning the Incentive Plan is presented in
the following tables. As of March 31, 1998, the exercise price of individual
vested stock options ranged from a low of $9.50 per share to a high of $14.34
per share.
HF BANCORP, INC. STOCK BASED INCENTIVE PLAN: STOCK OPTION INFORMATION
Stock Stock Average
Options Stock Options Exercise
Stock Stock Cumulatively Options Available Price Of
Options Options Vested & Cumulatively For Future Vested
Date Authorized Outstanding Outstanding Exercised Grants Options
- ---- ---------- ----------- ----------- --------- ------ -------
09/03/96 661,250 630,340 0 0 30,910 N/A
12/31/96 661,250 618,250 0 0 43,000 N/A
03/31/97 661,250 528,853 112,850 0 132,397 $10.05
06/30/97 661,250 523,185 109,182 0 138,065 $10.04
09/30/97 661,250 638,545 125,182 0 22,705 $10.59
12/31/97 811,250 629,945 115,882 11,100 170,205 $10.65
03/31/98 811,250 667,244 213,287 29,734 114,272 $10.38
- --------------------------------------------------------------------------------
HF BANCORP, INC. STOCK BASED INCENTIVE PLAN: STOCK AWARD INFORMATION
Stock
Awards
Stock Stock Stock Available
Awards Awards Awards For Future
Date Authorized Outstanding Vested Grants
- ---- ---------- ----------- ------ ------
09/30/96 198,375 195,075 0 3,300
12/31/96 198,375 189,801 0 8,574
03/31/97 198,375 121,887 37,294 39,194
06/30/97 198,375 121,227 37,954 39,194
09/30/97 198,375 154,527 37,954 5,894
12/31/97 198,375 154,527 37,954 5,894
03/31/98 198,375 120,250 67,597 10,528
13
14
HF BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1998
(UNAUDITED)
Derivatives Contracts
The Company uses various types of derivative products to manage
interest rate exposure. When these instruments meet certain criteria, they
qualify for hedge accounting treatment. Hedge criteria include demonstrating how
the hedge will reduce risk, identifying the specific asset, liability, or firm
commitment being hedged, and citing the time horizon being hedged. Active
derivatives (e.g. interest rate swaps) qualifying for hedge accounting treatment
are accounted for on an accrual basis, with periodic amounts receivable or
payable recorded as an adjustment to interest income or interest expense. Gains
or losses on terminated derivatives that qualified for hedge accounting are
amortized over their original contractual lives on a straight-line basis in the
event the position being hedged is not liquidated. The Company does not
currently employ derivatives that do not meet the criteria for the hedge
accounting.
Loan Impairment
The Bank applies the provisions of SFAS No. 114, "Accounting By
Creditors For Impairment of A Loan", to all loans in its portfolio. As a
majority of the Bank's loans are collateral dependent, most impaired loans are
accounted for based upon the fair value of their collateral. In applying the
provisions of SFAS No. 114, the Bank considers a loan to be impaired when it is
probable that the Bank will be unable to collect all contractual principal and
interest in accordance with the terms of the loan agreement. However, in
determining when a loan is impaired, management also considers the loan
documentation, current loan to value ratios, and the borrowers' current
financial position. The Bank considers all nonaccrual loans and all loans that
have a specific loss allowance applied to adjust the loan to fair value as
impaired.
Commitments and Contingencies
At March 31, 1998, the Company maintained commitments to sell $1.5
million in residential fixed rate mortgage loans on a servicing released basis
and to originate $10.0 million in various types of loans. The Company maintained
no commitments to purchase loans or assume borrowings at March 31, 1998.
Recent Accounting Pronouncements,
In June 1997, the FASB, issued SFAS No. 130, "Reporting Comprehensive
Income" and SFAS No. 131, "Disclosures about Segments of an Enterprise and
Related Information". SFAS No. 130 establishes standards for reporting and
display of comprehensive income and its components in a full set of
general-purpose financial statements. SFAS No. 131 establishes standards of
reporting by publicly held business enterprises and disclosure of information
about operating segments in annual financial statements and, to a lesser extent,
in interim financial reports issued to shareholders. SFAS Nos. 130 and 131 are
effective for fiscal years beginning after December 15, 1997. As both SFAS Nos.
130 and 131 deal with financial statement disclosure, the Company does not
anticipate the adoption of these new standards will have a material impact on
its financial position or results of operations.
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15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Forward-Looking Statements
Certain matters discussed in this Form 10-Q Report may constitute
forward looking statements within the meaning of the Private Securities
Litigation Reform Act Of 1995. These forward looking statements relate to, among
other things, expectations of the business environment in which the Company
operates, projections of future performance, adequacy of the allowance for
estimated loan losses, trends in credit experience, perceived opportunities in
the market, and statements regarding the Company's mission and vision. These
forward looking statements are based upon current management expectations, and
may therefore involve risks and uncertainties. The Company's actual results,
performance, or achievements may differ materially from those suggested,
expressed, or implied by forward looking statements due to a wide range of
factors including, but not limited to, the general business environment, the
California real estate market, competitive conditions among bank and non-bank
financial services providers, regulatory actions or changes, and other risks
detailed in the Company's reports filed with the Securities and Exchange
Commission, including the Annual Report on Form 10-K for the fiscal year ended
June 30, 1997.
General
H.F. Bancorp, Inc. (referred to herein on an unconsolidated basis as
"HFB" and on a consolidated basis as the "Company") is a savings & loan holding
company incorporated in the State of Delaware whose principal business is to
serve as a holding company for Hemet Federal Savings & Loan Association (the
"Bank") and for other banking or banking related subsidiaries which the Company
may establish or acquire. As a legal entity separate and distinct from its
subsidiaries, HFB's principal source of funds is its existing capital and
assets, and future dividends paid by and other funds advanced from its
subsidiaries. Legal limitations are imposed on the amount of dividends that may
be paid and loans that may be made by the Bank to HFB. The Company's common
stock is listed on the Nasdaq National Market ("NASDAQ") under the symbol
"HEMT".
At March 31, 1998, the Company had $1,065.7 million in assets, $586.8
million in net loans receivable, and $868.5 million in deposits. The Company is
subject to regulation by the Office Of Thrift Supervision ("OTS"), the Federal
Deposit Insurance Corporation ("FDIC"), and the Securities and Exchange
Commission ("SEC"). The principal executive offices of the Company and the Bank
are located at 445 East Florida Avenue, Hemet, California, 92543, telephone
number (909) 658 - 4411, toll free (800) 540-4363, facsimile number (909) 925 -
5398. The Bank is a member of the Federal Home Loan Bank of San Francisco
("FHLB") and its deposit accounts are insured by the FDIC through the Savings
Association Insurance Fund ("SAIF") to the maximum extent permitted by law.
On September 27, 1996, Hemet Federal Savings & Loan Association
consummated the acquisition of Palm Springs Saving Bank ("PSSB") by purchasing
their 1,131,446 shares of common stock for $16.3 million. The acquisition was
accounted for under purchase accounting guidelines and therefore generated
intangible assets. On June 21, 1996, the Bank entered the North San Diego County
market through the purchase of three branch offices and the assumption of
deposit liabilities totaling $185.2 million from Hawthorne Savings Bank. In
conjunction with the purchase, the Bank generated a core deposit intangible of
$6.6 million, or 3.6% of the deposits assumed (see "Intangible Assets").
The Company conducts business from nineteen full service branch
offices and one centralized loan servicing center. In addition, the Company
supports its customers through 24 hour telephone banking and ATM access through
an array of networks including STAR, CIRRUS, PLUS, and NOVUS. Through its
network of banking offices, the Bank emphasizes personalized service focused
upon two primary markets: households and small businesses. The Bank offers a
wide complement of lending and depository products. The Bank also supports its
customers by functioning as a federal tax depository, providing merchant
bankcard services, and supplying various forms of electronic funds transfer. In
addition, the Bank, through third party relationships, makes various non FDIC
insured investment products available to its customers, including mutual funds
and selected insurance related products.
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16
Recent Developments
Office Of Thrift Supervision Regulatory Exam
During March and April, 1998, the OTS conducted its periodic safety
and soundness regulatory exam of the Bank. This exam was a factor in the
Company's issuance of a press release on May 7, 1998 which restated previously
announced earnings for the third quarter of fiscal 1998 (see "May 7, 1998 Press
Release"). The OTS is scheduled to meet with the Company's Board Of Directors at
the end of May, 1998, and the final regulatory reports from this exam are
expected to be received during the fourth quarter of fiscal 1998. Based upon
preliminary discussions held with OTS personnel, management does not anticipate
that the final examination findings will require the Bank to record material
additional loan loss provisions, net charge-offs, or valuations against real
estate acquired through foreclosure. This belief stems from management's working
with the OTS to review specific loans, general credit management practices, and
the adequacy of the Bank's allowance for estimated loan losses in developing the
significant credit related expenses recorded during the third quarter of fiscal
1998. However, the Company can provide no assurance concerning the contents of
the final examination reports, and the required actions which could potentially
derive therefrom.
Year 2000 Computer Issue
The Year 2000 Issue concerns the potential impact of historic
computer software code that only utilizes two digits to represent the calendar
year (e.g. "98" for "1998"). Software so developed could produce inaccurate or
unpredictable results upon January 1, 2000, when current and future dates
present a lower two digit year number than dates in the prior century. The
Company, similar to most financial services providers, is significantly subject
to the potential impact of the Year 2000 Issue due to the nature of financial
information. Potential impacts to the Company may arise from software, hardware,
and equipment both within the Company's direct control and outside of the
Company's ownership, yet with which the Company electronically or operationally
interfaces. Financial institution regulators have intensively focused upon Year
2000 issues, issuing guidance concerning the responsibilities of senior
management and directors. Year 2000 testing and certification is being addressed
as a key safety and soundness issue in conjunction with regulatory exams.
In order to address the Year 2000 Issue, the Company has developed
and implemented a five phase plan divided into the following major components:
- - awareness
- - assessment
- - renovation
- - validation
- - implementation
The Company has substantially completed the first two phases of the
plan and is currently working internally and with external vendors on the final
three phases. Because the Company outsources its data processing and item
processing operations, a significant component of the Year 2000 plan is to work
with external vendors to test and certify their systems as Year 2000 compliant.
Other important segments of the Year 2000 plan are to identify those loan
customers whose possible lack of Year 2000 preparedness might expose the Bank to
financial loss, and to highlight any servicers of purchased loans which might
present Year 2000 operating problems.
The Company's Board Of Directors has established a Year 2000
subcommittee to monitor the Company's progress with achieving and certifying
Year 2000 compliance. In addition, the Company has retained an external
consulting firm to assist with its Year 2000 program.
Management currently estimates Year 2000 compliance costs, which are
expensed on a current period basis, at between $200,000 and $300,000. This range
of cost does not include normal ongoing costs for computer hardware (including
ATM's) and software that would be replaced in the next year even without the
presence of the Year 2000 Issue in conjunction with the Company's ongoing
programs for updating its delivery infrastructure. This cost estimate may change
as the Company progresses in its Year 2000 program and obtains additional
information associated with and conducts further testing concerning third
parties.
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17
May 7, 1998 Press Release
On May 7, 1998, the Company issued a press release in which it
announced a restatement of previously communicated earnings for the quarter and
fiscal year to date ended March 31, 1998. The restatement resulted from
additional provisions for estimated loan losses and the establishment of greater
valuation reserves for foreclosed real estate. In the May 7 press release, the
Company also announced that its is evaluating alternatives for improving future
financial performance, with the likelihood that non-recurring charges of an
operating nature would be recorded in the quarter ending June 30, 1998. The
press release also presented that, while the Company is unable to identify
specific costs or savings at this time, it is nearing completion of analyses of
a variety of options to augment profitability by implementing fundamental
changes to the Company's cost structure, operating platform, and distribution
network. The restructuring charges may materially impact the Company's financial
results for the quarter and fiscal year ending June 30, 1998.
Consolidation In The Financial Services Industry
The pace of consolidation in the financial services industry
quickened during the most recent quarter, with mergers now occurring even among
the largest 20 banks in the country. Within the Company's market:
- - Washington Mutual is merging the American Savings, Great Western,
Coast Federal, and Home Savings franchises into the largest thrift in
the country
- - California Federal is merging its franchise with those of Glendale
Federal, CenFed, and Redlands Federal, to create a thrift with assets
over $50 billion
- - Bank Of America is merging with NationsBanc to produce the largest
commercial bank in the country
As a result of these mergers, the Company will soon be challenged by
a number of much larger competitors who benefit from a more extensive branch
network, more advanced technology, and financial resources well beyond the
capacity of the Company. On the other hand, the above mergers may present an
excellent opportunity to acquire business currently served by the merging
institutions, as customers often become disenfranchised when their branch,
financial service providers, products, or pricing change in conjunction with a
merger.
Potential Federal Legislation
Over the past year, the US House Of Representatives has been debating
a potentially significant reform of the federal laws governing the financial
services industry under the moniker of "HR 10". The recent announcement of a
historic planned merger between Travelers Corporation and Citicorp, which would
meld insurance, commercial banking, and investment banking under one corporate
umbrella for the first time in decades, may spur Congress to adopt legislation
at the risk of their opportunity to guide such financial industry consolidation
being usurped by regulatory edict, court decisions, and market realities. The
scope of issues which HR 10 may address is vast, including the possible
elimination of the federal thrift charter, a merging of bank and thrift
regulators and insurance funds, and the future of the FHLB system.
Congress has recently been considering an increase in the loan limits
applicable to FHA mortgages. Any increase in such limits would likely
unfavorably impact the Company, as the government would thereby strongly
influence a larger portion of the residential mortgage market. Congress is also
considering a series of other bills which could present a significant impact
upon the Company, including legislation addressing bankruptcy reform, and the
potential payment of interest on corporate demand deposit accounts and financial
institution balances at the Federal Reserve Banks.
The US Supreme Court recently reached a landmark decision restricting
the growth of credit unions, an event favorable to the Company, as credit unions
do not have to pay income taxes, providing them with a significant advantage in
pricing consumer financial services. In addition, credit unions are not subject
to the same level of regulatory burden as banks and thrifts. Congress is
currently debating legislation which would potentially reverse or amend the
Supreme Court decision and thereby permit credit unions to compete throughout a
broader segment of the Company's market. Management is unable to predict what
legislation, if any, may eventually be enacted, and the possible impact of such
legislation.
17
18
Overview Of Business Activity And Results
During the nine months ended March 31, 1998, the Company continued
implementing its strategic plan of evolving an almost 80 year old savings & loan
into a community based financial services firm, while at the same time building
long term shareholder value and strengthening the Company's involvement in and
contributions to the communities it serves. Significant events and achievements
during the most recent quarter included:
- - Management continued efforts to establish the operational and
financial foundations necessary to support the strategic plan.
- - A $2.3 million provision for estimated loan losses was recorded, as
subsequently detailed under "Allowance For Loan Losses" and
"Provision For Estimated Loan Losses".
- - Significant management changes were effected in retail banking,
lending, and Bank operations, with the new team members bringing the
skills, experience, and commitment needed to successfully implement
the strategic plan. This staff turnover presented the Company with
various associated non-recurring costs, including severance pay and
recruitment fees. These non-recurring costs, however, were offset
during the most recent quarter by a gain on the sale of the Company's
merchant bankcard portfolio.
- - New products and services were introduced for:
- consumer checking
- business checking
- mutual funds
- fixed and variable annuities
- retail foreign banknote exchange
- income property and multifamily loans
- - Checking deposits reached a record high for the Company, and the cost
of deposits declined notably for the second consecutive quarter.
- - Mortgage banking activity continued to expand, driven by both the
Company's actions to augment this operation and by strong customer
demand for residential fixed rate mortgages.
- - Reductions in various operating costs were achieved, driven in
particular through the more effective use of technology and enhanced
management of third party relationships.
- - The Company's economic exposure to increasing interest rates was
reduced.
- - The Company aggressively worked to liquidate its portfolio of real
estate acquired through foreclosure, with $379,000 in provisions for
valuation reserves posted during the most recent quarter. These
provisions were accompanied by significant sales of foreclosed
properties, resulting in the Company's owning just $1.6 million in
net foreclosed real estate at March 31, 1998.
- - Performance planning and assessment was established for all managers,
complemented by the adoption of specific goals.
- - Stock options were extended to substantially all of the Bank's
employees with positions of department manager and above. Management
believes that, in conjunction with the ESOP, this stock option
allocation provides a powerful incentive for the Company's employees
to build shareholder value and speed the successful achievement of
the strategic plan.
18
19
To some extent, the above accomplishments were offset by the
particularly flat and low state of the Treasury security yield curve throughout
the fiscal third quarter, as exhibited by the differential between the 1 year
Treasury security and the 10 year Treasury security totaling just 27 basis
points at both December 31, 1997 and March 31, 1998. Flat and nominally low
yield curves present particular challenges to portfolio lenders such as the
Company, who maintain net liability sensitive positions. The shape of the yield
curve discourages borrowers from selecting the adjustable rate loans that the
Company utilizes to build its balance sheet, while encouraging refinancing of
existing loans and securities, a significant volume of which the Company owns at
a premium to par. During the three months ended March 31, 1998, the Company
experienced very high loan and security prepayments, consistent with the
Mortgage Banker's Association Application Volume Refinance Index peaking at
above 3000 in January 1998 (a reading of 1000 is typically viewed as a strong
refinance market).
In addition, the flatness of the yield curve during the most recent
quarter reduced the spread derived from the Company's net liability sensitive
position, pressuring net interest income. Management responded to this
environment by augmenting its mortgage banking activity and aggressively
focusing upon reducing the Company's cost of funds. However, should the current
capital markets environment persist, or become more unfavorable, there can be no
assurance that the Company will be successful in offsetting its negative
financial effects. In particular, should the bond equivalent yield on the 10
year Treasury security decline to the 5.25% range for an extended period of
time, the Company would likely be severely challenged to maintain the nominal
size of its loan portfolio without increasing its economic exposure to future
increases in market interest rates.
Additional information concerning the above accomplishments and challenges is
presented in the pages which follow.
Changes In Financial Condition From June 30, 1997 to March 31, 1998
Total assets increased $81.0 million, or 8.2%, from $984.7 million at
June 30, 1997 to $1,065.7 million at March 31, 1998. Net loans receivable rose
$102.5 million, or 21.2%, from $484.3 million at June 30, 1997 to $586.8 million
at March 31, 1998. The nominal and relative increases in the loan portfolio have
been key objectives of management, as such increases, when conducted with
prudent underwriting, provide for:
- - a more effective deployment of the Company's strong capital position
- - a greater return on shareholders' equity
- - enhanced support of the communities in which the Company operates
During the third quarter of fiscal 1998, total assets expanded by
$2.4 million and net loans receivable declined by $3.3 million, as the Company
experienced the aforementioned increase in prepayments from mortgage related
assets. In addition, contrary to recent quarters, the Company did not purchase
any loans in the secondary market during the past three months due to limited
availability of product and the resulting relatively high pricing.
Net loans held for sale increased from $335,000 at June 30, 1997 to
$3.6 million at March 31, 1998, as the Company continued building its mortgage
banking operation. The Company has been expanding the volume of loans originated
for sale and the range of secondary market avenues utilized for selling in order
to:
- - better manage the Company's interest rate risk position
- - maintain high liquidity
- - generate a recurring stream of non-interest income
- - obtain improved sales execution
- - respond to increased customer demand for fixed rate financing
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20
Investment securities held to maturity declined from $26.8 million at
June 30, 1997 to $10.1 million at March 31, 1998 primarily due to the call of
Agency debentures. Investment securities available for sale fell from $145.0
million at June 30, 1997 to $112.2 million at March 31, 1998 primarily due to
the sale and call of long term, fixed rate Agency debentures in conjunction with
the Company's interest rate risk management program (see "Interest Rate Risk
Management And Exposure"). However, during the most recent quarter, investment
securities available for sale climbed from $91.6 million to $112.2 million due
to the purchase of low duration, AAA rated, current pay, non-Agency, fixed rate
collateralized mortgage obligations ("CMO's"). During the past three months,
management invested the majority of available cash flows into CMO securities
instead of the adjustable rate and short term balloon Agency mortgage backed
securities purchased in prior periods due to concern over financial exposure to
security prepayments given the surging volume of mortgage refinances combined
with relatively high prices for the types of securities purchased in prior
periods.
Mortgage-backed securities held to maturity declined 13.0% from
$151.4 million at June 30, 1997 to $131.8 million at March 31, 1998 due to
amortization and prepayments. In addition, all mortgage backed security
purchases in fiscal 1998 have been classified as available for sale.
Mortgage-backed securities classified as available for sale rose
$42.1 million, or 38.5%, from $109.5 million at June 30, 1997 to $151.6 million
at March 31, 1998. However, mortgage backed securities classified as available
for sale declined $13.5 million during the most recent quarter, due to
accelerated prepayments and the aforementioned decision to focus the
reinvestment of available cash flows into the CMO market.
The Company's investment in the capital stock of the Federal Home
Loan Bank of San Francisco ("FHLB") increased from $6.2 million at June 30, 1997
to $6.5 million at March 31, 1998 due to dividends credited. The Company has
received notification from the FHLB that it will be required to purchase
approximately $1.5 million in additional capital stock during the fourth quarter
of fiscal 1998, due to the Company's growth and because of the restructuring of
the balance sheet over the past year to emphasize loans and mortgage related
securities.
The Company's net investment in real estate acquired through
foreclosure dropped from $5.3 million at June 30, 1997 to $1.6 million at March
31, 1998, as the Company aggressively sought to conclude disposing of the
portfolio of troubled assets acquired in conjunction with the PSSB purchase. A
general strengthening of the real estate market in Southern California also
helped accelerate the reduction in foreclosed property.
Net real estate acquired for investment declined from $418,000 at
June 30, 1997 to none at March 31, 1998, as the Company sold its final two real
estate projects during the first half of fiscal 1998 at a nominal gain, and in
so doing exited the real estate development business.
Gross intangible assets declined from $14.5 million at June 30, 1997
to $12.7 million at March 31, 1998 due to the continued amortization of the
intangible assets generated in conjunction with the North San Diego County
branch purchase from Hawthorne Savings Bank and the PSSB acquisition.
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21
Total deposits rose from $839.7 million at June 30, 1997 to $855.6
million at December 31, 1997 to $868.5 million at March 31, 1998. Key trends
within the deposit portfolio include:
- - Management continued the Bank's emphasis upon attracting consumer and
small business checking accounts as a means of lowering the cost of
funds, bolstering fee income, and establishing customer relationships
for future sales of other products and services. Checking deposits
increased $13.7 million, or 18.6%, fiscal year to date. Several new
checking products were introduced during the most recent quarter.
- - Customers continued their positive response to the Bank's "Platinum"
money market deposit account, which provides competitive, tiered
money market interest rates for liquid funds. In conjunction with
this product, total money market deposits increased from $38.6
million at June 30, 1997 to $65.6 million at December 31, 1997 to
$73.2 million at March 31, 1998.
- - Savings deposits fell from $111.7 million at June 30, 1997 to $96.9
million at March 31, 1998, as the Company priced its passbook based
deposit products less aggressively in order to encourage customer
migration into statement based products. Management believes
statement based products present the Bank with fewer operational
problems (and losses), result in faster customer service, and more
effectively mesh with upcoming advances in technology.
- - Certificate of deposit balances declined slightly from $615.5 million
at June 30, 1997 to $611.0 million at March 31, 1998, as the
Company's marketing efforts have focused upon transaction accounts,
and due to the Bank's adoption of relatively less aggressive pricing
for base, or "sheet", CD rates. Instead, the Bank has migrated
towards relationship pricing for CD's based upon the volume and range
of business the customer conducts with the Company. Management
believes this pricing approach has led to a deepening of
relationships with many customers, somewhat offset by a loss of
single "CD only" accounts which are often the most rate sensitive.
- - The ongoing consolidation in the financial services industry
continues to leave an increasing number of customers without a local
and / or full service branch of their former bank; making a portion
of such customers receptive to sampling Hemet Federal's quality
customer service.
Advances from the FHLB-SF increased from $50.0 million at June 30,
1997 to $100.0 million at March 31, 1998 due to the Company's need to fund the
increase in its loan portfolio. During the past three months, FHLB advances
declined $10.0 million, as the Company used cash flows from prepayments on
mortgage related assets to retire a maturing fixed rate advance.
Total stockholder's equity increased from $81.0 million at June 30,
1997 to $83.8 million at March 31, 1998 due to:
- - net income generated fiscal year to date
- - appreciation in the portfolios of investments designated as available
for sale, in conjunction with lower general market interest rates
- - continued amortization of the Company's deferred stock compensation
- - the exercise of stock options (funded with Treasury stock) during the
current fiscal year
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22
Interest Rate Risk Management And Exposure
In an effort to limit the Company's exposure to interest rate
changes, management monitors and evaluates interest rate risk on an ongoing
basis, through an internal simulation and modeling process, various management
reports, and via participation with the OTS Market Value Model. Management
acknowledges that interest rate risk and credit risk compose the two greatest
financial exposures faced by the Company in the normal course of its business.
In recent quarters, the Company has maintained a net liability
sensitivity, meaning that, in aggregate, the Company's liabilities reprice more
quickly and by a greater magnitude than do its assets. This net liability
sensitivity primarily arises from the longer term, higher duration mortgage
backed and investment securities and whole loans maintained on the Company's
balance sheet, for which the Company's only current match funding sources are
demand deposit accounts, non interest bearing liabilities, a segment of core
deposit transaction accounts, certain borrowings, and capital. A net liability
sensitive position typically translates to improved profitability and higher
economic value during decreasing rate environments. Conversely, this position
presents the likelihood of constrained net interest income and average spreads
during periods of increases in general market interest rates. In addition, due
to the significant volume of mortgage related assets maintained on the balance
sheet, and the embedded optionality present in such assets, the Company is
financially exposed to both the nominal levels of interest rates and the
relative levels in interest rates, most often characterized by the shape or
slope of the Treasury yield curve.
During the nine months ended March 31, 1998, the Company continued
its program of moderating interest rate risk while building a less volatile base
of core earnings. Specific actions during the current fiscal year included:
- - The sale of $50.0 million and the call of $57.0 million in longer
term, fixed rate Agency debentures.
- - The sale of $11.4 million in fixed rate, residential loan
originations on a servicing released basis.
- - The secondary market purchase of $107.7 million in adjustable rate
residential mortgages which, when added to the impact of internal
originations, brought the percentage of gross loans presenting
adjustable interest rates to 73.9% at March 31, 1998.
- - The continuation of the Company's loan origination program which
encourages the generation of adjustable rate mortgages through
favorable pricing and terms to the customer combined with incentives
to the Company's sales force.
- - The continued migration away from loans which reprice based upon the
11th District Cost Of Funds Index ("COFI") in favor of loans which
reprice based upon Prime, Treasury, or LIBOR rates. The Company has
emphasized the non-COFI indices due to their greater responsiveness
to changes in capital markets interest rates and because of increased
concentration of control of the COFI into a small number of very
large thrifts. At March 31, 1998, approximately 26.1% of the
Company's gross loans repriced based upon COFI, and the Company's
investment portfolios contained no COFI based securities.
- - The development and marketing of new products which improve the
Company's interest rate risk profile, including new checking programs
and Prime based home equity lines of credit ("HELOC's").
- - The redeployment of periodic cash flows from longer term, fixed rate
mortgage-backed securities, whole loans, and debentures into other
assets presenting much lower duration.
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23
Management believes that, although investment in adjustable rate
assets, some of which present introductory discount rates, may reduce short term
earnings below amounts obtainable through investment in fixed rate or higher
duration assets, an asset portfolio containing a greater percentage of
adjustable rate product reduces the Company's exposure to adverse interest rate
fluctuations and enhances longer term profitability and economic value. This is
consistent with the overall investment policy of the Company, which is designed
to manage its aggregate interest rate sensitivity, to generate a favorable
return without incurring undue interest rate risk, to supplement the Company's
lending activities, and to provide and maintain liquidity. However, there can be
no assurance that any substantial quantity of adjustable rate loans meeting the
Company's underwriting standards will be available in the future.
The Company has also utilized a variety of financial instruments to
manage its interest rate risk, including off balance sheet transactions such as
interest rate agreements including swaps, caps, and floors. The Company
originally entered into its existing off balance sheet positions to
synthetically adjust the duration of the Company's liabilities to more closely
match that of its assets. On July 10, 1995, the Bank terminated four interest
rate swap contracts with an aggregate notional amount of $60.0 million, invoking
a termination fee of $4.9 million which, for accounting purposes, is being
amortized to interest expense over the individual remaining contract lives of
each swap.
During the nine months ended March 31, 1998, the Company amortized
$626,000 of the deferred loss to interest expense, and charged interest expense
for $744,000 related to current existing interest rate swaps with an aggregate
notional amount of $35.0 million. Additional information concerning the Bank's
current and terminated interest rate swap positions is provided in the following
table:
Summary Of Interest Rate Swaps
Active Interest Rate Swaps
Rate Basis Rate Basis
Notional Maturity Bank Bank Bank Bank Swap
Amount Date Receives Receives Pays Pays Resets
------ ---- -------- -------- ---- ---- ------
$20,000,000 01/06/99 3 month LIBOR Actual/360 9.800% Fixed 360/360 quarterly
$15,000,000 01/30/99 3 month LIBOR Actual/360 7.274% Fixed 360/360 quarterly
Total $35,000,000
Terminated Interest Rate Swaps
Original 3/31/98 Loss Daily
Notional Termination Deferred Deferred Amortization Loss
Amount Date Loss Loss Completion Amortization
------ ---- ---- ---- ---------- ------------
$10,000,000 07/10/95 $557,730 $0 03/27/97 $890
$20,000,000 07/10/95 $1,338,145 $0 04/30/97 $2,024
$10,000,000 07/10/95 $631,816 $0 11/25/97 $726
$20,000,000 07/10/95 $2,328,601 $444,537 11/21/98 $1,892
Total $60,000,000 $4,856,292 $444,537
Management estimates that the cost to terminate the two active
interest rate swaps at March 31, 1998 approximated $769,000.
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Intangible Assets
The purchase of the three branches from Hawthorne Savings and the
acquisition of PSSB each generated intangible assets. Under OTS regulations,
intangible assets reduce regulatory capital, resulting in lower capital ratios
than would otherwise be the case. At March 31, 1998, the reduction in the Bank's
regulatory capital resulting from intangible assets was $9.7 million.
Liquidity
Liquidity is actively managed to ensure sufficient funds are
available to meet the ongoing needs of both the Company in general and the Bank
in particular. Liquidity management includes projections of future sources and
uses of funds to ensure the availability of sufficient liquid reserves to
provide for unanticipated circumstances. HFB's and the Bank's investment
portfolios are structured to provide an ongoing source of cash from scheduled
payments and anticipated prepayments from mortgage related securities, in
addition to cash flows from periodic maturities, typically from securities with
balloon final payments.
At March 31, 1998, the Company maintained $28.5 million in cash and
cash equivalents, up from $18.4 million at June 30, 1997. This increase was due
to the Bank's planned accumulation of excess cash equivalent balances in
anticipation of customer payments for property and income taxes during the first
half of April, 1998.
During the quarter ended March 31, 1998, the Bank was granted its
second and third unsecured "federal funds" lines of credit from the
institution's primary correspondent banks, as an additional means to provide for
contingent liquidity needs. There is no guarantee, however, that funds from such
lines will be available at all times or that such lines will be maintained in
future periods.
At April 10, 1998, the Bank maintained untapped borrowing capacity at
the FHLB-SF in the amount of $292.1 million, up $81.5 million from three months
prior. During the quarter ended March 31, 1998, the Bank pledged additional
loans and securities (primarily CMO's) to the FHLB to augment its liquidity
position. In addition, due to the Company's relatively low loan to deposit ratio
of 68.0% at March 31, 1998, the Company maintained significant excess collateral
in both loans and securities; collateral which is available for either
liquidation or secured borrowings in order to meet future liquidity
requirements.
Effective November 24, 1997, the OTS reduced the thrift regulatory
liquidity requirement from 5.0% to 4.0%, removed the 1.0% short term liquidity
requirement, significantly increased the scope of assets qualifying for the
"numerator" in the liquidity formula, and decreased the "denominator" in the
formula. As a result of these statutory changes and the composition of the
Bank's balance sheet, the Bank's regulatory liquidity ratio has exceeded 20.0%
since the Bank's adoption of the new regulatory formula effective January 1,
1998.
Liquidity needs for HFB on a stand alone basis are met through
available cash, periodic earnings, cash flows from its investment portfolio,
exercises of vested stock options, and principal and interest payments
associated with its loan to the ESOP.
24
25
Regulatory Capital Compliance
The Federal Deposit Insurance Corporation Improvement Act of 1991
("FDICIA") required the OTS to implement a system providing for regulatory
sanctions against institutions that are not adequately capitalized. The severity
of these sanctions increases to the extent that an institution's capital
continues to decline. Under FDICIA, the OTS issued the Prompt Corrective Action
("PCA") regulations with established specific capital ratios for five separate
capital categories as set forth below:
Core Capital To
Adjusted Core Capital To Total Capital
Total Assets Risk-weighted To
(Leverage Ratio) Assets Risk-weighted Assets
---------------- ------ --------------------
Well capitalized 5% or above 6% or above 10% or above
Adequately capitalized 4% or above 4% or above 8% or above
Undercapitalized Under 4% Under 4% Under 8%
Significantly undercapitalized Under 3% Under 3% Under 6%
Critically undercapitalized Ratio of tangible equity to adjusted total assets of 2% or less
The following table summarizes the capital ratios required by FDICIA
for an institution to be considered well capitalized and the Bank's regulatory
capital at March 31, 1998 as compared to such ratios.
Core Capital To Core Capital To Total Capital To
Adjusted Risk-weighted Risk-weighted
Total Assets Assets Assets
------------------- --------------------- ----------------------
Balance % Balance % Balance %
------- --- ------- --- ------- ---
(Dollars in Thousands)
Hemet Federal's regulatory
capital $ 64,760 6.16% $ 64,760 15.12% $ 68,866 16.08%
Well capitalized requirement 52,531 5.00 25,694 6.00 42,823 10.00%
--------- ----- ------- ----- ------ ------
Excess $ 12,229 1.16% $ 39,066 9.12% $ 26,043 6.08%
========== ===== ======== ===== ======== ======
Adjusted assets (1) $1,050,621 $428,233 $428,233
========== ======== ========
(1) The term "adjusted assets" refers to the term "adjusted total assets" as
defined in 12 C.F.R. section 567.1(a) for purposes of core capital requirements,
and refers to the term "risk-weighted assets" as defined in 12 C.F.R. section
567.1(bb) for purposes of risk-based capital requirements.
25
26
The Bank is also subject to OTS capital regulations under the
Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA").
These regulations require the Bank to maintain: (a) tangible capital of at least
1.5% of adjusted total assets (as defined in the regulations), (b) core capital
of at least 3% of adjusted total assets (as defined in the regulations) and (c)
total capital of at least 8.0% of risk-weighted assets (as defined in the
regulations).
The following table summarizes the regulatory capital requirements
under FIRREA for the Bank at March 31, 1998. As indicated in the table, Hemet
Federal's capital levels at March 31, 1998 exceeded all three of the currently
applicable minimum FIRREA capital requirements.
PERCENT OF
ADJUSTED
AMOUNT TOTAL ASSETS
------ ------------
(Dollars In Thousands)
Tangible Capital
Regulatory capital $64,760 6.16%
Minimum required 15,759 1.50
------- -------
Excess $49,001 4.66%
======= =======
Core Capital
Regulatory capital $64,760 6.16%
Minimum required 31,519 3.00
------- -------
Excess $33,241 3.16%
======= =======
PERCENT OF
RISK-WEIGHTED
AMOUNT ASSETS
------ -------------
Risk-based Capital
Actual capital $68,866 16.08%
Minimum required 34,259 8.00
------- -------
Excess $34,607 8.08%
======= =======
At March 31, 1998, the Bank's regulatory capital levels exceeded the
thresholds required to be classified as a "well capitalized" institution. The
Bank's capital ratios detailed above do not reflect the additional capital (and
assets) maintained by the holding company.
Management believes that, under the current regulations, the Bank
will continue to meet its minimum capital requirements in the coming year.
However, events beyond the control of the Bank, such as changing interest rates
or a downturn in the economy in the areas where the Bank has most of its loans,
could adversely affect future earnings and, consequently, the ability of the
Bank to meet its future minimum capital requirements.
26
27
Credit Profile
Nonperforming Assets
The following table sets forth information regarding nonaccrual
loans, real estate acquired through foreclosure, and repossessed consumer
assets.
March 31, 1998 June 30, 1997
-------------- -------------
(Dollars In Thousands)
Nonaccrual loans before valuation reserves $ 3,851 $ 5,217
Investment in foreclosed real estate before valuation
reserves 2,225 6,308
Investment in repossessed consumer assets before
valuation reserves 19 10
------- -------
Total nonperforming assets $ 6,095 $11,535
======= =======
Nonperforming loans to gross loans net of
undisbursed loan funds 0.64% 1.06%
Nonperforming assets to total assets 0.57% 1.17%
The reduction in nonperforming assets during fiscal 1998 primarily
resulted from the Company's continuing to cycle through the portfolio of
troubled assets acquired in conjunction with the purchase of PSSB on September
27, 1996. In addition, a gradual recovery in real estate markets and the economy
in the Company's primary lending areas has favorably impacted the Company's
ability to dispose of foreclosed real estate. Additional information concerning
the Company's non-accrual loans at March 31, 1998 is presented in the following
table.
Gross Non-Accrual Loans
March 31, 1998
(Dollars In Thousands)
Originated By Originated By
PSSB Hemet Federal TOTAL
---- ------------- -----
Residential real estate $ 998 $ 798 $1,796
Multifamily real estate -- -- --
Commercial real estate -- -- --
Construction 1,036 -- 1,036
Land/Lots -- 858 858
Consumer -- 1 1
Commercial business 100 60 160
------ ------ ------
TOTAL $2,134 $1,717 $3,851
27
28
Classified Assets
The following table presents information concerning classified
assets. The category "OAEM" refers to "Other Assets Especially Mentioned", or
those assets which present indications of potential future credit deterioration.
History of Classified Assets
(Dollars In Thousands)
OAEM Substandard Doubtful Loss Total
December 31, 1995 $ 9,217 $ 9,130 -- $ 2,618 $20,965
March 31, 1996 $ 8,287 $10,207 -- $ 3,030 $21,524
June 30,1996 $11,070 $ 8,189 -- $ 3,140 $22,399
September 30, 1996 $17,454 $22,007 -- $ 4,037 $43,498
December 31, 1996 $17,793 $20,588 -- $ 2,820 $41,201
March 31, 1997 $16,646 $18,733 -- $ 3,035 $38,414
June 30, 1997 $ 9,586 $19,834 -- $ 2,952 $32,372
September 30, 1997 $ 8,656 $15,805 -- $ 3,051 $27,512
December 31, 1997 $ 9,572 $12,932 -- $ 1,843 $24,347
March 31, 1998 $10,885 $11,701 $ 55 $ 2,526 $25,167
The Company experienced an anticipated significant increase in
classified assets upon the acquisition of PSSB in September, 1996. Since the
acquisition, management has worked to reduce the classified asset total through
various means including aggressive collection efforts, foreclosure with
subsequent property sales, and settlement of troubled assets for less than face
value. As a result of its due diligence process in conjunction with the
acquisition of PSSB, management required PSSB to recognize $2.2 million in
additional loan and real estate loss provisions prior to the consummation of the
acquisition.
Impaired Loans
At March 31, 1998, the Company maintained total gross impaired loans,
before specific reserves, of $9.2 million, constituting 71 credits. This
compares favorably to total gross impaired loans of $16.3 million at June 30,
1997. A total of $1.9 million in specific reserves were established against
impaired loans at March 31, 1998. The average recorded investment in impaired
loans during the quarter ended March 31, 1998 was $7.7 million, and the average
recorded investment in impaired loans during fiscal 1998 was $10.5 million. The
Company's impaired loan portfolio at March 31, 1998 was disproportionately
represented by credits originated by PSSB prior to its acquisition, as
highlighted in the following table. At March 31, 1998, the remaining portfolio
of loans originated by PSSB prior to its acquisition totaled $109.1 million, or
17.8% of the Company's total gross loans.
Gross Impaired Loans At March 31, 1998
(Dollars In Thousands)
Originated Originated
By By
PSSB Hemet Federal TOTAL
------ ------------- ------
Accrual Status $1,379 $3,990 $5,369
Non Accrual Status $2,134 $1,717 $3,851
------ ------ ------
TOTAL $3,513 $5,707 $9,220
28
29
The above table also highlights that a portion of the Company's
impaired loans at March 31, 1998 were either fully current or with only minor
delinquency, as $5.4 million (58.2%) were maintained on accrual status. Interest
is accrued on impaired loans on a monthly basis except for those loans that are
90 or more days delinquent or those loans which are less than 90 days delinquent
but where management has identified concerns regarding the collection of the
credit. For the nine months ended March 31, 1998, accrued interest on impaired
loans was $64,000 and interest of $316,000 was received in cash. If all
nonaccrual loans had been performing in accordance with their original loan
terms, the Company would have recorded interest income of $267,000 during the
nine months ended December 31, 1997, instead of interest income actually
recognized on cash payments of $78,000.
Allowance For Loan Losses
The allowance for loan losses is established through a provision for
loan losses based on management's evaluation of the risks inherent in the loan
portfolio. Management reviews the Bank's loan loss allowance on a monthly basis.
In determining levels of risk, management considers a variety of factors,
including asset classifications, economic trends, industry experience and
trends, geographic concentrations, estimated collateral values, management's
assessment of the credit risk inherent in the portfolio, historical loan loss
experience, and the Bank's underwriting policies. The allowance for loan losses
is maintained at an amount management considers adequate to cover losses in
loans receivable which are deemed probable and estimable. While management uses
the best information available to make these estimates, future adjustments to
the allowances may be necessary due to economic, operating, regulatory, and
other conditions that may be beyond the Bank's control. In addition, various
regulatory agencies, as an integral part of their examination process,
periodically review the Bank's allowance for loan losses. Such agencies may
require the Bank to recognize additions to the allowance based on judgments
different from those of management.
During March and April, 1998, the OTS conducted its periodic safety
and soundness regulatory exam of the Bank. In conjunction with that exam, the
OTS raised issues concerning:
- - the appropriate credit classification for nine loans with gross
principal balances totaling $6.2 million
- - the adequacy of the Bank's general and specific allowances for loan
losses
- - the credit profile of the remaining portfolio of loans acquired
through the purchase of PSSB
- - the scope of the credit management function, particularly as related
to income property and land loans
Management worked with the OTS to evaluate the identified reductions
in credit classification, compare the Bank's general reserves to peer financial
institutions, stratify the $109.1 million in remaining gross loans originated by
PSSB prior to the acquisition, and analyze potential improvements in the
internal asset review process. As a result of these efforts, the Company:
- - recorded $2.3 million in provisions for estimated loan losses during
the most recent quarter
- - reduced the credit classification for the identified loans (the
majority of which were loans secured by income property and land)
effective for March 31, 1998 reporting
- - assigned $750,000 in additional specific reserves
- - segmented the $22.6 million in income property and land loans
remaining from the PSSB acquisition
- - commenced modifying the Bank's credit management program
In addition, during the most recent quarter, the Bank hired a new
Chief Credit Officer with significant commercial banking experience in portfolio
credit management.
29
30
The following tables present activity in the Bank's allowances for
estimated loan losses and estimated real estate losses during the nine months
ended March 31, 1998 and 1997:
Nine Months Ended March 31,
---------------------------
1998 1997
---- ----
(Dollars In Thousands)
Allowance for Loan Losses:
Balance at June 30 $ 4,780 $ 3,068
Allowance acquired from PSSB -- 2,963
Loan chargeoffs:
Residential real estate (446) (674)
Multifamily real estate (197) (26)
Commercial real estate (313) (70)
Construction -- (217)
Land/Lots (288) (154)
Consumer (160) (14)
Commercial business (90) --
------- -------
Total chargeoffs (1,494) (1,155)
Loan recoveries -- --
Provision for estimated loan losses 2,700 309
------- -------
Balance at March 31 $ 5,986 $ 5,185
======= =======
===============================
March 31, June 30,
--------- --------
1998 1997
---- ----
Allowance for estimated loan losses as a percent of
nonperforming loans 155.45% 91.63%
Allowance for estimated loan losses as a percent of
gross loans receivable net of loans in process 1.00% 0.97%
30
31
Nine Months Ended March 31,
---------------------------
1998 1997
------- -------
(Dollars In Thousands)
Valuation Allowances : Real Estate Acquired Through Foreclosure
Balance at June 30 $ 1,020 $ 381
Allowance acquired from PSSB 0 491
Net chargeoffs (1,313) (119)
Provision to increase valuation allowances 939 65
------- -------
Balance at March 31 $ 646 $ 818
Valuation Allowances : Real Estate-Development
Balance at June 30 $ 577 $ 1,536
Net chargeoffs (577) (1,008)
Provision to increase valuation allowances 0 49
------- -------
Balance at March 31 $ 0 $ 577
TOTAL VALUATION ALLOWANCES FOR REAL ESTATE $ 646 $ 1,395
======= =======
Loan charge-offs and provisions to increase valuation allowances on
foreclosed real estate during fiscal 1998 were concentrated in credits obtained
in conjunction with the acquisition of PSSB. The ratio of allowance for
estimated loan losses to nonaccrual loans increased from 91.63% at June 30, 1997
to 155.45% at March 31, 1998 due to a decline in nonaccrual loans from $5.2
million to $3.9 million, combined with an increase in the allowance for
estimated loan losses from $4.8 million to $6.0 million. The ratio of allowance
for estimated losses to gross loans receivable net of loans in process rose from
0.97% at June 30, 1997 to 1.00% at March 31, 1998, as the Company expanded its
reserve balances in proportion to the growth in the loan portfolio. At March 31,
1998, 74.9% of the Bank's gross loan portfolio was comprised of residential real
estate loans, while 97.0% of the gross loan portfolio was composed of loans
secured by real estate.
The Company exited the real estate development business during the
first half of fiscal 1998 after selling the final two projects at a nominal
gain. The Company's inventory of foreclosed properties and repossessed consumer
assets at March 31, 1998 is summarized in the following table. During the three
and nine months ended March 31, 1998, the Company recognized $379,000 and
$939,000, respectively, in post acquisition writedowns, primarily in order to
speed the liquidation of the remaining problem assets acquired through PSSB.
Real Estate Acquired By Foreclosure and Repossessed Consumer Assets
March 31, 1998
(Dollars In Thousands)
Gross Valuation Net Percent
Type Of Property Balance Reserves Balance Of Total
- ---------------- ------- -------- ------- --------
Residential 1 - 4 Units $ 972 $110 $ 862 53.9%
Multifamily more than 4 Units 0 0 0 0.0%
Commercial / Industrial 498 123 375 23.5%
Land / Developed Lots 755 413 342 21.4%
Repossessed Consumer Assets 19 0 19 1.2%
---------- ---------- ----------- --------
Total $2,244 $ 646 $1,598 100.0%
The Bank accounts for real estate owned through foreclosure at fair
market value upon acquisition, and management believes that adequate valuation
reserves have been established based upon current market conditions. At March
31, 1998, approximately $431,000 in foreclosed real estate was in escrow under
contract for sale. However, management can offer no assurances regarding whether
and when such escrows will close.
31
32
Comparison Of Operating Results For The Three Months And Nine Months Ended
March 31, 1998 and March 31, 1997
General
The Company reported a net loss of $464,000 for the third quarter of
fiscal 1998, compared to $357,000 in net income for the three months ended March
31, 1997. Basic and diluted loss per share were $0.07 for the three months ended
March 31, 1998, while basic and diluted earnings per share were $0.06 for the
quarter ended March 31, 1997. The loss for the most recent quarter resulted from
significantly higher provisions for estimated loan losses.
The Company reported net income of $765,000 for the nine months ended
March 31, 1998, compared to net earnings of $1.5 million for the same period the
prior fiscal year, excluding the prior year impact of the one time assessment to
recapitalize the SAIF. Including the non-recurring assessment, the Company
reported a loss of $1.3 million for the nine months ended March 31, 1997. Basic
and diluted earnings per share for the nine months ended March 31, 1998 were
$0.12, compared to basic and diluted earnings per share of $0.24 for the prior
fiscal year excluding the impact of the SAIF assessment. With the SAIF special
assessment included, the Company reported basic and diluted loss per share of
$0.20 for the nine months ended March 31, 1997.
The Company's earnings during the current fiscal year have been
unfavorably impacted by significantly higher provisions for estimated credit
losses and by increased losses from real estate operations. These unfavorable
factors have more than offset improvements in a number of areas of the Company's
financial performance, including increased net interest income and greater
non-interest income. The various components of the Company's financial
performance are discussed in greater detail in the sections which follow.
When reviewing results for the nine months ended March 31, 1998 for
current and prior fiscal years, it is important to note that the prior fiscal
year included about two quarters' impact of the PSSB acquisition, versus a full
three quarters' effect in the current fiscal year. Due to the timing of the PSSB
purchase and the growth experienced by the Company in recent quarters, the
Company maintained a greater average balance sheet during the nine months ended
March 31, 1998 than in the prior year, somewhat offset by the impact of the
additional costs associated with operating a larger financial institution.
32
33
Net Interest Income
Net interest income for the quarter ended March 31, 1998 was $6.5
million, up 13.0% from $5.7 million for the same quarter the year before. Net
interest income for the nine months ended March 31, 1998 was $18.7 million, up
13.2% from $16.5 million for the same period the previous fiscal year. The
Company's net interest margin on average total assets improved to 2.41% during
the quarter ended March 31, 1998, exceeding the 2.31% realized during the same
quarter in fiscal 1997. For the nine months ended March 31, 1998, the Company's
net interest margin on average total assets was 2.35%, ahead of the 2.30%
registered for the same period the prior fiscal year. The Company's improvement
in net interest income during the quarter ended March 31, 1998 was achieved
despite:
1. a reduction in the Company's net liability sensitivity in conjunction
with the Bank's interest rate risk management program (see "Interest
Rate Risk Management And Exposure")
2. a challenging market environment stemming from the relatively flat
and low yield curve, which presents multiple unfavorable impacts upon
primarily portfolio lenders such as the Company:
A. an increase in prepayment rates on loans and securities,
with a majority of the security and purchased loan
positions maintained at a premium to par, including the
portfolio of loans added in conjunction with the PSSB
acquisition and recorded under purchase accounting
B. diminished customer demand for new adjustable rate
originations in favor of fixed rate products, resulting in
both constrained variable rate loan volume and curtailed
pricing margins
C. less net interest income resulting from the Company's net
liability sensitive position due to the relatively small
rate differentials present in the Treasury yield curve
During the most recent quarter, the above unfavorable factors were
offset by the Company's progress in deposit mix and pricing, enhanced cash
management, and reduced drag from non-earning assets. The Company's average
spreads on total assets during fiscal 1998 would have been higher if not for the
maintenance of several short term investment positions which generated
additional nominal net interest income, but reduced the average effective
spread. The Company's ratio of average interest earning assets to average
interest bearing liabilities improved from 1.07 during the third quarter of
fiscal 1997 to 1.09 during the most recent quarter due to:
- - the Company's continued amortization of intangible assets (see
"Intangible Assets")
- - growth in demand deposits
- - a decline in non-performing assets
- - an increase in capital
Average interest earning assets increased from $901.3 million during
the nine months ended March 31, 1997 to $1,009.3 million during the same period
in fiscal 1998, reflecting both the impact of the PSSB acquisition and the
Company's internally generated balance sheet growth.
33
34
Interest Income
Interest income increased 9.1% from $17.1 million during the quarter
ended March 31, 1997 to $18.6 million during the three months ended March 31,
1998, as increased interest on loans and mortgage backed securities was only
partially offset by a decline in interest and dividends on investment securities
which stemmed from the Company's selling longer term, fixed rate, relatively
high coupon investment securities in conjunction with its interest rate risk
management program. Interest income for the nine months ended March 31, 1998
totaled $55.6 million, up 12.7% from the $49.4 million reported for the same
period during the prior fiscal year, with the acquisition of PSSB contributing
to the increase.
Interest income on loans increased from $9.0 million during the three
months ended March 31, 1997 to $11.4 million during the quarter ended March 31,
1998, as the average balance of loans outstanding during the most recent quarter
was $592.5 million, up 30.4% from the same quarter one year prior. The favorable
effect of this increase in average loan balances was somewhat offset by a
decline in the average rate earned on loans, from 7.94% during the fiscal 1997
period to 7.70% during the fiscal 1998 period. This decline in average rate
stemmed in part from the surge in refinance activity which occurred during the
three months ended March 31, 1998. Consequently, many of the Company's higher
yielding adjustable rate loans were refinanced with lower yielding fixed rate
loans, a significant portion of which the Company sells into the secondary
market. In addition, the Company's loan mix continued to heavily emphasize
comparatively lower yielding residential mortgages, with 74.9% of the loan
portfolio's gross principal balance at March 31, 1998 comprised of residential
mortgages.
For the nine months ended March 31, 1998, interest income on loans
totaled $31.9 million, up 38.0% from the same period the prior year. Significant
increases in average balances outstanding were augmented by a 12 basis point
rise in average rate to generate the 38.0% increase.
Interest income on mortgage backed securities rose from $3.8 million
during the quarter ended March 31, 1997 to $4.7 million during the most recent
quarter, as an increase in average balance from $230.7 million to $293.7 million
was sufficient to offset a decline in average rate from 6.58% to 6.40%. Over the
past two years, the Company has sold a substantial portion of its long term,
fixed rate mortgage backed securities portfolio, with new purchases focusing
upon adjustable rate and low duration fixed rate mortgage backed securities. In
addition, during the most recent quarter, prepayment speeds on the Company's
mortgage backed securities portfolio increased significantly, accelerating
premium amortization and thereby constraining effective yield. This was, for
example, evident in the Company's $148.2 million par value portfolio of GNMA II
ARMs, where prepayment speeds rose significantly despite the seasoning of the
portfolio.
For the nine months ended March 31, 1998, interest on mortgage backed
securities totaled $14.2 million, up 10.7% from $12.8 million during the same
period the prior fiscal year, as the effect of increases in average volumes more
than offset a decline in average rate.
Interest income on investment securities for the three months ended
March 31, 1998 was $2.5 million, down from $4.3 million during the same quarter
the prior year. Similarly, interest income on investment securities during the
nine months ended March 31, 1998 decreased 29.0% versus the same period the
prior year. Over the past year, a number of relatively high coupon, long term,
fixed rate Agency debentures have been called (in conjunction with lower market
interest rates), while the Company has also sold other long term, fixed rate
investment securities as part of its interest rate risk management program (see
"Interest Rate Risk Management And Exposure"). Somewhat offsetting these
factors, the Company has maintained, on average, a more fully invested position,
while also utilizing repurchase agreements instead of federal funds sold in
order to maximize returns on overnight liquidity.
34
35
Interest Expense
Interest expense rose 7.1% from $11.3 million during the three months
ended March 31, 1997 to $12.1 million during the same period for the most recent
fiscal year, as increases in interest expense on deposits and borrowings more
than offset a decline in net hedging expense. For the nine months ended March
31, 1998, interest expense increased 12.4% versus the same period the prior
year, due to an expansion in the average balance sheet resulting from the PSSB
acquisition and internal growth.
Interest expense on deposits increased from $9.9 million during the
quarter ended March 31, 1997 to $10.0 million during the most recent quarter, as
the average volume of interest bearing deposits rose from $810.1 million to
$822.7 million, while the average interest rate paid declined 1 basis point from
4.89% to 4.88%. During the most recent quarter, the Company aggressively pursued
building its portfolio of transaction accounts, developing several new business
checking products and extensively marketing a tiered, higher rate consumer NOW
product with particularly attractive features for those retail customers
desiring to maintain relatively high balances in their primary checking account.
The Company also implemented "relationship pricing", whereby those customers
conducting a broader range of business with the Bank can benefit from more
attractive CD pricing. In conjunction with these efforts, the Company altered
its base CD pricing toward approximately the market median. As a result of these
multiple initiatives, the Bank's weighted average cost of deposits (including
non-interest bearing deposits) has declined as follows:
September 30, 1997 4.83%
December 31, 1997 4.76%
March 31, 1998 4.70%
For the nine months ended March 31, 1998, interest expense on
deposits rose to $30.8 million from $28.0 million during the same period the
prior fiscal year. The average balance of interest bearing deposits rose from
$776.5 million during the first nine months of fiscal 1997 to $821.8 million
during the similar period in the current fiscal year, while the average rate
rose from 4.81% to 5.00%.
Interest expense on borrowings increased from $679,000 during the
three months ended March 31, 1997 to $1.7 million during the most recent
quarter, as the average balance of borrowings rose from $55.0 million to $115.0
million, while the average rate climbed from 4.94% to 5.85%. During the 1998
fiscal year, the Company has increased its use of both short term borrowings (to
fund short term security positions) and longer term borrowings (to fund loan
portfolio growth) as a means of generating increased net interest income.
For the nine months ended March 31, 1998, interest expense on
borrowings totaled $4.8 million, versus $2.5 million during the same period the
prior fiscal year. Consistent with the results for the most recent quarter,
average balances rose from $63.3 million to $107.5 million, while the average
rate increased from 5.28% to 5.90%.
Net interest expense of hedging transactions declined from $762,000
during the three months ended March 31, 1997 to $421,000 during the most recent
quarter. For the nine months ended March 31, 1998, net interest expense on
hedging transactions declined to $1.4 million, compared to $2.3 million during
the same period the prior fiscal year. The conclusions of amortization periods
for the deferred losses associated with terminated interest rate swaps have been
accretive to the Company's reported net interest income in recent periods. At
March 31, 1998, the Company maintained $445,000 in deferred losses associated
with terminated interest rate swaps, with these losses scheduled to conclude
amortizing on November 21, 1998. In addition, the Company's two active interest
rate swaps, with a notional principal balance of $35.0 million, mature in
January 1999. Therefore, effective commencing in February 1999, the Company's
annualized net interest margin on total assets should improve by approximately
15 basis points due to the elimination of the interest rate swaps, all else held
constant.
35
36
Provision For Estimated Loan Losses
The provision for estimated loan losses totaled $2.3 million during
the quarter ended March 31, 1998, versus $101,000 recorded during the third
quarter of fiscal 1997. Provision for estimated loan losses for the nine months
ended March 31, 1998 was $2.7 million, compared to $309,000 charged against
income during the first nine months of the prior fiscal year. The significantly
greater provisions in the current fiscal year were a result of:
- - the need for expanded general reserves in conjunction with a
significantly increased loan portfolio and in light of peer financial
institution credit experience and reserve levels
- - higher charge-offs, with such charge-offs disproportionately stemming
from the portfolio of loans acquired through the PSSB purchase
- - deterioration in individual credits, primarily secured by income
property and land, leading to the need for greater specific reserves
The Company's ratio of allowances for estimated loan losses as a percent of
non-accrual loans rose from 91.63% at prior fiscal year end (June 30, 1997) to
155.45% at March 31, 1998. Management anticipates recording additional, but more
normalized, provisions for estimated loan losses in future periods in
conjunction with both ongoing operations and the implementation of the strategic
plan. Those aspects of the strategic plan which will particularly impact future
levels of provisions for estimated loan losses include, but are not limited to:
- - planned continued growth in the loan portfolio and increases in the
Company's ratio of loans to deposits
- - changes in the loan portfolio mix, especially those aimed at:
- improving net interest spreads
- reducing the Company's exposure to increases in general
market interest rates
- enhancing the Company's support of small businesses in
the communities it serves
- - the need to maintain a strong reserve position in support of the
Company's evolution into a community based financial services firm
serving a more diversified clientele with a broader array of credit
products
Other Income & Expense
Other income & expense improved from $78,000 in expense during the
quarter ended March 31, 1997 to $123,000 in income during the most recent
quarter, as:
- - Deposit related fee income for the quarter ended March 31, 1998 was
$640,000 up 69.3% from $378,000 for the same quarter a year earlier.
During the most recent quarter, the Company bolstered fee income by
commencing surcharging non-Bank customer use of its ATM's and by
continuing to expand the Bank's portfolio of transaction deposit
accounts.
- - During the quarter ended March 31, 1998, the Company sold its
merchant bankcard portfolio, generating a pre-tax gain of $200,000.
The Company will continue to provide merchant bankcard services to
existing and future customers through a third party relationship,
with the Company earning fee income from new merchant bankcard
accounts without the associated operational overhead and exposure to
potential losses.
- - The net loss from real estate operations for the quarter ended March
31, 1998 was $312,000, compared to a net loss of $54,000 for the same
quarter the previous year. The increased losses from real estate
operations in the current fiscal year primarily resulted from
aggressive efforts to dispose of troubled assets acquired in
conjunction with the purchase of PSSB.
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- - Net gains on loans held for sale rose from $10,000 during the third
quarter of fiscal 1997 to $56,000 during the most recent quarter due
to an expansion in the Company's mortgage banking operation, combined
with increased customer demand for fixed rate mortgages given 30 year
interest rates in the 7% range.
- - During the quarter ended March 31, 1998, the Company recognized an
impairment writedown on a FNMA interest only strip security which was
acquired many years ago. This security is backed by relatively high
coupon mortgages, which have increased in prepayment speed in
conjunction with the lower general market interest rates applicable
to much of fiscal 1998. The Company's remaining investment in this
security at March 31, 1998 was $153,000.
Other income & expense for the nine months ended March 31, 1998
totaled $204,000 in expense, versus income of $807,000 during the same period
the prior fiscal year. In addition to those factors detailed above for the most
recent quarter, other key components of the change in fiscal year to date
results included:
- - Net gains on the sale of available for sale securities declined from
$1.0 million in fiscal 1997 to $62,000 during the current fiscal
year, as the Company sold a large volume of longer term, fixed rate
mortgage backed securities during the prior fiscal year in
conjunction with its interest rate risk management program and in
order to generate funds for reinvestment into loans and other more
interest rate sensitive assets.
- - Amortization of intangible assets totaled $1.8 million in fiscal
1998, versus $1.4 million the prior fiscal year, due to the timing of
the PSSB acquisition.
General & Administrative Expenses
General & administrative expenses for the quarter ended March 31,
1998 were $5.1 million, up 4.3% from $4.9 million for the same quarter the prior
fiscal year. A significant portion of this increase was caused by $172,000 in
employee related restructuring costs during the most recent quarter, as the
Company eliminated several upper level management positions, hired a new Chief
Credit Officer, and moved to strengthen both sales and operations effectiveness
by restructuring or turning over a number of other positions.
General & administrative expenses for the nine months ended March 31,
1998 totaled $14.5 million, up slightly from $14.4 million during the same
period the previous year. The latter figure does not include the $4.8 million
pre-tax charge for the FDIC assessment to recapitalize the SAIF. With that
charge included, the Company's general & administrative expenses for the nine
months ended March 31, 1997 were $19.1 million. General & administrative
expenses for the nine month period in the current fiscal year include the impact
of the PSSB acquisition throughout the period, while prior fiscal year to date
figures include only about six months of the operating costs associated with
four additional full service branches, a significantly increased deposit
portfolio, and an expanded lending territory. General & administrative expenses
during the nine months ended March 31, 1997 included certain non-recurring costs
associated with the integration of PSSB, including check printing expenses and
various costs for services provided by outside professionals and vendors.
The ratio of general & administrative expenses to average assets
declined from 1.97% during the quarter ended March 31, 1997 to 1.90% during the
most recent three months. This improvement was also reflected in the Company's
efficiency ratio, which declined from 87.79% for the third quarter of fiscal
1997 to 79.94% for the same period in fiscal 1998. When comparing the Company's
efficiency ratio to industry averages or peer financial institutions, it is
important to isolate the unfavorable effects of the active and terminated
interest rate swaps, net losses from real estate operations, and the
amortization of intangible assets, as these factors do not directly reflect upon
the effectiveness of the core banking operation. Excluding the aforementioned
three factors, the Company's efficiency ratio during the most recent quarter was
64.37%.
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During the current fiscal year, the Company has implemented a broad
series of initiatives targeted at improving productivity and lowering its
efficiency ratio while still providing the caliber of customer service which
differentiates community banks from large money center or super regional
institutions. Such initiatives executed during the most recent three months
included:
- - The reduction of excess real estate through the consolidation of
operating departments and the sub-lease or sale of vacated space. At
March 31, 1998, the Company was under contract to sell one of its
administrative buildings at a nominal gain, with such sale projected
to decrease ongoing operating expenses.
- - A significantly enhanced program for the sale of alternative
investment products (non-FDIC insured) was implemented. The Company
now offers a broader range of fixed annuities, mutual funds, and
variable annuities to its customers.
- - The Bank made greater use of its enhanced ACH origination capability,
replacing paper checks and other manual processes with far more
efficient automated transactions.
- - Foreign banknote exchange services were introduced at all 19 branch
locations, with the intention to target market to the many foreign
"snowbirds" who spend each winter in the Company's market areas.
- - The Company processed its first loan payments via lockbox services.
The future expansion of this program should both reduce operating
costs and minimize lost float.
- - Transit settlement operations and overnight investment programs were
fine-tuned to maximize the amount interest income realized in
conjunction with the Company's role as a payment processor.
- - Branch staffing levels were adjusted to better correlate employee
availability with peaks in customer activity, thereby reducing
overall cost while augmenting customer service.
Management is continuing to pursue multiple avenues for further
improving the Company's long term efficiency ratio, with several additional
initiatives slated for introduction and / or expansion during the fourth quarter
of fiscal 1998. These initiatives address both bolstering revenues from client
services and reducing operating expenses, particularly fixed operating costs and
those associated with administrative functions. The Company is also
investigating a series of future product and service delivery options, from
different types of physical facilities to various electronic alternatives. As
presented in the Company's May 7, 1998 press release, the implementation of
certain of these strategic initiatives is likely to generate up front costs.
Moreover, in conjunction with the initiatives described above, and
the development of a more robust sales organization, the Company is experiencing
increases in certain operating costs, including those associated with
establishing the staffing, physical plant, and technology foundations for
expanded volume and new product delivery. There can be no assurances regarding
the range of additional initiatives which might be implemented, the degree of
success to be realized from such initiatives, or the future trends in the
Company's operating costs and efficiency ratio.
Income Taxes
Income tax expense decreased from $312,000 during the quarter ended
March 31, 1997 to a benefit of $327,000 for the most recent three months due to
changes in pre-tax income. Fiscal 1998 year to date income tax expense totaled
$544,000, versus a benefit of $834,000 during the nine months ended March 31,
1997, also due to changes in pre-tax income. The Company's nominal tax rates
remained substantially unchanged between current and prior fiscal year.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
For a discussion of the nature and extent of market risk exposures,
see "Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations - Interest Rate Risk Management and Exposure".
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PART II - OTHER INFORMATION
Item 1. Legal Proceedings
The Company is not involved in any material pending legal proceedings
other than routine legal proceedings occurring in the ordinary course
of business. Such other routine legal proceedings in the aggregate
are believed by management to be immaterial to the Company's
financial condition or results of operations.
Item 2. Changes in Securities
None.
Item 3. Defaults Upon Senior Securities
Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
Not applicable.
Item 6. Exhibits and Reports on Form 8-K
A. Exhibits
(27) Financial Data Schedule
B. Reports on Form 8-K
The Company filed no reports on Form 8-K during the quarter
ended March 31, 1998.
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SIGNATURES
Pursuant to the requirements of The Securities
Exchange Act Of 1934, the registrant has duly
caused this report to be signed on its behalf by
the undersigned thereunto duly authorized.
HF BANCORP INC.
(Registrant)
Date: May 12, 1998 By: /s/ Richard S. Cupp
--------------------
Richard S. Cupp
President
Chief Executive Officer
Date: May 12, 1998 By: /s/ Mark R. Andino
-------------------
Mark R. Andino
Vice President
Treasurer
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